Collateralized debt obligations (CDOs), the bad boys of the financial crisis of 2008, are coming back. CDOs are securities that hold different types of debt, such as mortgage-backed securities and corporate bonds, which are then sliced into varying levels of risk and sold to investors. With the Federal Reserve committed to keeping interest rates low, investors such as pension funds seeking higher returns are driving demand once again for these structured securities, which are riskier but provide more bang for the buck than safer bets such as Treasuries and investment-grade corporate bonds.
After those dark days, CDOs were largely abandoned as too complex and too risky, but they're beginning to make a return and it will be hard for the major banks to resist getting back into them. According to Bloomberg, sales of CDOs linked to everything from hotels to offices and shopping malls are poised to climb to as much as US $10 bn this year, about 10 times the level of 2012. The driving force behind this financial regurgitation is the search for yield.
But the environment is far different today for CDOs than in the years leading up to what was dubbed the "Great Recession," the worst financial downturn since the Great Depression. For starters, the market for synthetic CDOs is still tiny, and most investors want nothing to do with them. CDOs may be coming back, but investors are looking for a different type of debt. They want commercial, instead of non-agency residential mortgage-backed securities (CMBS). CMBSs hold the real estate debt of shopping malls, apartment buildings and other businesses, which did not suffer the same degree of downturn in the crisis as residential properties.
Plus not only are lenders far more cautious, regulators seem to be waking up, capital requirements are tightening and investors also have learned their lesson. The hope now is that there are going to be smarter and more informed buyers out there.