Readers Question: What are CDOs? How do they work? Could you please explain in detail as I am very confused.
CDOs are effectively a type of bond, which is backed by loans, other bonds or assets.
Banks used CDOs to reduce the amount of debt on their balance sheet.
One way to think of them is like this: A bank may have some mortgage loans which are worth £10,000. This bank may then sell a CDO to another bank. What this means is that the second bank has a bond backed by the mortgage loan. Therefore, as the mortgage is paid back, the second bank will get interest payments.
However, if people default on their mortgages, then the person owning the CDO is going to see a decline in the value of the CDO.
The first bank has in effect sold on its mortgage loans to another company. Therefore, if the person with a mortgage defaults, the risk is born by the person who bought the CDO.
CDO’s played an important role in the credit crunch because they meant when mortgage defaults rose, many banks around the world went bankrupt.
Part of the problem is that people buying CDOs were not aware of the risk involved.
CDOs can also involve other types of assets – not just loans
- CDOs at wikipedia