What is CDO?

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What is CDO?
CDO is a financial term that stands for ‘collateralized debt obligation’. CDO is an investment security that is backed’”or secured’”by a pool of other bonds, loans, or assets. The CDO a type of structured asset-backed security and is traded in public security markets. CDOs do not typically deal with mortgages’”rather a CMO, or collateralized mortgages obligation does.

The risk of a CDO is classified into different categories known as ‘trenches’’”sometimes called ‘slices’. Typically, the higher the risk for the CDO is, the higher the potential return’”or profit’”there is to be made. The CDOs in the lowest risk trenches are often referred to as ‘senior trenches’. These senior CDOs have the first claim on interest and principal. The highest risk trenches are the first to pay out any defaults on the CDO. Because of the increased risk, these CDOs often have either the highest interest rates, or the lowest cost.

CDOs are created by corporate entities to gain funds that are need immediately. The entity is required to hold an asset of some type for collateral. As cash flows come in from the assets, payments are made the holders of the CDOs. The ones in the lowest trenches receive the money first, and up the chain in order of risk; not all trenches may receive a payment.

The first CDO was issued in 1987 by the bank Drexel Burnham Lambert Inc. for the company Imperial Savings Association. Within a decade, CDOs became popular and were increasing at a rate far faster than other asset backed securities in the public market. In 2005, the estimated value of the CDO market was $1.5 trillion USD. However, the recession and mortgage crisis in 2007 caused a significant fall in CDOs. Many of the CDOs became worthless when investors stopped paying out principal and interest. This led to a decrease in the number of CDOs issues and purchased. This in turn helped contribute to the fall of some banks and lenders.

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