The Nomad Economist
Premiered May 17, 2022
Arguably, the financial crisis was caused in large part by something called a collateralized debt obligation, or CDO.
The global financial meltdown, at the cost of over $20 trillion, resulted in millions of people losing their homes and jobs in the worst recession since the Great Depression, and nearly resulted in a global financial collapse.
This is the toxic financial product (i.e., CDO – Collateralized Debt Obligation). Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are different concepts with frequent overlap between them.
MBS are investments that are repackaged by small regional banks as a means of funding mortgages by reselling them as securities through investment markets. CDO investments are typically used for packaging many mortgages and other loan instruments together by risk level for investors.
Many MBS are also CDOs. After a small bank funds a mortgage, the mortgage is then packaged as an investment with real estate backing the security as collateral. A CDO (collateralized debt obligation) can be backed by any debt collateral, including mortgages, bonds, private loans, etc. Mortgage-Backed Security (MBS) is a type of CDO that is explicitly backed by a pool of mortgages.
A CDO (Collateralized Debt Obligation) is a type of bond that is sold almost exclusively to institutions. An ordinary Government or Corporate Bond is a loan made to a Government or Company. Terms of the bond determine when it needs to be paid back and at what interest rate. Most Bonds are backed by the authority of the government or the assets of the company.
A CDO is a loan to an artificial entity created specifically for the CDO. The CDO is backed by a portfolio of Loans or Mortgages pledged to it. The loans are purchased from the Original Lender. Lenders will frequently sell off discounted, performing loans to brokerage firms so that the Lenders can initiate new loans (and collect the fees that go with new loans). The terms and credit rating of each CDO is based on the rates and quality of the loans pledged to it.
Unlike ordinary Corporate Bonds, CDOs generally have pre-payment risk. That is, the people who took the underlying loans may pay them off early. Consequently, CDOs pay typically both principal and interest over the life of the bond. CDO’s containing mortgages were among the securities at the root of the 2008 Financial crises. CDOs are improperly given high credit ratings often defaulted, as did the securities used to insure against default.
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In the old system, when a homeowner paid their mortgage every month; the money went to their local lender. And since mortgages took decades to repay, lenders were careful. In the new system, lenders sold the mortgages to investment banks.
The investment banks combined thousands of mortgages and other loans, including car loans, student loans, and credit card debt, to create complex derivatives called collateralized debt obligations or CDOs.
The investment banks then sold the CDOs to investors. Now when homeowners paid their mortgages, the money went to investors all over the world.
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