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What are CDOs (Collateralized Debt Obligations)?

Collateralized debt obligations (CDOs) are a type of asset-backed security (ABS) and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. CDOs are divided by the issuer into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. Since 1987, CDOs have become an important funding vehicle for fixed-income assets.

During the credit bubble of the mid-2000s, a few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that financial derivatives such as CDOs and other ABSes were greatly increasing risk in the financial markets, but their views were dismissed. With the advent of the 2007-2008 credit crunch, it has become clear that CDOs, like all ABSes, suffer from a fundamental flaw that causes all tranches to be extremely high risk for investors: loan originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance, which causes unchecked degradation of underwriting standards. This problem was exacerbated by the failure of credit rating agencies to take into account the collapse of underwriting standards when valuing these products. The institutions buying CDOs relied on the ratings agencies, as they lacked the competency to monitor credit performance and/or estimate expected cash flows. Major loss of confidence has therefore occurred in the validity of the process used by ratings agencies to assign credit ratings to CDO tranches and this loss of confidence persists into 2009.

As many CDO products are held on a mark to market basis, the new understanding of the underlying risks of CDOs and the associated collapse of liquidity in these products led to substantial write-downs starting in 2007 and continuing into 2009.

What are ABSs?
What are CDCs?
What are CDSs?
What are CDIs?
What are MBSs?