First CDO was introduced by Drexel Burnham Lambert Inc. in 1987. After this, various financial firms issue CDO’s by forming portfolio of different kind of loans. During early 1990’s, it became very popular as it was giving returns which were higher than corporate bonds by 2-3 %. Another factor which contributed to its popularity was that CDO’s at that time were diversified. For example, it includes everything from an aircraft equipment debt to credit card loan. Due to this, diversification the risk level of these CDO’s was very low.
During the period of 2001-2003, consumers’ confidence in market was low due to slower economy and events of 9/11. Due to lower spending capacity of the consumer, there was economic uncertainty in the USA. This resulted in reduction in volume of business of companies and unemployment.
This was a period of popularity and growth for CDO’s. During early 2003, the spending of the customers increases due to lower interest rates. Consumers take advantages of attractive deals presented by mortgage lenders and finance companies like FMCC and GMAC. Due to attractive deals presented by mortgage lenders, there was a vital increase in sale of homes and it’s financing. Investment banks and finance companies started to repackage these loans and sell them to investors. This resulted into a structure pattern; demand for loans was high and brokers were finding these borrowers in exchange for fixed pre-determined fees. After that, the lender i.e. banks would repackage these loans and sell them to investors. The mortgage deal that became very popular during this period was 30-year adjustable rate mortgage which had negative impact on economy.
Popularity of the CDO’s was increased from 2001 to 2003 mainly because of the increase in home sales and lower interest rates on mortgage. During early 2007, mortgage rates started to reset and drop down that resulted in default in payment of interest and installments. These defaults forced the banks to stricken their lending procedures that resulted in difficulty in procurement of loan by business organization. Effect of this resulted in bankruptcies (Shiller, 2012).
Operating mechanism of CDO has been explained with the help of stepwise example-
Let us assume that there is a commercial bank named A which approved various kinds of mortgage loans such as car loan, home loan, credit card loan, etc. Now A (commercial bank) will sell this loan to B which is an investment bank.
Now investment bank ‘B’ will form a portfolio of say $50000 different mortgage loans. This portfolio will be repackaged into a financial instrument called COD.
These COD’s will be sold by B to investors which may be investment fund, finance bank, retirement fund, etc.
The income received by A (Commercial bank) in form of interest and principle will be transferred to investors. In case of default, the risk will be transferred to these investors. The degree of risk can be analyzed by an investor with the help of their debt rating assigned by credit rating agencies.
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