Collateralized debt obligations, commonly known as CDOs, are bonds backed up by a pool of loans. The word collateral means that the loans are backed up by a physical asset. CDOs benefit borrowers as well as lenders, and can provide a profitable alternative for investors.
A collateralized debt obligation is simply a pool of future payment promises. Assume a bank lends money to 1,000 car buyers and receives an average of $300 from each borrower every month. The title of each car would naturally have a lien, allowing the bank to seize the vehicle if the borrower fails to make monthly payments. Should the bank need urgent cash, it can contact a large investor with money, such as a mutual fund, and promise to pass on all payments from car buyer for the next year to this institution, in exchange for an immediate lump sum payment. This arrangement is a collateralized debt obligation, because the promise of the bank to the mutual fund is backed up by the vehicles, which are the collateral in this case.
In theory, a collateralized debt obligation can be backed up by any type of loan with a collateral. CDOs backed up by mortgage loans are often classified differently and referred to MBS, which stands for Mortgage Backed Securities. The basic idea, however, is the same regardless of whether the collateral is industrial equipment, houses or motorcycles.
A pool of future payment obligations can be divided up into several risk tranches to satisfy the risk tolerance of various types of investors. The bank with 1,000 borrowers, who make an average monthly payment of $300, can either pass on $300,000 to one mutual fund or $150,000 each to two mutual funds. The latter arrangement might state that should borrowers fail to pay and the confiscation of the cars fail to make up for the shortfall, all monthly losses up to $30,000 will be absorbed by the first mutual fund. Naturally, the first mutual fund is in a privileged position and must pay a greater sum upfront to be entitled to these payments.
Assume several car buyers default on their car loans and the monthly proceeds -- after accounting for the confiscation of vehicles and their sales proceeds -- is $280,000; a shortfall of $20,000. The legal arrangement calls for the entire loss, up to $30,000, be reflected on the payments passed through to the first mutual fund. The first fund will, therefore, receive $130,000, while the second fun will get the usual $150,000. Had the shortfall been $40,000, the first $30,000 would be absorbed by the first mutual fund, and the remaining $10,000 loss would hit the second fund. The funds would thus receive $120,000 and $140,000, respectively.
Since CDOs often change hands between large investors, small investors usually cannot buy them directly. However, mutual funds opened to individual investors often hold CDOs, and it is therefore beneficial for the small investor to understand this financial security class.