page_title: Collateralized debt obligation
section_title: Subprime mortgage boom
hierarchical_section_title: Collateralized debt obligation / Market history / Subprime mortgage boom
caption_attribution_description: English: How the volume of CDOs issued globally crashed in the subprime crisis but has recovered somewhat. Data is from Securities Industry and Financial Markets Association. SIFMA, Statistics, Structured Finance, Global CDO Issuance and Outstanding (xls). http://www.sifma.org/research/statistics.aspx
context_page_description: A collateralized debt obligation is a type of structured asset-backed security. Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities. Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default derived from ratings on those bonds or assets.
  The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk.
context_section_description: In 2005, as the CDO market continued to grow, subprime mortgages began to replace the diversified consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the collateral in CDOs. According to the Financial Crisis Inquiry Report, "the CDO became the engine that powered the mortgage supply chain", promoting an increase in demand for mortgage-backed securities without which lenders would have "had less reason to push so hard to make" non-prime loans. CDOs not only bought crucial tranches of subprime mortgage-backed securities, they provided cash for the initial funding of the securities. Between 2003 and 2007, Wall Street issued almost $700 billion in CDOs that included mortgage-backed securities as collateral. Despite this loss of diversification, CDO tranches were given the same proportion of high ratings by rating agencies on the grounds that mortgages were diversified by region and so "uncorrelated"—though those ratings were lowered after mortgage holders began to default.
  The rise of "ratings arbitrage"—i.e., pooling low-rated tranches to make CDOs—helped push sales of CDOs to about $500 billion in 2006, with a global CDO market of over US$1.5 trillion. CDO was the fastest-growing sector of the structured finance market between 2003 and 2006; the number of CDO tranches issued in 2006 (9,278) was almost twice the number of tranches issued in 2005 (4,706).
  CDOs, like mortgage-backed securities, were financed with debt, enhancing their profits but also enhancing losses if the market reversed course.
caption: The volume of CDOs issued globally crashed during the subprime crisis but has recovered slightly. (source: SIFMA, Statistics, Structured Finance[38]
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