Collateralized debt obligation (CDO)

A Collateralized Debt Obligation, or CDO, is a synthetic investment created

by bundling a pool of similar loans into a single investment that can be
bought or sold. An investor that buys a CDO owns a right to a part of this
pool's interest income and principal.
For example, a bank might pool together 5,000 different mortgages into a
CDO. An investor who purchases the CDO would be paid the interest owed
by the 5,000 borrowers whose mortgages made up the CDO, but runs the
risk that some borrowers don't pay back their loans. The interest rate is a
function of the expected likelihood that the borrowers whose loans make
up the CDO will default on their payments - determined by the credit
rating of the borrowers and the seniority of their loans.
CDOs are created and sold by most major banks (e.g. Goldman Sachs,
Bank of America) over the counter, i.e. they are not traded on an
exchange but have to be bought directly from the bank. Securities
Industry and Financial Markets Association estimates that US$ 503 billion
worth of CDOs were issued in 2007.[1]
CDOs played a prominent role in the U.S. subprime crisis, where critics say
CDOs hid the underlying risk in mortgage investments because the ratings
on CDO debt were based off of misleading or incorrect information about
the creditworthiness of the borrowers.

I. How CDOs Work

Bundling debt into a CDO changes the riskiness of investing in debt in two
ways:
Reduction of Statistical Outliers
First, CDOs reduce the effect of statistical outliers : CDOs turn individual
loans into a portfolio in which a default by any single lender is unlikely to
have an enormous impact on the portfolio as a whole. By aggregating
many different mortgages together into a CDO, investors can own a small
percentage of many different mortgages, and therefore the CDO's losses
as a result of borrowers defaulting on their obligations usually represent
the statistical averages in the market as a whole.
Tranches
Second, CDOs are created in tranches - portions of the underlying debt
that vary in their riskiness, despite being backed by a generic pool of
bonds or loans.
Typically, a pool of debt is divided into three tranches, each of which is a
separate CDO. Each tranche will have different maturity, interest rates and
default risk. This allows the CDO creator to sell to multiple investors with
different degrees of risk preference.
The bottom tranche will pay the highest interest rate, but will be the first
to lose money if some of the loans in the pool aren't repaid. The top
tranche will have the lowest interest rate, but will always be the first to be
repaid - the bottom two tranches have to be wiped out before the top
tranche is affected. This allows bankers to create investments with risk /
reward profiles that are very different from the underlying debt in the
pool. So, one pool of mortgages can be divided into three CDOs, one with
an "AAA" debt rating that pays low interest, one with an intermediate debt
rating with moderate interest, and one with a low debt rating with high
interest. This is important because some asset manager are only allowed
to invest in "AAA" rated debt - dividing a pool of debt that is not AAA rated
into three different CDO tranches means at least some portion of that debt
is now AAA rated and can be purchased by institutions that can only invest
in AAA debt.
For example: A bond pool of $100 million is divided into three tranches
and is expected to earn 15%, or $15 million in interest per annum. The
pool is divided into 3 tranches, A ($25 million), B ($50 million) and C ($25
million), where A is senior to B, and B is senior to C. The associated
interest rate with each tranche is 10%, 15% and 20% respectively.
Therefore, if none of the bonds default, A receives $2.5 million, B receives
$ 7.5 million, and C receives $ 5 million. However, if there is a default and
the interest income is reduces to $11 million - in this case, since A and B
are senior to C, they will be settled before C is settled. As a result, tranche
A and B receives their full interest of $ 2.5 million and $7.5 million,
whereas tranche C only receives $ 1 million.
CDO Market
CDOs are structured by investment banks and are bought by all types of
asset managers, including hedge funds, insurance companies, banks and
pension funds. CDOs can also be purchased through most retail brokerage
accounts.

II. Other Types of CDOs

Collateralized mortgage obligations (CMOs) and collateralized bond

obligations (CBOs) are examples of CDOs in which the loans that make up
the pool of debt in the CDO are mortgages and bonds, respectively.
Synthetic CDOs
The term synthetic applies to a CDO in which the underlying assets are
credit default swaps (CDS) rather than debt instruments like bonds or loan.
Credit default swaps are insurance on debt. The buyer of the insurance
pays a certain amount to the seller in exchange for protection from
default. In effect, these securities behave very similarly to the underlying
debt, but are easier to buy and sell.
CDO^2
CDO Squared, Cubed, etc refers to a security that is constructed from
pools of CDOs rather than a pool of debt instruments such as loan or bond.
Essentially, this is a CDO of CDOs.

III.Criticisms of CDOs

CDOs have been criticized as being highly complex instruments that are
difficult to value. Warren Buffet is on record for calling CDOs financial
weapons of mass destruction -- since he believes, contrary to the
philosophy behind CDOs, that default risk is correlated and cannot be
diversified away.[5] CDOs and other such debt-related derivatives have
been blamed for making the 2007 credit crisis a lot more severe than it
should have been and have led to the failure of institutions such as
Lehman Brothers (LEH), MBIA (MBI) and AIG. [6]