Collateralized Debt Obligation - Creation of CDOs

Creation of CDOs

CDO can be created as long as global investors are willing to provide the money to purchase the pool of bonds the CDO owns. CDO volume grew significantly between 2000–2006, then declined dramatically in the wake of the subprime mortgage crisis, which began in 2007. Many of the assets held by these CDOs had been subprime mortgage-backed bonds. Global investors began to stop funding CDOs in 2007, contributing to the collapse of certain structured investments held by major investment banks and the bankruptcy of several subprime lenders.

A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other asset-backed securities and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the subprime mortgage crisis in 2007, this view has gained substantial credibility. Credit rating agencies failed to account adequately for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs with the highest possible grade.

Many CDOs are marked to market and thus experienced substantial write-downs as their market value collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008 period.