Collateralized Debt

Collateralized debt obligations (CDOs) are constructed from a portfolio of fixed-income assets. They are an unregulated asset-backed security and are classified as a structured credit product. The debt, including bonds or mortgages, are pooled, sliced up and resold to investors. These debt instruments are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO returns to investors.

Analyzing Collateralized Debt Obligations is difficult because not only does it require analysis of an entire portfolio of assets, in some arrangements an investor has no way of even knowing what collateral has been or will be purchased. Needless to say, there is a lot of opportunity for manipulation or abuse by those packaging and marketing Collateralized Debt Obligations.

Because of the complex structure of CDO products, the lack of government regulation, and the credit rating agencies failure to evaluate the risks before awarding the securities a AAA rating, many Collateralized Debt Obligations imploded thereby contributing to the 2008 financial crisis and credit crunch.

As many CDO products are held on a mark to market basis, the collapse of liquidity in these products led to sizable write-downs and losses.  For further details on the implications of mark to market accounting, see our reportWhat to Make of Mark to Market.