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In the simplest terms, a collateralized debt obligation (CDOs) is a loan on something that has collateral. Unlike a simple loan at your local bank, CDOs have specific rules about who should invest in them, how they are rated and are specific in their scope of investment.
Local banks or credit unions need to free up money so they can loan again to local investors and borrowers. They will often sell the loans that they have on their books to another, larger firm. These providers will gather all these loans together, and slice them into pieces called tranches. These tranches are then sold to larger institutions such as hedge funds to carry in their portfolios.
CDOs are put together for a special purpose. They are a pool of assets of a particular kind such as high yield bonds or asset backed securities. Pooling them together helps the rating services rate them, and big, institutionalized investors know how risky they are when adding them to their portfolio
There are two basic types of CDOs: the synthetic CDO, which is issued to help banks or insurance companies to free up money on their books. The second is the Arbitrage Transaction, which allows the sponsor to earn a yield on the spread between the yield offered and the payments that are made to the various tranches.
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Some Rules for CDOs
Certain tranches of CDOs are rated by such services such as Moody's. This helps investors understand the qualitiy of the obligation that they are buying. It also helps ensure that the portfolio requirements that hedge funds or mutual funds are being met when these CDOs are being purchased. Regulations apply to these obligations and the first payments are always made to the senior tranches.
There are restrictive covenenants placed up the investors of these asset managers who are are investing in these obligations and certain tests are required to maintain the credit rating when it is issued.
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Payment and Risks
The funding for each tranches is provided by the senior note holder, who always receives payment first. However, other loans can be made to complete the funding for the tranches. These loans, mezannine loans and equity loans have a far greater risk and yield.
It is easy to understand why local lenders would want to sell off their loans, since it opens up their lending capital again. When a loan type begins to default, it can wipe out the funding for the tranches issued by the institution that gathered together all the loans to make the tranches. Collateralized Debt Obligations not only provide the basis for the mutual funds in which investors have their long term investments, but they also provide a way to open up the money at the local level.
The recent mortgage meltdown, which wiped out many of the tranches, is an example of how one tranche can severely affect the credit market. In the end, all credit parties need to be paid in order to keep the local banks on Main Street, and the small investor, financially healthy.