Understanding Derivatives

Collateralized Debt Obligations

Written by Bennet Grill for Gaebler Ventures

Entrepreneurs should understand how various financial instruments work. In this article, we take a look at collateralized debt obligations or CDOs. CDOs are a form of credit derivative that creates a series of cash flows from a pool of credit assets.

Collateralized Debt Obligations (CDOs) are a form of credit derivative which are backed by a specific set of assets.

Collateralized Debt Obligations

These assets are divided into different tranches, which represent different levels of risk: typically senior, mezzanine, and equity--not unlike the ratings of the same name describing corporate debt.

The writers of collateralized debt obligations--most often investment banks--sell the cash flows of these assets to investors.

Investors of the equity and mezzanine tranches of CDOs get a higher interest rate in their investment than investors in the senior tranche because the former two carry a much greater risk than the latter. Conversely, the senior tranche is the most secure level of investment and is the last to suffer from the defaults or losses in a collateralized debt obligation.

Collateralized debt obligations can be funded through either cash or synthetic sources.

In order to issue a "cash" collateralized debt obligation, a set of assets must be organized in the form of a Special Purpose Vehicle (SPVs.) Assets organized under these SPVs for cash CDOs include fixed income securities (e.g. bonds) bank loans, and other cash assets. Within the ranks of CDOs are securities categorized by the underlying assets: if it is backed by bonds the CDO is called a collateralized bond obligation (CBO); by mortgages, a collateralized mortgage obligation (CMO), which is a certain form of a mortgage backed security; by loans, a collateralized loan obligation (CLO.)

A "synthetic" collateralized debt obligation isn't funded through the purchase of assets--it is exposed to the risk of a number of assets by selling a form of credit derivative called the credit default swap (CDS).

Through the sale of the CDS, the issuer of the CDO assumes the risk of a certain asset in exchange for a premium paid to it by the purchaser of the CDS. The investors of a synthetic CDO receive a portion of these premiums in exchange for assuming a portion of the risk of these assets. There is a class of CDOs called hybrid collateralized debt obligations which are a combination of cash and synthetic CDOs.

To make matters even more confusing, there is a product called a "CDO squared," which is a CDO with a different CDO serving as the underlying asset.

The complicated nature of collateralized debt obligations is said to have contributed to the credit crisis of 2007-- especially considering the role of CDOs with mortgage backed securities.

Collateralized debt obligations have played a large part in the nation's economy and help shape the way debt is reorganized in capital markets--they are an important subject for entrepreneurs and those interested in understanding business finance.

Bennet Grill is a writer who has a passion for business and finance. He is currently an Economics major at Duke University in North Carolina.

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