CDS and CDOs Explained in Plain Language

Few abbreviations were quoted as often during the financial crisis as CDS and CDO. They sound technical, but the basic ideas are fairly simple. This article explains both without maths, so that references to them in discussions or in the Collapse! game are easier to follow.

Starting with a loan

When a bank lends money, it earns interest but takes the risk that the borrower will not repay. For decades banks kept most of their loans. Later, they began selling them to investors, which let them lend more because they could recycle their funds.

What is a CDO?

A collateralised debt obligation, or CDO, is a financial product created by pooling many debts, such as mortgages or corporate loans, and then slicing the combined income into layers called tranches. Investors in the top layers are paid first and so take less risk, while investors in lower layers are paid last, accept bigger losses if borrowers default, and usually receive a higher return.

The idea is that a diversified pool should behave more predictably than a single loan. The weakness appears when the borrowers in the pool are all affected by the same event, such as a nationwide fall in home prices. Then many loans may fail together, and the layers that appeared safe can lose value too. Some CDOs were also built from pieces of other securities, which made them very hard to understand.

What is a CDS?

A credit default swap, or CDS, works like an insurance-style contract. One party pays regular fees to another, and in return the second party agrees to pay out if a particular borrower or security defaults. A buyer might hold the debt and want protection, or might have no holding at all and simply be betting that a default will occur.

A CDS can help spread risk when it is used carefully. The difficulty is that the seller must actually be able to pay when many defaults occur at once. If sellers have written far more protection than they can afford, a wave of claims can threaten their survival, and every party that relied on the protection suddenly loses it.

Why they mattered in the crisis

Together these products linked banks, insurers, funds and investors in a long chain. When mortgage losses grew, doubts about CDOs made it hard to value them, and doubts about CDS sellers made it hard to know who could really pay. That uncertainty helped freeze the system, since firms were unsure about the health of their trading partners.

What changed afterwards

Regulators and lawmakers in many countries introduced new rules after the crisis, aimed at making derivative trading more transparent and at requiring more capital to be held against risk. Opinions differ on how effective the changes have been.

Connecting it to the game

In Collapse!, blocks stand for factors of this kind. The tower is built on the idea that no single piece is solely responsible, and removing one can set off a chain reaction, which is a useful mental picture for how these products were connected. For context, see the timeline of the crisis and the explanation of too big to fail.