In this article, you will learn what is the meaning of CDO. The earliest CDOs were constructed in 1987 by the former investment bank Drexel Burnham Lambert. CDOs are called collateralized because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.
What is the Meaning of CDO?
CDO means Collateralized Debt Obligation. A collateralized debt obligation (CDO) is a security that is derived from other securities. The CDO uses funds that are raised from investors to purchase debts.
The principal and interest payments from those debts create a revenue stream that is used to pay investors. By slicing up the underlying obligations into different risk levels, or tranches, the CDO offers a range of financial products providing different risk and return options for investment.
A CDO is the broadest category of this type of complex financial investment, which can be made up of anything from mortgages to credit card debts. Particular forms of CDOs can be created by only using one type of debt — For example, business loans or mortgages .
CDO Structure
The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt—pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.
The higher the credit rating, the lower the coupon rate (rate of interest the bond pays annually). If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings; the lowest-rated credit is paid last.
The senior tranches are generally safest because they have the first claim on the collateral. Although the senior debt is usually rated higher than the junior tranches, it offers lower coupon rates. Conversely, the junior debt offers higher coupons (more interest) to compensate their greater risk of default; but because they are riskier, they generally come with lower credit ratings.
What are the Benefits of CDOs?
Like all types of assets, CDOs have benefits as well as drawbacks. Their role in the housing bubble and the subprime mortgage crisis was the result of their main disadvantages: complexity, which made them difficult to value accurately; especially from subprime borrowers.
However, there are also two main benefits:
Diversification: Because the debt bundled in a CDO is spread over many mortgages or other loans, investors are exposed to a range of risks. As long as not all the loans used as collateral are subprime loans, there is an element of diversification in each CDO .
Liquidity: A single bond or loan is a relatively ill liquid asset for a bank to hold. A CDO, however, turns those into liquid assets. Holding more liquid assets means banks can expand their lending and generate more revenue.
Bottom Line
A CDO is a structured finance product that is backed by a pool of loans and other assets. It can be held by a financial institution and sold to investors. This is about what is the meaning of CDO.
