Asset-Backed Security – ABS vs. Collateralized Debt Obligation – CDO

Asset-backed security (ABS) is a type of investment that is backed by a pool of debt, such as auto loans or home equity loans. A collateralized debt obligation (CDO) is a version of an ABS that may include mortgages as well as other types of assets.

In either case, the owner of such a product makes money, directly or indirectly, from the repayment of principal and interest by the pool of consumers whose loans have been packaged to create that security.

The ABS evolved from mortgage-backed securities (MBS), which were first introduced in the 1980s. An MBS is comprised of mortgages that are sold by the banking institutions that issued them. An investment bank or other financial institution will buy these debts and repackage them, after sorting them into categories such as residential or commercial. Each package becomes an MBS that can be purchased by investors.

The ABS is, similarly, a pool of assets, but the pool consists of any debt other than mortgages. It might be made up of credit card debt, outstanding auto loans, student loans, or any other debts.

In either case, the investor in an MBS or an ABS earns money, directly or indirectly, as the borrowers repay the interest and principal on the loans.

A CDO is an ABS issued by a special purpose vehicle (SPV). The SPV is a business entity or trust formed specifically to issue that collateralized debt obligation. The underlying debt will sometimes further classify a CDO.

• Collateralized loan obligations (CLOs) are CDOs made up of bank loans.
• Collateralized bond obligations (CBOs) are composed of bonds or other CDOs.
• Structured finance-backed CDOs have underlying assets of ABS, residential or commercial MBS, or real estate investment trust (REIT) debt. 
• Cash CDOs are backed by cash-market debt instruments, while other credit derivatives support synthetic CDOs.

Further, a collateralized mortgage obligation (CMO) is a complex type of MBS. Unlike a CDO, a CMO is based on MBS only. That means it can be hit particularly hard by interest rate changes, prepayments of debt, and mortgage credit risks.

CDOs and CMOs are both targeted at institutional investors, not individuals.

In a CMO, interest rate and principal payments may be broken down into various classes of securities, depending on the riskiness of the mortgages.

In a CDO, however, instruments with various degrees of credit quality and rates of return are grouped into at least three batches, called tranches, each with the same maturity level. The equity tranches pay the highest yield but carry the lowest credit ratings. The senior tranches provide the best credit quality but the lowest yield. The mezzanine tranches fall somewhere between the equity and senior tranches in terms of credit quality and yield.

The subject of mortgage-backed securities and collateralized debt obligations cannot come up without reference to the financial crisis of 2008, which was largely caused by the collapsing value of mortgage-backed securities backed by subprime mortgages.

The bubble in home prices was fed by subprime lending. Those subprime mortgages were packaged and sold on, to be repackaged and resold to institutions. As the bubble began deflating, homeowners were forced into default, and the securities that derived an income from the repayment of those loans plummeted in value.

The financial crisis eventually dissipated, and by 2011 the mortgage-backed securities market had returned to something like normalcy.

• An ABS is a type of investment that offers returns based on the repayment of debt owed by a pool of consumers.
• A CDO a version of an ABS that may include mortgage debt as well as other types of debt.
• These types of investments are marketed mainly to institutions, not to individual investors.