Collateralized Debt Obligation (CDO)
Candlefocus EditorCDOs are built on pools of loans and other assets. When a loan in the pool goes into default, the lender is able to recoup some of the principal from the collateral backing the loan. Using this process, investors, banks and corporations are able to mitigate losses from the moment a loan goes into default. Likewise, the tranches of CDOs can be further used to express the level of risk in each section of the underlying loans, with senior tranches having the lowest risk.
CDOs took a particularly bad rap during the 2007-2009 financial crisis, as CDOs backed by risky subprime mortgages were among the major factors that caused the global economic downturn. Despite of their poor association with the crisis, CDOs continue to be used as viable tools for mitigating risk and creating more liquid capital for banks and investors.
By creating distinct industries of Wall Street financiers, CDOs have provided an opportunity to diversify risk and open up more avenues of capital. By selling their underlying assets to investors, big Wall Street banks are able to recuperate capital without incurring a loss. From an investors perspective, CDOs offer a medium to high risk avenue of potential return that is complemented by the potential of being cushioned against significant losses
Such investments are best suited for those who have the patience to monitor the markets, have a good handle on their financial risk and understand the inherent pitfalls of pooling and tranching. Those wary of their own financial literacy may consider looking into other more conservative options of gaining capital.
To summarize, a collateralized debt obligation (CDO) is a financial engineering tool used for mitigating risk and creating more liquid capital for banks and investors. Through the process of securitization and tranching, assets are pool and divided into different tranches or classes of securities, each of which has different levels of risk and return. However, it is only meant for those who understand the inherent risks of the market, as well as the potential of the investment.