Collateralized debt obligations

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Collateralized Debt Obligations, also called CDOs, are complex financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralized because they have some type of collateral behind them.

Types of CDOs include asset-backed commercial paper, which consists of corporate debt, and mortgage-backed securities, which contain mortgages.

CDOs allow banks and corporations to package and sell off their debt, freeing up capital to invest or lend. However, they shift loans away from the originators and onto other investors, allowing the originators to avoid having to collect on the loans. They are often so complicated that buyers can't be sure what is in the package they are buying.[1] And since CDO managers can change the contents of a CDO after it’s sold, investors may not know how much subprime risk they face.[2]

Synthetic CDOs are backed by credit default swaps rather than actual loans or bonds themselves.[3]

Markets watchers were given a crash course in CDOs after headlines about Goldman, Sachs & Co. being sued by the Securities and Exchange Commission (SEC) hit the wires in 2010. On Apr. 16 of 2010, the SEC charged Goldman, Sachs & Co. and one of its vice presidents for defrauding investors by misstating and omitting key facts about a financial product tied to subprime mortgages as the U.S. housing market was beginning to falter.[4]

In this case, the CDO transactions were a bet on the value of a bundle of mortgages that the investors didn’t own.[5]

ALSO SEE: Collateralized mortgage obligation

References

  1. Collateralized debt obligations. About.com.
  2. The Poison in Your Pension. Bloomberg.
  3. US Regulators Subpoena Big Banks Over CDOs. Financial Times.
  4. Press Release. SEC.
  5. When Wall Street Deals Resemble Casino Wagers. The New York Times.