Securitisation: Introduction to Collateral Debt Obligations (CDOs)

Costas Andreou
Feb 23, 2019 · 4 min read


A CDO is a securitised product that allows investors to gain exposure to an underlying, diversified pool of assets (debt instruments). CDOs is a very broad category that include many other more granular products.

For instance, if the underlying assets that make up the CDO are loans, then the CDO would be known as a Collateralised Loan Obligation (CLO); if it were mortgages, then it would be known as a Mortgage Backed Security (MBS).

CDOs follow the same set up that we have previously seen in the series with the issuer of the CDO setting up a special purpose vehicle (SPV) and a portfolio manager tasked to identify the underlying securities.

CDOs come in many flavours and they can address different investor needs. They can be made up of multiple tranches, allowing investors to vary their risk-return profiles in what is known as a ‘Waterfall Cash Flow Structure’, or they can be Single Tranche.

Types of CDOs

CDOs are often split into two groups: Cash and Synthetic.

Cash CDOs are made up by actual assets, such as bonds, loans, etc. whereas Synthetic CDOs are made up by other derivative products (such as Credit Default Swaps (CDSes), Options, etc).

Note: Credit Default Swaps is a derivative product that offers insurance against credit events (think Default).

Synthetic CDOs have gotten a bad rap following their role in the financial crisis. Their complex structure and nature meant that from a single, isolated pool of assets there could be a significant number of contracts that depent on them, making it difficult to assess the total number of people or money betting on them.

Insurance Contracts on MBS Tranches being Securitised and turned into a Synthetic CDO

Take for example a Synthetic CDO that gives you exposure to a pool of CDSes. The payoff of the CDO, depends on the underlying CDSes, which in turn depend on the credit quality of the thing they insure; potentially mortgages, loans, bonds or tranches of other CDOs (which in turn would depend on the underlying pool or asset). As you can probably already see, things get more and more complicated at each level and it can be difficult for investors to know exactly what they have exposure on. A single pool of mortgages, worth 1 million GBP, could have over 1 Billion GBP betting on it due to the nature of these instruments.

Why create CDOs in the first place?

Every other article written after 2008 in regards to CDOs or Securitisation will one way or another criticise these products and the banks that put them together. Before we jump on that bandwagon, it is important to understand the primary reasons behind the introduction of these products and the problems they solved.

Let us first begin with Securitisation. Securitisation of Mortgages was first imagined in order to solve a very real problem that banks were facing. Every single mortgage that banks underwrote had to be held on the bank’s balance sheet, limiting the bank’s ability to extend any further credit. As banks begun moving their mortgages off the balance sheet into a SPV and selling off CDO/MBS securities, they were able to continue to serve the public by extending more mortgages as the risk of the mortgages was taken up by investors.

Then came along a special class of investors (such as Pension Funds), that were restricted by regulation as to the riskiness of the investments they could make. They could only invest in instruments that were deemed of highest quality; instruments that were rated as AAA. Investing in individual debt instruments posed a number of difficulties. For one, individual debt instruments they were of insignificant size to the huge investments Pension Funds look to make and then most of them (loans, mortgages, etc) are not rated. CDOs solved that problem, as by introducing Waterfall Cash Flow Structures meant that the most secure Tranches were rated AAA and Pension Funds could now get exposure to these instruments.

More to the above, CDOs allow banks to repackage lower rated tranches of other Asset Backed Securities (ABS) and come up with new AAA rated debt instruments. That is because the Waterfall payment structure implies that a very large percentage of the underlying loans will need to default before the senior tranches are affected.

The same logic applied in reverse with more risky investment firms, such as Hedge funds, looking to invest in more risky instruments for a higher pay-out.

B rated CDO Tranches repackaged to give a new CDO which has Tranches rated higher than B

So how do banks make money out of these?

CDOs enable banks to make money in a number of ways.

Firstly, by moving loans off the balance sheet and into a SPV, the banks can continue issuing more loans. More loans equal more fees. Then there’s the CDO charges for setting up the SPV and paying the CDO manager.

Finally, there are arbitrage opportunities (mismatches in the prices) between the underlying loans and the actual CDOs tranches. As the different CDO tranches get their ratings, investors are often willing to pay higher for the perceived safety.

All data and information provided on this blog post is for informational purposes only. The author makes no representations as to accuracy, completeness, correctness, suitability, or validity of any information on this site and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.

Any referenced links to internal or external website content are not owned by the blog post author and there is no affiliation. Use at your own discretion.


A publication dedicated in explaining all things finance…

Costas Andreou

Written by

Figuring out how the world works through sharing knowledge, techniques and code!


A publication dedicated in explaining all things finance, banking and financial technology simply.

More From Medium

More from FinanceExplained

More from FinanceExplained

More from FinanceExplained

Welcome to a place where words matter. On Medium, smart voices and original ideas take center stage - with no ads in sight. Watch
Follow all the topics you care about, and we’ll deliver the best stories for you to your homepage and inbox. Explore
Get unlimited access to the best stories on Medium — and support writers while you’re at it. Just $5/month. Upgrade