What is Collateralized Debt Obligation (CDO)?

Collateralized debt obligations (CDOs) are investment-grade securities that are backed by a pool of various other securities, such as bonds, loans and other assets. They are called collateralized since there is some type of collateral behind them.

CDOs represent different types of debt and credit risk. They are divided by the issuer into different tranches (or slices) and each tranche has a different maturity and risk that is associated with it: senior tranches (rated AAA in terms of safety), mezzanine tranches (rated AA to BB), and equity tranches.

Since losses are applied in reverse order of seniority (in other words from the highest risk tranches to lowest) the most highly rated tranche, the senior tranche, is protected by the subordinated structure. The equity tranche on the other hand remains most vulnerable and is often referred to as "first-loss tranche" or "toxic waste". Therefore, it offers higher interest rates in order to compensate for the added default risk.

The issuer of the CDO gets a commission when the CDO is issued and management fees during the CDO's life. This is how a CDO differentiates from a mortgage or mortgage-backed securities (MBS); the investment in a CDO is not a direct investment in the particular collateral but rather an investment in the cash flows produced by the CDO's assets.

One of the positive sides of CDOs is that they provide more liquidity in the economy by allowing banks and corporations to sell off debt. This in return helps them free up more capital.

Yet, a downside is that CDOs allow originators of the loans to avoid collecting on them when they become due since other investors are already owners of those loans. As a result this loosens the lending standards.

Additionally, creating CDOs from other CDOs allows large financial institutions to hide their debt and losses by pooling their debt with other financial institutions in order to move it off their books and then bringing it back onto their books as the so called Synthetic CDO asset.

Due to the complexity and lack of transparency of the CDOs, many buyers do not really understand what they are buying and rely solely on the trust of the institution that is selling the CDO. This causes market panic when sellers lose the trust in the product and makes CDOs difficult to resell, which is one of the causes for the banking liquidity crisis in 2007.

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