What is a collateralised debt obligation (CDO)?
It's a package of different debts - like loans, mortgages or credit card debt - that banks sell to investors in portions known as tranches on the secondary market. The repayments of the debt obligations owed to the bank serve as the collateral that give the CDOs value for investors.
Where have you heard about CDOs?
CDOs are often blamed for the 2008 financial crisis.
The structure of CDOs encouraged banks to give out risky sub-prime mortgages to people with poor credit during the housing boom of 2003-2004. Then, when house prices crashed, the CDO bubble burst and inflicted high losses - in the billions - on the financial institutions who had sold them.
What you need to know about CDOs.
The principle behind CDOs is that by grouping together a number of debts you diversify the risk of non payment. For example, if you have a package of 1,000 mortgages, even if 5% of those mortgages are not being repaid on time, the profits on the other 95% should cover any losses.
The banks sell on this package of debt to investors - often hedge funds and pension funds - allowing them to free up capital for new loans or investments.
CDOs are split into tranches with different risk profiles - from senior tranches with higher credit ratings and lower coupon rates, to junior tranches with lower credit ratings and higher coupon rates. The payments are made in order of seniority so senior tranches have the least risk.
One problem with CDOs is that they move the loan's risk of default from the bank to the investors; so the bank is more likely to lend to borrowers that aren't credit worthy.
Another downside of CDOs is their complexity; good and bad debt are packaged together in the same portfolio to get higher credit ratings so it's difficult even for sophisticated investors to know exactly what they are buying.