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Collateralized Debt Obligations: Definition & Examples

Instructor: Ian Lord

Ian has an MBA and is a real estate investor, former health professions educator, and Air Force veteran.

In this lesson we will define what a collateralized debt obligation is along with specific forms and terminology as well as how this type of investment works for banks and investors.

Collateralized Debt obligations

Collateralized debt obligations played a major role in the 2008 financial crisis, but not many people can explain exactly what they are. Understanding them and how they work is helpful in seeing that these investments can still be worthwhile. Let's define a collateralized debt obligation and look at the different kind of examples, especially those other than real estate.

Definition

A collateralized debt obligation (CDO) is a form of credit derivative. With a regular debt obligation, a bank holds a loan on an asset and receives regular payments. If the borrower doesn't pay as agreed, the bank can repossess the asset used as collateral on the loan. But when a bank puts together a CDO, those loans are packaged together and sold to investors as a tranche, or divided units of a loan.

For example, let's say that Dave buys a house and takes out a $150,000 mortgage with a monthly payment of $900 from BigMoneys Bank. Eager to get the loan off its books, the bank packages Dave's loan along with hundreds of other loans and the PTown Pension Company buys a tranche to diversify its investment portfolio.

Different tranches have different credit ratings. The higher level tranches have a higher credit rating with first priority for payments to investors and low risk of default. The downside is that these tranches offer a lower coupon or interest rate.

The lower level tranches have a higher risk of default, but in exchange for the risk offer significantly higher rates of return to investors.

The PTown Pension Company purchased one of these higher risk tranches because it was looking for a higher performing investment. The PTown Pension Company accepts a higher interest rate now in compensation for the possibility that Dave and other homeowners will stop making payments.

The CDO can promise investors a rate of return on their investment that is backed by the cash flowing in each month from the loan payments. The promise of cash flow is the underlying asset that investors count on to generate returns.

Each month millions of people like Dave make their regular loan payments. The PTown Pension Company owns the CDO and receives the repayment of the principal and interest instead of the bank.

Why doesn't the bank get the money? It's because the bank sold off the loans. By doing so the bank now has the money in hand to make even more loans. The bank also no longer carries the risk that borrowers will default on the loans. The PTown Pension Company now accepts the risk that if another housing crisis happens in the future it might not get paid if homeowners stop paying their mortgages.

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