CDOs are group loans that can sometimes be a mess

Secured debt securities nearly crippled the global economy in 2008

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Secured Debt Securities (CDOs) are a financial tool used by banks to repackage individual loans and resell them to investors in the secondary market.

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This type of tool is known as a “derivative” because its value derives from the underlying assets, which can range from auto loans to credit cards and from business debt to mortgages.

Their popularity south of the border means that while not as common in Canada, the Canadian economy still felt their impact, especially during the 2008 financial crisis that CDOs helped create.

How these investments work

Secured debt securities are a collection of secured debts, this is where the “secured” part comes in. With secured debts, borrowers are required to put up an asset as collateral. If they are lacking, this asset can be seized.

They are generally supported by institutional investors such as pension funds, insurance companies, banks, investment managers and other financial institutions.

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Different types of CDOs may be known by different names, depending on the type of loans put up in the CDO. For example, a mortgage CDO is known as a “mortgage backed security” (MBS), while other debt collections like credit cards, student loans, and business debts are called “Asset backed securities”.

The advantage of CDOs is that when the economy is strong, these high risk investments can generate better returns than other fixed income products in their portfolio. For institutional investors like pension funds, insurance companies and hedge funds, this translates into higher profits.

Since CDOs are not tangible assets, their value is determined by a computer model. As these have become more complex, so has the risk assessment.

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To mitigate this for slightly more conservative investors, CDOs are divided into risk levels, or tranches. CDOs are placed in these tranches by credit rating agencies, which assign a credit rating to it.

If a loan were to default, the senior tranches (with the highest credit ratings) would be repaid in priority over the subordinated tranches. But they also receive a lower coupon rate compared to junior tranches with lower credit ratings.

Where you might know CDOs

CDOs are a riskier investment than your standard portfolio of stocks and bonds because there is always the possibility that some borrowers will default on their loans – and when they do, the results can be dramatic.

The collapse of mortgage-backed securities in the United States, caused by overly optimistic ratings of MBSs by rating agencies, led to the financial crisis of 2008. This brought CDOs out of favor.

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American banks were selling houses to people who realistically could not afford them. So when house prices fell from 2006, many of these people defaulted on their loans.

For banks and institutional investors who held mortgage-backed securities, this was a huge problem. The situation only started to improve in the United States when the Federal Reserve stepped in and bought these CDOs.

Yes, Canada has its own mortgage-backed securities, but they are very different from the ones that brought the US real estate market to its knees. The Canadian TH program is administered by the Canada Mortgage and Housing Corporation and did not collapse during the financial crisis.

Canada avoided the worst

As the initial crisis began in the United States, its implications were felt around the world.

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from Canada Bank Act prevented Canadian banks from making the same risky investments as lenders in the United States, but that did not prevent the effects of the American recession from being felt north of the 49th parallel.

In part because CDOs were less common in this country, no Canadian financial institution went bankrupt, and the country’s recession was relatively mild compared to other downturns decades before.

Although they offer the possibility of great rewards, the history of CDOs shows that you need to be careful when risking large sums of money in the debt markets.

This article provides information only and should not be construed as advice. It is provided without warranty of any kind.

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