Banking Terms—Collateralized Debt Obligation
Bankers do love their esoteric phrases. A collateralized debt obligation is a type of security that is backed by an underlying asset. If the underlying asset is a mortgage or a bundle of mortgages, it is known as a mortgage-backed security. If the underlying asset is a commercial loan, it is called asset-backed commercial paper. CDOs can also be created for auto loans, credit card debt, and really almost any variety of loan made by a financial institution. The “collateralized” in the name comes from the fact that there is an underlying asset (collateral) on which the security is based. This is unlike derivatives, which have no underlying asset and are in fact just a bet that conditions will change in a specific way.
The problem with assessing the value of a CDO lies in truly knowing the value of the underlying asset. How much is a $1 million dollar mortgage worth? How much is it worth if there is no possible way the homeowner will actually be able to make the payments? The people buying and selling CDOs often do not fully understand the value of the underlying asset. Often there is no way for them to find out. As long as nearly every homeowner, car owner, credit card holder, and business with an outstanding loan makes payments in full and on time, everything is just peachy. When a few entities default, there are some losses but the system absorbs them. When default becomes widespread, which began to happen in 2007, a lot of organizations found themselves holding supposedly safe investments that suddenly had little value.
CDOs serve to spread risk, which theoretically should provide some degree of security. In the event of a disaster in the loan market, which hit worldwide in 2008, investors found that the risk had been spread for sure. Nearly everybody lost and lost big.
It then became more widely known that loan ratings do not mean a great deal. Many loans that were rated AAA did not deserve that rating but the papers were peddled back and forth based on other banks acceptance of the rating. It is remarkable that so many otherwise smart people in the banking and investment community could have been so stupid.