THE Great Securitization Debate: CDOS VS. CLOS
Analyzing the instruments behind financial crises
1. DID CDOS cause THE 2008 GREAT RECESSION? (The Past)
YES. CDOs were a core accelerant and “the engine” of the crisis.
Collateralized Debt Obligations (CDOs) were the primary vehicle used to repackage and distribute massive amounts of high-risk debt across the global financial system. When the underlying debt defaulted, the entire structure collapsed.
STEP 1: The fatal collateral
- CDO COLLATERAL (2007): SUBPRIME MORTGAGES (Residential Mortgage-Backed Securities – RMBS).
- The Problem: These loans were granted to borrowers with poor credit, often with little documentation, under the assumption that U.S. housing prices would NEVER fall [1.1] [1.2].
STEP 2: Credit Rating Deception
Rating agencies gave high ratings (AAA) to the of these CDOs, even though they were filled with risky assets. This made them appear safe to institutional investors (pension funds, insurance companies) worldwide [1.4].
STEP 3: The correlation collapse
The key structural failure was the assumption that if one homeowner defaulted, it wouldn’t be correlated with others. When the housing market fell nationally, defaults became highly CORRELATED.
2. CDO VS. CLO: SIMILAR YET FUNDAMENTALLY DIFFERENT
3. Will CLOS cause the next Recession? (The Future)
PROGNOSIS: CLOs are more resilient, but the underlying market poses risks.
CLOs are structurally safer than the CDOs of 2008. The most senior (AAA) CLO tranches have historically experienced ZERO defaults [2.3]. However, the market faces two major challenges:
STEP 1: The Cov-lite deterioration
The main risk is the deterioration of loan quality within the CLO pools [1.1].
- RISK FACTOR: “COVENANT-LITE” LOANS. These loans have fewer protections for investors (i.e., less ability to intervene when a company’s financial health declines). These now make up a large portion of the leveraged loan market [2.2].
- The Scenario: A severe, prolonged economic recession leads to widespread corporate defaults across many industries.
STEP 2: The stress test
If corporate defaults reach extreme levels, the losses would first wipe out the Equity tranche, then the junior Mezzanine tranches.
STEP 3: Market ripples
Even if AAA tranches survive, a collapse of the junior tranches would cause significant disruption and massive losses for institutional investors who hold the riskier parts of the CLO structure. The sheer size of the leveraged loan market is large enough to create major ripples in the financial system, turning a “run-of-the-mill recession into something worse” [1.1], [2.4].
CONCLUSION: CLOs are unlikely to be the sole cause of a recession, but they could amplify one significantly if corporate debt quality continues to erode and a major economic downturn occurs.
References:
[1.1] Collateralized loan obligations: could these obscure products cause the next global financial crisis – Synovus
[1.2] Were Collateralized Debt Obligations (CDOs) Responsible for the 2008 Financial Crisis? – Jul 14, 2022, Investopedia
[1.3] CLOs vs. CDOs: Understanding the Difference – VanEck – Aug 18, 2025, VanEck
[1.4] Collateralized debt obligation – Wikipedia – Wikipedia
[2.2] Collateralized loan obligations in the age of COVID-19 – Jun 22, 2020, cornerstone.com
[2.3] CLOs Endured the Great Financial Crisis. Will CLOs Suffer the Fate of CDOs in the Next One? – Feb 14, 2023, Clarion Capital
[2.4] Recession and CLOs – Rabobank – Jul 4, 2019, Rabobank
[3.2] CLOs: Fact vs. Fiction | Portfolio for the Future | CAIA – Aug 6, 2023, CAIA
[3.3] Contrasting CLOs to CDOs and CMBS – Bluerock – Feb 15, 2023, BlueRock
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