CDO, or Collateralized Debt Obligation, is a financial instrument that originated from the securitization of debt. It is a type of structured asset-backed security that pools together various types of debt obligations, such as bonds, loans, or mortgages, and issues different tranches of securities to investors. Each tranche represents a different level of risk and return.
CDOs were first developed in the early 1990s as a means to diversify and distribute risk associated with a large portfolio of debt. The underlying assets of a CDO are typically divided into senior, mezzanine, and equity tranches, based on their level of priority in receiving interest and principal payments. The senior tranches are generally considered the most secure and have the highest credit ratings, while the equity tranches are the riskiest but offer higher potential returns.
CDOs can be either cash flow or market value-based. In a cash flow CDO, the payments made by the underlying assets are used to pay interest and principal to investors, whereas in a market value-based CDO, the securities are valued periodically, and payments are made accordingly.
CDOs gained significant attention during the global financial crisis of 2007-2008 when the collapse of the housing market led to a wave of mortgage defaults and subsequent losses for CDO investors. This highlighted the complexity and opaqueness of CDOs, and their role in amplifying systemic risks in the financial system.
Overall, CDOs are financial instruments that enable the securitization and packaging of multiple debt obligations into tradable securities with varying risk profiles, aimed at diversifying risk and attracting a wide range of investors.
