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What is Collateralized Debt Obligation?

Definition of Collateralized Debt Obligation

Collateralized Debt Obligation is a general term used to describe is a general term used to describe asecurity that comprises a number of initially separate securities backed by tangible assets that are bundled together to achieve a higher credit rating and thus a higher price than the lower credit-rated parts could be sold for. Developed by U.S. investment firm Drexel Burnham Lambert (under the then investment guru, Michael Milken) for the corporate debt market, CDOs initially involved loans for lower rated corporate and for emerging market entities, which, Milken had established, were much likelier to repay their loans than their 'junk' credit rating status implied. Essentially, in the early 2000s, these provided investors with a stream of higher-interest payments at regular intervals than could be gained by investment in higher rated bonds. Later on, in the mid 2000s, the market grew exponentially and came to be dominated by mortgages and mortgage-backed securities markets, a large portion of which were based on mortgages to individuals who were not easily able to repay them. When the U.S. raised interest rates, many of these mortgages went unpaid, in turn causing banks to seize the underlying assets (property), in turn causing property prices to plummet, in turn causing the prices of CDOs to spiral downward. The sheer size of the CDO market, and the fact that they were held by so many banks around the world, meant that the capital base of the globe's financial institutions became imperilled, causing a lack of confidence in the world interbank money markets, which ultimately led to the onset of the global financial crisis in 2007/08.
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