Collateralized Debt Obligation - Market History and Growth

Market History and Growth

The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for Imperial Savings Association, a savings institution that later became insolvent and was taken over by the Resolution Trust Corporation on June 22, 1990. A decade later, CDOs emerged as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles.

CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds with the same credit rating. Economist Mark Zandi of Moody's Analytics wrote that various factors had kept interest rates low globally in the years CDO volume grew, because of fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the U.S. trade deficit. This made U.S. CDOs backed by mortgages a relatively more attractive investment versus, say, U.S. treasury bonds or other low-yielding, safe investments. This search for yield by global investors caused many to purchase CDOs, trusting the credit rating, without fully understanding the risks.

CDO issuance grew from an estimated $20 billion in Q1 2004 to its peak of over $180 billion by Q1 2007, then declined back under $20 billion by Q1 2008. Further, the credit quality of CDOs declined from 2000–2007, as the level of subprime and other non-prime mortgage debt increased from 5% to 36% of CDO assets; yet the credit ratings of the CDOs did not change. In addition, financial innovations such as credit default swaps and synthetic CDOs enabled speculation on CDOs. This dramatically increased the amount of money that moved among market participants. In effect, multiple insurance policies or wagers could be stacked on the same CDO. If the CDO did not perform per contractual requirements, one counterparty (typically a large investment bank or hedge fund) had to pay another. Michael Lewis referred to this speculation as part of the "Doomsday Machine" that contributed to the failure of major banking institutions and smaller hedge funds, at the core of the subprime mortgage crisis. There are allegations that at least one hedge fund encouraged the creation of poor quality CDOs so bets could be made against them.

Willingness to create CDOs and sell them to investors may also reflect the greater profit margins that CDOs provide to their originators, such as major investment banks and other participants in the shadow banking system, as well as in the traditional depository banking system. Investment banking and credit rating agency profits increased dramatically in the years leading up to the crisis. From 2000-2006, structured finance (which includes CDOs) accounted for 40% of the revenues of the credit rating agencies. During that time, one major rating agency had its stock increase sixfold and its earnings grew by 900%.

Further, depository banks used CDOs as a form of securitization, meaning that the bank did not have to hold the loans it originated on its books and could transfer them (along with related risk) to investors. This in turn enabled the banks to lend again, remaining in compliance with capital requirement laws and generating additional origination fees.

Another factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs.

In late 2005 research firm Celent estimated the size of the global CDO market at USD 1.5 trillion and projected that the market would grow to nearly USD 2 trillion by the end of 2006. Synthetic CDOs also expanded under the tenure of Federal Reserve chairman, Alan Greenspan who later expounded on the previously unrecognized risk of these devices in his testimony to a Congressional investigative committee on April 7, 2010.