Collateralized Debt Obligation (CDO)

A general inclusive term which covers Collateralized Bond Obligations, Collateralized Loan Obligations, and Collateralized Mortgage Obligations,

Collateralized Debt Obligation

An asset-backed security backed by the receivables on loans, bonds, or other debt. Banks package and sell their receivables on debt to investors in order to reduce the risk of loss due to default. Returns on CDOs are paid in tranches; that is, the individual loans backing each CDO have different levels of risk, and investors are paid out according to the level of risk they have acquired. Banks offer higher interest rates to investors willing to buy CDOs backed by higher-risk loans. From a bank's perspective, in addition to reducing risk, CDOs also reduce their capital requirements because they can raise funds through the issue of CDOs. While, theoretically, CDOs can be backed by mortgages, one usually refers to these as collateralized mortgage obligations.

collateralized debt obligation (CDO)

A debt security collateralized by a variety of debt obligations including bonds and loans of different maturities and credit quality.

Case Study Collateralized debt obligations (CDOs) originated in the 1990s when financial institutions began moving debts off their balance sheets by selling new securities (CDOs) using bonds and loans—often of relatively low credit quality—as collateral. Each CDO package permits investors to choose particular securities of different risk, ranging from investment-grade to very speculative. A CDO is considered high quality when it enjoys first claim on cash flows produced by the package of loans and bonds. This safety results in high-quality CDOs promising investors relatively low rates of return. CDOs with a lower claim to a package's cash flows carry a high rate of return because of the increased likelihood that some of the payments from the underlying collateral will not occur. Many CDOs were issued with low-grade bonds as collateral at a time when junk bond defaults were in the range of 2% to 3%. The subsequent meltdown of telecommunications and other high-tech firms in 2000 and 2001 resulted in increased defaults on debt that caught many CDO investors by surprise. In fact, the sudden decline in credit quality surprised even professional investors. Financial services company American Express was forced to take pretax writeoffs of over $1 billion in the first seven months of 2001 to account for the decreased market value of the CDOs and other debt securities held in its portfolio. Bank One and insurance companies Lincoln National, American General, and Torchmark were also forced to take large writeoffs on CDO holdings.

Wall Street Words: An A to Z Guide to Investment Terms for Today's Investor by David L. Scott. Copyright © 2003 by Houghton Mifflin Company. Published by Houghton Mifflin Company. All rights reserved. All rights reserved.

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