A CDO – or collateralized debt obligation – groups together various debt obligations such as mortgages and loans. These pooled cash-flowing assets are then structured into tranches with varying risk profiles and re-sold to investors as bonds.
In the commercial real estate business CDOs are also known as CRE CDOs (commercial real estate collateralized debt obligations) or CLOs (collateralized loan obligations).
How are CDOs created?
Creating a collateralized debt obligation is more complicated than a two-party transaction such as a bank making a loan to a borrower to purchase an office building or a tenant signing a long-term lease with a landlord. That’s because as many as six parties can be involved in creating a CDO:
- Lenders create mortgages with borrowers and then sell the debt
- Securities firms review the credit quality of the debt collateral, package various notes together, and re-structure them into tranches with different levels of risk and yield
- Ratings agencies assign CDOs credit ratings, as they do when rating bonds
- CDO managers manage the portfolio of collateralized debt obligations
- Financial guarantors offer prospective purchasers of CDOs insurance against potential losses in exchange for insurance premium payments
- Institutional investors such as pension funds and hedge funds seeking to boost risk-adjusted yields purchase CDOs
What is the difference between a CDO and a CMBS?
A commercial mortgage-backed security, or CMBS, is created when commercial real estate mortgages are pooled together. A collateralized debt obligation, or CDO, can be backed by any type of debt including commercial real estate-backed mortgages, bonds, and private loans.
Both types of securities are designed for institutional investors. Because CMBSs are backed by mortgages they can be affected by changes in interest rate, borrower prepayments, and credit risks in the mortgage market. CDOs attempt to manage risk by grouping the underlying debt instruments into different classes or tranches, from best quality and lowest yield to lower quality and higher yield.
Top advantages of CDOs
CDOs boost job creation and grow real estate markets by giving lenders more liquidity. Lenders benefit from CDOs in three ways:
- Selling mortgage backed loans generates more cash for a bank to make more loans
- Default risk from the loan is transferred from the bank to investors
- CDOs provide banks with another profitable product to sell to large investors
It’s not only lenders who benefit from CDOs. Thousands of white collar jobs are created on Wall Street and in other global financial centers to write and manage the sophisticated computer programs that create CDOs. More jobs are then created when sales people are hired to market these financial products to investors.
This job growth combined with the liquidity that CDOs add to the economy also helps keep the housing and commercial real estate markets strong.
Major disadvantages of collateralized debt obligations
But too much liquidity, combined with the way CDOs are structured, can also create problems. There are four major disadvantages to collateralized debt obligations:
- Too much liquidity can create real estate asset bubbles. Too much capital chasing too few deals causes real estate prices to rise and cap rates to compress.
- Debt – in the form of mortgage, credit card, auto, and student loans – also grows quickly when too much money is in the market and interest rates are low.
- Transfer of risk when banks sell CDOs to investors can encourage lax lending standards since banks are no longer affected if the loan defaults.
- CDOs can be complicated. The computer models that CDOs are based on make assumptions about asset prices, interest rates, and borrower credit worthiness that may not be true in the long run.
In 2006 the U.S. real estate market began its down cycle. Rightly or wrongly, lax lending standards and the complexity of CDOs were widely blamed for making a declining market worse and for contributing to the global financial crisis.
Recent growth of CDOs in the U.S.
Today CDOs are also known as CLOs, or collateralized loan obligations. It’s the same financial product with a different name. Over the last few years, issuance of CDOs and CLOs has been booming.
In 2016 $2 billion in new commercial real estate CDOs/CLOs were issued, followed by $7.5 billion in 2017. Over the past 12 months Blackstone Mortgage Trust issued $1 billion and mortgage REIT TPG Real Estate Finance Trust issued just over $932 million.
Both Deutsche Bank and Morgan Stanley predict that about $110 billion in CDOs will be issued in 2018, with commercial real estate CDOs making up about $11 billion of the total issuance.