What is the meaning of Collateralized Debt Obligations (CDOs)?

Tuesday, April 20, 2010

Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDO is an investment-grade security backed by a pool of bonds, loans and other assets. CDOs do not specialize in one type of debt but are often non-mortgage loans or bonds.  Collateralized debt obligations are similar in structure to a collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk.

Collateralized Debt Obligations Chart

CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk. The higher the risk, the more the CDO pays.

A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the 2007-2008 credit crunch, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs.

Many CDOs are valued on a mark to market basis and thus have experienced substantial write-downs on the balance sheet as their market value has collapsed.

Source: Wikipedia/ Investopedia

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