The bank was well known for both its junk bond business and employed Michael Milken, who played a significant role in developing the junk bond market and later was jailed for violating securities laws.
The first collateralized debt obligations were created by Drexel Burnham Lambert during the 1980s, when Wall Street was booming. Were CDOs responsible for the global financial crisis? Note: CDOs are divided into tranches, each of which reflects its level of risk. As with any fixed-income security, the safest tranche will bear the lowest coupon rate, while the junior debt will have a higher coupon rate since it carries the greatest risk of default. In the case of default, mezzanine is paid before the subordinated (junior) tranches. Mezzanine tranches are rated from B to BBB. The mezzanine tranche comes between the senior and subordinated debt. Payment continues according to the tranches' credit ratings, with the lowest-rated tranche the last to be paid. If the loan should default, the holders of the senior tranche are first in line to be paid from the underlying collateral. Senior tranches are the least risky, with investment-grade credit ratings and a lower chance of default.
Most CDOs mature at ten years.ĬDOs are divided into tranches, each of which reflects a different level of risk. The investor receives interest at the stated coupon rate as well as the principal when the CDO reaches maturity. However, these cash flows are dependent on the cash flows from the original borrower. The market for CDOs exists because these securities guarantee cash flows to the owner. Note: CDOs aren't available to retail investors and are typically sold to institutional investors in lots valued in the millions of dollars. CDOs aren't available to retail investors and are typically sold to institutional investors in lots valued in the millions of dollars. These investors often buy CDOs in the hope that they'll offer higher returns than their fixed-income portfolios of similar maturity. Rating agencies, like Standard & Poors and Moody's, assign credit ratings to the CDO.įinally, the CDO is sold to institutional investors such as pension funds, insurance companies, investment managers, and hedge funds. Once the CDO manager selects the debt to be pooled, the investment banks can get to work structuring the security. The CDO manager selects the debt to serve as collateral, which could be anything from mortgages, student loans and auto loans to credit card or corporate debt. Then it takes a number of professionals to get the security to market. As these are extremely complex instruments, it takes sophisticated computer modeling and a team of quantitative analysts to package the debt and value the bundles of loans that make up a CDO. Retail banks, commercial banks, and other financial institutions create CDOs to sell in the secondary market. The promised repayment of the underlying debt serves as collateral. The assets are pooled and packaged into a product that can be sold to investors as an income-producing asset. These assets could include commercial or residential mortgages, bonds, auto loans, student loans, and other types of debt. A collateralized debt obligation (CDO) is a type of security that derives its value from underlying assets.
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