What Is a Collateralized Debt Obligation?
Collateralized debt obligations (or CDOs) gained a lot of attention when they played a part in the 2008 financial crisis. They are investment securities based on debt.
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What is CDO?
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A CDO is investment-grade security that is backed by a pool of assets. (These assets may include bonds, loans or other debts.)
How Do They Differ From Other Securities?
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Unlike other kinds of investment vehicles, like mortgaged-backed securities (MBS) and commercial mortgage-backed securities (CMBS), CDOs do not specialize in just a single kind of debt. They are usually loans or bonds.
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Meaning for Investors
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CDOs stand out because they represent various kinds of debt and credit risk for investors, usually called "tranches" or "slices." Each slice of a CDO has its own maturity and risk, apart from the rest. Simply put, an investor gets paid more the higher risk CDOs he buys (if they succeed).
How Do Investors Get Paid?
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When debtors and creditors pay interest on the money they were loaned, that interest gets passed on to those who own the CDOs.
Role in Financial Crisis
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Because CDOs can be backed by many kinds of debt, including mortgages and credit cards, when people stopped paying these bills, those who owned CDOs stopped getting paid. Many investors lost billions of dollars on these investments when borrowers--and ultimately the CDOs--defaulted.
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References
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