CDOs – Collateralised Debt Obligations

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

5 thoughts on “CDOs – Collateralised Debt Obligations”

  1. Just thought I’d add to that.

    One thing to note about CDOs is that they are bundles of mortgage debt *of all different qualities*.

    Part of them is very unlikely to get paid back, as it has been lent to people who never had the money to pay it back, and their house prices are now falling (this is largely the ‘subprime’ part).

    But, some of it really is good, and really will be paid back eventually.

    So, it’s not actually as simple as ‘all CDOs are worthless’: actually, a lot of parts of CDOs still have value. But, banks just don’t know how much of it has become worthless, so they don’t know how much trouble they are all in: and to minimise risk, they’ve reduced their lending to each other (i.e., made it more expensive).

    The trouble now is getting the banks to start lending more cheaply to each other again, which will reduce their costs and hopefully be passed on into cheaper loans for companies and individuals. This is what the government has been pushing for recently, with some success:

  2. Thanks for this article! The question I have is: is it true that goverments can creative money out of thin air?

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