CDO Market

By: EconomyWatch Content   Date: 30 January 2010

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Collateralized debt obligations enable the creation fixed income securities from a diverse pool of debt instruments, such as loans and corporate bonds, having varying yields and risks. Due to this inherent nature of collateralized debt obligations, the CDO market is a relatively stable segment of the overall financial and credit market. 

Nature of the CDO Market

The CDO market is difficult to map and quantify because of its diverse, heterogeneous and fragmented nature. In fact, a sizeable portion of the market comprises of unrated private deals. The CDO market is, nonetheless, expanding as these instruments facilitate the significant dispersion of risk in the banking and financial sector. This, in turn, enables to attain overall financial stability.

 

While the CDO market is perceived to be completely risk averse; investors must bear in mind that the instruments in a CDO are subject to specific risks. For instance, a CDO constructed with loans will be influenced by the prevalent market interest rates. Consequently, strain in one segment of the credit market is likely to spill over to the CDO market as well. Besides, the limited transparency and liquidity of CDO markets may exacerbate the overall financial system, leading to sharp price swings. This risk, which is often latent, must be correctly understood and properly managed by investors to avoid high potential losses.

 

History and Growth of the CDO Market

Collateralized debt obligations were first issued in 1987 by bankers at Drexel Burnham Lambert Incorporation for the Imperial Savings Association. The CDO market emerged a decade later as the fastest-growing segment of the asset-backed securities market. This growth is evident from the fact that an increasing number of debt originators, from insurance and mutual fund companies to unit trusts and commercial banks, deal in CDOs.

 

Even investors are steadily venturing into the CDO market as collateralized securities offer higher returns than other securities, such as bonds, with the same credit rating. In fact, according to a report by JP Morgan, the cash flow in the CDO market surpassed $100 billion globally, of which 75% originated in the US, 20% in Europe and 5% in Asia. By late 2005, this figure reached $ 1.5 trillion according to reports by Celent, a global research firm.

 

 

 


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