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What Is a Collateralized Debt Obligation?

By Motley Fool Staff – Jun 7, 2017 at 9:10AM

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Here's what you need to know about this often-misunderstood type of investment.

A collateralized debt obligation (CDO) is a collection of pooled assets that generate income, such as mortgages, auto loans, or corporate bonds, to name a few. The assets are pooled together and divided into tranches to be sold to investors. Each tranche can have a substantially different credit quality and risk level.

What is a CDO?

A collateralized debt obligation is a bundle of income-generating debt assets, such as mortgages or auto loans. In other words, the loans themselves are the "collateral" that backs the CDO. The basic idea is that by doing so, these packages of loans can then be sold to investors as income-producing assets.

Interest rates written on pieces of paper.

Image source: Getty Images.

CDOs are a type of derivative, which just means that their value comes from the value of other assets – in this case the underlying pool of loans. If the underlying assets are mortgage loans, they are referred to as mortgage-backed securities.

The assets in a CDO are pooled together, and then split into pieces known as tranches, which are then sold to investors. And these tranches can vary significantly in their risk profile. Senior tranches have first priority when it comes to the collateral (the underlying loans) in the event of a default, and therefore are safer and pay lower interest rates than the junior tranches of the same CDO.

Advantages of CDOs

CDOs can be excellent financial tools when used responsibly and for their intended purpose. From the standpoint of the banks who sell CDOs, the sale of these instruments gives them more funds to lend to other customers, and takes the risk of default off of the bank.

From the investors' perspective, the CDO can be matched to their specific risk tolerance. If an investor doesn't have much of a tolerance for risk, he or she could buy a senior tranche of the CDO that represented the highest quality loans. On the other hand, an investor with higher risk tolerance who wanted a higher return could get it with a junior tranche backed by somewhat riskier loans.

The financial crisis

Unfortunately, the liquidity created by the boom in CDOs in the mid-2000s combined with the incentives for bankers to sell as many of them as possible (which led to very relaxed credit standards) caused a bubble in the U.S. housing market. And a lot of the CDOs that were sold at the time were composed of mortgage loans made to borrowers who weren't creditworthy, and were valued based on the assumption that home prices would keep going up.

When prices ceased climbing, defaults skyrocketed and a panic ensued. Banks stopped selling CDOs almost immediately, and the housing market plunged. As CDOs dropped in value, many investors -- such as pension funds and corporations -- lost billions.

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