What are CDOs?
• Collateralized debt obligations (CDOs) are a
type of structured asset-backed security
(ABS) whose value and payments are derived
from a portfolio of fixed-income underlying
• CDOs are assigned different risk classes, or
tranches, whereby "senior" tranches are
considered the safest securities.
• Interest and principal payments are made in
order of seniority, so that junior tranches
offer higher coupon payments (and interest
rates) or lower prices to compensate for
additional default risk.
CDOs spread risk
• A few academics, analysts and investors
such as Warren Buffett and the IMF's
former chief economist Raghuram Rajan
warned that CDOs, other ABSs and other
derivatives spread risk and uncertainty
about the value of the underlying assets
more widely, rather than reduce risk
• With the advent of the 2007-2008 credit
crunch, this view has gained substantial
Value of CDOs
• Credit rating agencies failed to adequately
account for large risks (like a nationwide
collapse of housing values) when rating
CDOs and other ABSs.
• Many CDOs are valued on a mark to market
basis and thus have experienced
substantial write-downs on the balance
sheet as their market value has collapsed.
• The first CDO was issued in 1987 by bankers at now-
defunct Drexel Burnham Lambert Inc. for Imperial
Savings Association, a savings institution that later
became insolvent and was taken over by the
Resolution Trust Corporation on June 22, 1990.
• A decade later, CDOs emerged as the fastest
growing sector of the asset-backed synthetic
• CDOs offered returns that were sometimes 2-3
percentage points higher than corporate bonds with
the same credit rating.
• A major factor in the growth of CDOs was the 2001
introduction by David X. Li of Gaussian copula
models, which allowed for the rapid pricing of CDOs.
• In late 2005 research firm Celent
estimated the size of the global CDO
market at USD 1.5 trillion and projected
that the market would grow to nearly
USD 2 trillion by the end of 2006
• According to the Securities Industry and
Financial Markets Association, aggregate
global CDO issuance totaled
– US$ 157.4 billion in 2004,
– US$ 271.8 billion in 2005,
– US$ 520.6 billion in 2006,
– US$ 481.6 billion in 2007,
– US$ 61.8 billion in 2008.
• CDOs vary in structure and underlying
assets, but the basic principle is the same.
• Essentially a CDO is a corporate entity
constructed to hold assets as collateral
and to sell packages of cash flows to
• CDO is a financial structure that
repackages the cash flows from a set of
Constructing a CDO
A CDO is constructed as follows:
• A special purpose entity (SPE) acquires a portfolio
of underlying assets.
– Common underlying assets held include mortgage-backed
securities, commercial real estate bonds and corporate
• The SPE issues bonds (CDOs) in different
tranches and the proceeds are used to purchase
the portfolio of underlying assets.
– The senior CDOs are paid from the cash flows from the
underlying assets before the junior securities and equity
– Losses are first borne by the equity securities, next by
the junior securities, and finally by the senior securities.
Figure 1. Structure of a CDO.
B i : promised payment for bond i
Table 1. Pricing of CDO in Figure 1, assuming that bond
defaults are uncorrelated. Promised payoffs to the
bonds are $140 (senior), $90 (mezzanine), and $70
(subordinated). Each bond has a 10% risk-neutral
probability of default and has a 40% recovery rate. The
continuously compounded risk-free rate is 6%.
Table 2. Pricing of CDO in Figure 1, assuming that
bond defaults are perfectly correlated. Promised
payoffs to the bonds are $140 (senior), $90
(mezzanine), and $70 (subordinated). Each bond has a
10% risk-neutral probability of default and has a 40%
recovery rate. The continuously compounded risk-free
rate is 6%.
Table 3. Pricing of Nth to default bonds;
assumes the bonds owned as assets have
Table 4. Pricing of Nth to default bonds;
assumes the bonds owned as assets have
perfectly correlated defaults.