Collateralized Debt Obligation or CDO is a financial product that brings together assets that can generate cash flow and repackages into ‘tranches’ that can be sold off to potential investors. The reason why this obligation is collateralized is because the assets involved such as bonds and mortgages serve as collateral. These are typically purchased by insurance companies, hedge funds and other institutions that are willing to take risks in order to gain.
The risk profile of the tranches or portions can differ but senior ones are safer in comparison since they get to pick first in case of a default. That is why they have higher credit rating along with lower rates in coupons.
A total of 5 parties take part in creating a CDO. These are:
An obligation such as the CDO is often supported by mortgage based securities in the residential property industry but it is also sometimes backed by commercial securities, bank loans bonds and other products.
In order to create a CMO (Collateralized Mortgage Obligation), a financial institution such as a loan bank pools home loans that share similar characteristics into a saleable security.
On the other hand, the one who purchases the CMO can be at risk by factors such as prepayments, credit risks, seesawing interest rates and other anomalies. If for instance the interest rate rises, most CMO tranches will drop in value in the market. Plus, if the life of the CMO is increased, rising rates can compel the investor to remain committed for longer than anticipated.
Even though equity tranches can provide higher returns when the economy is faring well, their value can plummet drastically if the economy suffers or if mortgage defaults.
Financial education is so important, but barely taught at all in our schools. Having resources online is great, but not if they are inaccessible to so many. Thanks 508!