Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are assets that are used as collateral and then pooled together in order to be the basis of new securities that provide cash flows. A company buys the debt instruments, collects the cash from the debts, and then sells securities that are in effect purchases of a portion of the cash flow.

CDOs are used in structured financing operations created through complex legal and corporate entities for the purpose of transferring risk. When pools of assets in the form of debts are securitized it means that a default of one of the debts in the pool will not result in a total loss, but only a minor one that can be overcome by other factors.

When CDO pools are created investors can buy a tranch (from the French word tranche, for slice) of the pool. The tranching allows the cash flow from the assets at the bottom of the pool to be allocated to different investor groups in different ways. One goal is to create securities that are rated from the pool of unrated securities. By being rated a market in the securities can be created. There are different levels of tranching, with the most secure usually the senior tranch, followed by mezzanine tranches, followed by the subordinate levels of tranches. Cash flows go to the senior level first, then to the mezzanine level, and then to the subordinate levels. The latter are the least secure and entail the most risk if defaults occur.

CDOs issued as unregulated securities are based upon a portfolio of fixed income assets. The assets are rated by rating agencies that assign the values after each asset is assessed. The senior tranches are typically rated as AAA, while mezzanine tranches are rated from AA to BB. Subordinate tranches are usually unrated.

Investors in CDOs hold a piece of paper that entails risks. Ultimately the risk is based upon the credit risk of the collateral in the pool. CDOs have been unregulated since their introduction in 1987. During the credit crisis that developed rapidly after 2006 they came to be identified as a major source of the crisis. The complex nature of CDOs and their collapse in liquidity were reasons offered for the credit crisis. However, part of the failure to appreciate the risks involved lay in the distribution of financial knowledge. As a result some buyers were not equipped to measure the changing credit ratings and cash flows to the CDOs. In addition the credit rating agencies upon which they relied were also insufficiently skilled at properly valuing the CDOs.

CDOs are typically valued on a mark-to-market basis. This method of valuing an asset marks the asset's value as what it would bring today. However, the future value (as in the case of a futures contract) may be unknown and therefore merely a guess until it is sold at a future time. Because of the complexity of CDOs some businesses have used them to hide debt under the cover of CDOs. In addition many rating agencies failed in 2006 and afterward to accurately assign values to them, causing a loss of confidence in the rating agencies and a retreat from lending.

...