Collateralized Debt Obligations

By: EconomyWatch Content   Date: 14 January 2010

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Collateralized debt obligations or CDOs are financial instruments that are created with a pool of similar financial products, including loans, corporate bonds and asset-backed securities. However, unlike several individual financial instruments, collateralized debt obligations are not traded on a stock or commodity exchange. Instead, CDOs are built and sold over the counter by several major banks, including Goldman Sachs and Bank of America.

Types of Collateralized Debt Obligations

Collateralized bond obligations and collateralized mortgage obligations are the most commonly issued CDOs. They are created with pools of bonds and mortgages, respectively. Other types of collateralized debt obligations are:

·        Synthetic CDOs: The underlying assets in such CDOs are credit default swaps, instead of common debt instruments. Credit default swaps are financial instruments created with the extra amount paid by buyers of insurance to protect themselves from the risk of default.

·        CDO ^2: These are securities constructed with pools of CDOs instead of a pool of debt financial instruments. Thereby, this is a collateralized debt obligation of multiple CDOs. 

Benefits of Investing in Collateralized Debt Obligations

The most important reason for investing in CODs is to offset risk. In fact, risk-averse investors are increasingly committing their funds to collateralized debt obligations. According to the Securities Industry and Financial Markets Association, the global issuance of CDOs rose from $157 billion to $503 billion between 2004 and 2007. CDOs facilitate risk offsetting by:  

·        Reducing the impact of statistical outliers. Since a CDO turns individual loans into a collective portfolio, default by a single lender does not create an enormous impact on the returns from the portfolio as a whole. 

·        Creating multiple tranches, typically three, each having a different level of risk. Additionally, every CDO tranche has a distinct maturity period, interest rate and default risk.  

Criticisms of CDOs

Collateralized debt obligations are often criticized because of their highly complex nature. This is because valuing multiple instruments is not only difficult, but can also lead to inaccuracies. In fact, Warren Buffet has referred to CDOs as “financial weapons of mass destruction.” Buffet elaborates that, contrary to the fundamental nature of a CDO, the default risk of multiple financial instruments are correlated and cannot be diversified.

 

Collateralized debt obligations, along with other similar debt-related derivatives, have also been blamed for worsening the 2008 credit crisis, playing a vital role in the failure of financial giants like Lehman Brothers and AIG.

 

 

 

 


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