Structured Credit: Revival of CDOs, ABS, and MBS in Modern Portfolios

Structured Credit: Revival of CDOs, ABS, and MBS in Modern Portfolios

Overview: The Development of Structured Credit
Structured Credit has been a game changer in the finance industry for a long time, experiencing waves of innovations, setbacks, and revival. It all began in 1970, when Ginnie Mae introduced the concept of mortgage-backed securities (MBS), a revolutionary way to bundle home loans and sell them to investors. ⁽¹⁾ But then came a turning point in 2008, when banks and financial institutions took extreme risks and loans were given even to those with lower credibility. As these loans began to default, investor confidence was jolted, ultimately leading to a market collapse. ⁽²⁾

Despite this downtrend, structured credit has made a strong comeback, guided by stricter regulations and improved risk assessment models. As per the First Eagle Investment article “Structured Credit: Seeing the Forest for the Trees”, as of June 2024, there existed nearly $3.3 trillion of securitized debt outstanding in the non-agency-guaranteed structured credit market ⁽³⁾, driven by higher credit quality, better transparency, and better risk mitigation strategies.

What is Structured Credit and Its Role in Financial Markets?
Structured credit refers to a financial instrument that is created by assembling a pool of underlying assets like loans, mortgages, and receivables. These assets are bundled together, turned into securities, and then sold to investors in different slices, called "tranches," each carrying a different level of risk and possible return. By pooling assets and distributing risk across different investor classes, it enables financial institutions to maintain their liquidity by freeing up capital for further lending.
The primary structured credit includes Collateralized Debt Obligation (CDOs), Asset Backed Securities (ABS), and Mortgage-Backed Securities (MBS), each serving different purposes. These instruments have evolved significantly since the 2008 Financial Crisis, adjusting to new guidelines and market demands.

Collateralized Debt Obligations (CDOs):
These are financial instruments that pool various kinds of debt, like corporate bonds or loans which are split into various tranches based on the risk ratings. These tranches can range from low risk, low return to high risk, high return. ⁽⁴⁾ These can further be classified-

1.     Collateralized Loan Obligation (CLOs) – These are supported by a diversified pool of corporate loans, typically leveraged loans.

2.     Collateralized Bond Obligation (CBOs) – These are supported by a portfolio of corporate bonds, often of different credit quality.

3.     Commercial real estate collateralized debt obligations (CDOs) are financial instruments supported by a mix of commercial real estate-related debt. The collateral assets can includes commercial mortgage-backed securities (CMBS), mezzanine loans, real estate investment trusts (REITs), and various other securities related to real estate.

4.     Synthetic CDOs: These financial instruments rely on credit derivatives rather than physical debt assets. For instance, A synthetic CDO may be structured around credit default swaps linked to a group of companies instead of their actual bond.

Asset-Based Securities (ABS):
ABS are supported by different kinds of assets, such as auto loans, credit card loans, student loans, or any other consumer loans. Lenders sell these pools of loans to a special purpose vehicle (SPV), which then issues securities supported by these loans. ⁽⁵⁾ ABS-backed loans help banks free up capital for lending further, ensuring liquidity and a constant flow of financing for consumers.

Mortgage-Based Securities (MBS):
MBS are backed by pools of mortgages that can be of two types- residential or commercial. Banks bundle these mortgages and sell them to investors, who then get payments based on mortgage repayments. MBS provide liquidity to mortgage lenders, ensuring continued access to housing finance.

Factors Driving the Revival of Structured Credit
Structured Credit has made a strong comeback, driven by regulatory elevations and better risk mitigation strategies. Some key factors fuelling this recovery are-

1.     Changes in Regulatory Framework and Risk Mitigation Arrangements As a result of the 2008 Financial Crisis, regulators and policymakers introduced a series of measures aimed at addressing structural weaknesses and improving transparency and risk control in structured credit markets.
Basel III Reforms: A set of reforms were introduced in response to the 2007-09 financial crisis around stricter capital demands and risk retention rules, to ensure stability in the banking system. ⁽⁶⁾
Standardized Credit Risk Mitigation: To improve stability, the Bank for International Settlements (BIS) developed a framework to recognize risk and mitigation methods like collateral and guarantees.
Stronger Credit Risk Models: Central Banks around the world highlighted the demand for the adoption of better risk grading and monitoring methodologies.

2.     Role of Low-Rate Environment
Continuously low interest rates have made investors to look for higher return alternatives, making structured credit an appealing solution for income generation and diversification.
Yield Advantage: Structured credit provides higher initial yields, cushioning against rising risk-free rates. ⁽⁷⁾
Diversification Benefits: Structured credit brings relief to investors from inflation and low-interest rate risks, making it preferable in uncertain economic conditions.  ⁽⁷⁾

3.     Advancement in Risk Assessment and Securitization Practices
In this ever-growing technological world, technology has played a key role in transforming credit analysis, making it more efficient and transparent.
AI-Powered Credit Scoring: AI can now calculate your creditworthiness and reduce the risks of defaults. ⁽⁸⁾
Automated Risk Management: AI-driven tools analyze market trends, financial reports, and consumer sentiments. This provides real-time risk assessment. ⁽⁸⁾
Securitization Models: AI can improve loan quality and investors’ confidence through the proper structuring of loans. ⁽⁹⁾

The resurgence of structured credit is driven by regulatory improvements, investors’ demand for yields & diversification, and technological advancements. Thus, with AI-driven analysis, evolving securitization, and better risk management techniques, structured credit is reclaiming its position.

Risks and Considerations in the Structured Credit Market
Major risks that come with the structured credit products are about liquidity, market volatility, transparency issues, structural complexity, and differences in the views of institutional and retail investors.

1.     Liquidity Risks: Compared to traditional bonds, structured credit instruments are less liquid and can face limitations during financial crises. Investors may struggle to sell them at fair prices when the market is down. ⁽¹⁰⁾

2.     Market volatility: The 2008 Financial crisis taught us how much market dynamics affect structured credit, making it highly sensitive to interest rate changes, economic cycles, and investor sentiments. Interest Rate changes can affect structured credit products by impacting the cost of borrowing for issuers, swaying the default risk of underlying assets. A rise in interest rates usually leads to a decrease in the value of these products, especially those with fixed-rate components.⁽¹⁰⁾

3.     Transparency Risks: Credit Rating agencies play an important role in the structured credit market, but their methodologies and transparency have been widely doubted. Rating agencies are often paid by the issuers, raising concerns about biased ratings.

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4.     Model Risk: Model risk indicates the potential for adverse outcomes or financial losses that can occur due to errors or inaccuracies in the models that are relied upon for decision making. These can be a result of incorrect assumptions, faulty data, or coding errors, potentially leading to inaccurate forecasts and poor strategic decisions. Rebonato (2002) defines model risk as "the risk of occurrence of a significant difference between the mark-to-model value of a complex and/or illiquid instrument, and the price at which the same instrument is revealed to have traded in the market". ⁽¹²⁾ To mitigate this risk, financial institutions do rigorous validation and independent reviews to make it more accurate and reliable.

5.     Structural Risk: It refers to the potential for losses arising from how the deal is constructed. It includes the way cash flows are prioritized through waterfall structures, the subordination of tranches (where lower tranches absorb losses first), and the dependence on credit enhancements such as excess spread or reserve accounts.

Thus, Structured Credit offers high return opportunities, but investors must assess the risk carefully. With upgradations in risk assessment techniques, structured credit is moving towards a more stable and transparent environment.

Outlook: The Evolution of Structured Credit
Structured Credit has come a long way, but to stay in the future, it must continuously evolve itself keeping in mind factors like financial regulations, emerging trends in securitization and credit risk modelling, and the emerging role of ESG in finance.

Regulatory Changes
Regulatory frameworks are constantly evolving to improve transparency and reduce risks. Basel III and IV reforms levy stricter capital requirements on banks, ensuring that structured credit is supported by relevant deposits. The European Securities and Markets Authority (ESMA) has introduced new ESG-related guidelines, mandating agencies to reveal ESG-related factors in structured Credit Ratings. ⁽¹³⁾

Robust Growth in ABS Issuance
Development in technology and market are transforming securitization processes and the evaluation of credit risk. According to the Structured Finance Association, “By September 2024, ABS issuance hit $239 billion, up 26%, driven by student loans (+68%) and auto ABS (+16%).” ⁽¹⁴⁾ These figures emphasize about a strong comeback in investor appetite for structured products, specifically in sectors like education and auto financing, indicating a broader shift toward data-driven and sector-specific growth within structured credit markets.

CLO ETFs’ Impact On the Broader CLO Market
According to S&P Global, “The CLO ETF market has grown to over $19 billion as of late November 2024 from $120 million in 2020, fueled in part by investor appetite for exposure to floating rate debt in a rising interest rate environment.” ⁽¹⁵⁾ It also mentions that “If the CLO ETF market continues to grow at its current pace, it is possible that ETFs could increase CLO note price volatility in the case of a severe market dislocation.” ⁽¹⁵⁾

Private Credit’s Expansion into Asset-Based Finance
As securitization continues to be a common tool in the leveraged loan market, private credit firms are increasingly expanding into alternative asset classes. According to S&P Global’s article, “The potential market for private funding in ABF includes more than $5 trillion in consumer credit, along with the proliferating array of collateral in the esoteric asset-backed securitization space that stretches from intellectual property to hard assets.” ⁽¹⁵⁾

Structured Credit: A Catalyst in the 2008 Global Financial Crisis
Structured credit played an important role in the 2008 financial crisis. Financial products like mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) bundled thousands of home loans—many of which were risky—and made them look like safe investments. These products were often given AAA ratings by credit agencies, which made investors believe they were low-risk. As demand for these products increased, banks started lowering their lending standards, offering loans to borrowers with poor credit histories. Things started to go wrong when housing prices in the U.S. began to fall and more borrowers started defaulting on their loans. This caused concern among investors and led to problems in credit markets as trust in these products declined.

Another issue was the widespread use of credit default swaps—contracts meant to act like insurance on debt default. These contracts were traded widely, but with little regulation and insufficient capital reserves to support potential losse. When loan defaults rose, these contracts couldn’t be honored properly, making the situation worse and deepening the financial crisis. According to Journal of Insurance and Financial Management, “In September, 2008, Lehman Brothers Holdings Inc. (LBHI) with assets worth of over US$600 billion declared bankruptcy (Mawutor, 2014).”⁽¹⁶⁾ The crisis exposed how structured finance has outpaced the ability of markets and regulators in understanding and managing risks. As an article by Banco De España quoted, “ There is broad consensus that structured finance played an important role in the development and propagation of the financial turmoil. For example, the IMF has concluded that “… the proliferation of new complex structured finance products, markets, and business models exposed the financial system to a funding disruption and a breakdown in confidence” and that certain structured finance products “… likely exacerbated the depth and duration of the crisis by adding uncertainty relating to their valuation as the underlying fundamentals deteriorated”⁽¹⁷⁾

Conclusion
Structured credit has undergone a dynamic evolution, rising rapidly during the pre-2008 boom, facing a downturn due to the financial crisis, and is now experiencing a notable revival. Today, instruments such as Collateralized Debt Obligations (CDOs), Asset-Backed Securities (ABS), and Mortgage-Backed Securities (MBS) are once again playing a significant role in shaping investor portfolios. This comeback is driven by factors such as prolonged low interest rates, AI-driven risk assessment, and growing demand from institutional investors looking for higher returns.

While structured credit offers attractive return opportunities, it also presents risks that investors must carefully manage, including illiquidity, opacity in credit ratings, and volatile market dynamics. To integrate structured credit into their portfolios efficiently, investors can adopt strategies like diversification across different asset classes, selective exposure to credit tranches, and alignment with overall risk tolerance.

As financial markets continue to evolve, structured credit is poised to become a key component of modern investment strategies, driven by regulatory reforms, the growing importance of ESG considerations, and the increasing reliance on data-driven decision-making.

Sources:

1.      Ginnie Mae, Our History, 1968

2.      Investopedia, What Role did Securitization Play in the Global Financial Crisis, October 11, 2013

3.      First Eagle Investments, Structured Credit: Seeing the Forest for the Trees, August 2024

4.      Wall Street Mojo, Asset Backed Securities (RMBS, CMBS, CDOs), February 08, 2024

5.      Investopedia, Asset-Backed Security (ABS): What it is and How Different Types Work, June 28, 2024

6.      Investopedia, Basel III: What it is, Capital Requirements, and Implementations, May 01, 2025

7.      BBH, Structured Credit- A Full Toolbox to Protect Against Uncertain Rate Environments, February 25, 2022

8.      Akira AI, Credit Analysis: Re-Imagine Your Credit Scoring with AI Agents, December 21, 2024

9.      Tao Solutions, Artificial Intelligence “AI” in Structured Finance

10.   CFA Institute, Beyond Bank Runs: How Banks' Liquidity Risks Shape Financial Stability, February 12, 2025

11.   Drishti IAS, Issues related to Credit Rating Agencies in India, May 09, 2019

12.   Wikipedia, Model Risk, June 08, 2025

13.   Nauta Dutilh, ESG developments in Financial Institutions & regulations-2025, January 14, 2025

14.   Structured Finance Association, ABS Issuance Soars, SRT Interest Grows, But Cash ABS Remains King, September 26, 2024

15.   S&P Global, 2025 U.S. And Canada Structured Finance Outlook, December 13, 2024

16.   Journal of Insurance and Financial Management, The Bankruptcy of Lehman Brothers: Causes, Effects and Lessons Learnt, 2016

17.   Banco De Espana, Structured Finance and the Financial Turmoil of 2007-2008: An Introductory Overview

References:

1.      S&P Global, ABS Frontiers: How The Burgeoning CLO ETF Sector Could Impact The Broader CLO Market, November 26, 2024

2.      S&P Global, The Opportunity of Asset-Based Finance Draws In Private Credit, November 20, 2024

Disclaimer: This article is for educational purposes only and is based on publicly available sources. While efforts have been made to ensure accuracy, the content should not be considered professional advice.