CDOs or Collateralized Debt Obligations are derivatives like call options, put options, future contracts, and seen as investments like stocks, bonds, or commodities.
A surety of repayment of loans is used as collateral.
To make a CDO, Securities firms create tranches of loans. Different tranches are made depending on the credit rating. A CDO represents this tranche.
Senior CDOs are made of loans with AAA rating (AAA ratings are given to loans which have good credit history and likely to be guaranteed repaid, thus are safest).
Mezzanine CDOs are made of loans with BBB rating (lower than AAA & AA rating) and Junior CDOs are made of loans with B rating.
Rating agencies like Moody's Investors Service, Standard & Poor's, and Fitch Ratings give ratings to the tranches.
Lower the rating higher the risk of loan defaults, so the returns. When loan defaults Senior CDOs are paid first then Mezzanine and then Junior CDOs are paid. That’s why banks offer higher return rates on Junior CDOs, to attract investors.
The tranche made of mortgage loans is called Mortgage-BackedAsset-Backed Securities (MBS) and the tranche made of corporate debt, auto loans, or credit card debt is called Asset Backed Securities (ABS).
You can't buy a CDO directly. They're purchased by insurance companies, banks, pension funds, investment managers, investment banks, and hedge funds.
By selling these CDOs, banks move their risk of default to investors and they receive more money to give loans.
In 2007 before the financial crisis CDO market was at a peak with more than 150 Billion USD investment. But went down till 2017 to about 60 Billion USD. And suddenly rose to about 80 Billion USD in 2018.
“Hedge funds and other investors are reviving a type of securitized product that blew up during the financial crisis. This time around they’re convinced that the structures will not only weather the next downturn, but might even profit from it.”
_On Bloomberg By Claire Boston May 2, 2019, 3:30 PM GMT+5:30