Collateralized Debt Obligations (CDOs) have been described as asset-backed securities on steroids, since they take the concept of bundling together loans into larger packages and add a further layer of complexity by re-selling the debt in separate chunks, which have different levels of perceived riskiness.
Typically, a bank or other financial institution bundles together higher and lower risk loans and sell this package to a Special Purpose Vehicle (SPV), a company that it created specifically for this purpose. In the case of banks, this allows them to shift debt from their balance sheets, enabling them to lend more, take greater risks (and circumvent the Basel II regulations).
The SPV buys the debt by issuing bonds, which entitle investors to interest payments. If this debt were re-sold as a single package, it would be rated high risk and have a low credit rating, limiting the range of potential buyers (since many institutional investors have rules stating that they cannot invest in such products). This problem is overcome by structuring the loans into ‘tranches’: ‘junior’ (the highest risk), mezzanine and the supposedly lower risk ‘senior’ tranche. This financial magic trick allowed packages containing high risk loans (such as ‘sub prime’ lending) to be re-branded as ‘safe’. But it is not immediately obvious to the rating agencies responsible for assessing the risk of the different packages what is contained within them.
CDOs were at the heart of the 2008 financial crisis. By magically transforming risky assets into supposedly safe ones, they fueled a bubble that saw the CDO market grow to a value of $2 trillion in 2007 before collapsing.
A number of proposals for climate bonds and forest bonds suggest that they could be structured as CDOs.