Deciphering Collateralised Debt Obligation (CDO)

A Collateralised Debt Obligation (CDO) is a pool of individual loans, bonds and other assets that have been packaged into one product for sale to investors. Often a CDO will comprise many personal loans that have been packaged into a single product for sale, such as credit card, mortgage or motor vehicle debts.

Understanding CDOs and how they are created

When a pool of similar loans is bundled and packaged into a single product for sale to investors on the secondary market, a Collateralised Debt Obligation is created. An investor who buys a CDO product is entitled to the principal and interest income generated by the CDO.

For example, if you purchased a CDO that comprised of 2000 different mortgages, you would be entitled to receive interest payments owed by all the 2000 borrowers whose loans make up the CDO. However, you would also have to shoulder the risk of all the borrowers in the pool who fail to pay their mortgage.

How CDOs are bought and sold

CDOs are sold by major investment banks, such as the Bank of America and Barclays Capital. They are not traded on the exchange market. A CDO investment is bought directly from the bank and often sold over the counter.

CDOs can also be bought through retail brokerage accounts. Banks, insurance companies, hedge funds, pension funds and other asset managers are common buyers of CDOs, although individuals may also buy CDOs.

Types of CDOs

A CDO can be a managed or static financial arrangement. With a static CDO, collateral is fixed and investors are able to assess various tranches of the CDO with full knowledge of what the collateral will be through the life of the CDO. The primary risk involved here is that of credit investment.

In a managed CDO, an investment manager is assigned to manage the CDO portfolio and collateral. Many CDOs are managed arrangements that have the deal sponsor as the appointed portfolio manager. The primary risk involved here is that of the portfolio manager making poor investment decisions.

CDO failings

The complexity of CDOs is blamed for creating the global credit crisis. Initially, CDOs freed up capital and provided more liquidity in the economy to invest in new jobs and loans. Unfortunately, from early 2007, the extra capital created an asset bubble in housing, motor vehicle and credit cards. Housing prices and credit borrowing became unrelated and people bought houses en masse just to sell them.

By 2008, CDO had morphed into a global credit crisis that many countries are still reeling from. The CDO market and much of its derivative markets collapsed at the height of the credit crisis. If you are an average individual investor, you should probably not include Collateralised Debt Obligation in your portfolio.

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