Collateralized Debt Obligation

A Collateralized Debt Obligation (CDO) is a type of structured asset-backed security in which a pool of debt instruments — such as corporate bonds, leveraged loans, mortgage-backed securities, or other receivables — is held by a special purpose vehicle (SPV) that issues new securities backed by the cash flows from that pool. The issued securities are divided into tranches ranked by seniority: senior tranches are paid first and historically carried the highest credit ratings, while mezzanine and equity tranches absorb losses first in exchange for higher yields.

CDOs emerged in the late 1980s, with Drexel Burnham Lambert often credited with an early issuance in 1987, and expanded rapidly in the 2000s. Variants include:

• Cash CDOs, backed by actual debt instruments.
• Synthetic CDOs, which gain exposure through credit default swaps rather than owning the underlying assets.
• CDO-squared, whose collateral consists of tranches of other CDOs.
• CLOs (Collateralized Loan Obligations), a subset backed primarily by corporate leveraged loans.

CDOs played a central role in the 2007–2008 global financial crisis. Mortgage-backed CDOs containing subprime US home loans were widely issued and assigned high ratings by agencies including Moody's, S&P, and Fitch. When US house prices fell and subprime borrowers defaulted, senior tranches once rated AAA suffered severe losses, contributing to the collapse of Bear Stearns (March 2008) and Lehman Brothers (September 2008) and to large write-downs at AIG, Citigroup, Merrill Lynch, and UBS. The US Securities and Exchange Commission's 2010 settlement with Goldman Sachs over the Abacus 2007-AC1 synthetic CDO highlighted conflicts of interest in their structuring.

Post-crisis reforms — notably the Dodd-Frank Act (2010) in the United States and Basel III capital rules — imposed risk-retention requirements, stricter disclosure, and higher capital charges on securitization exposures, though CLOs and other CDO variants remain actively issued.