Collateralized debt obligation
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Collateralized debt obligations (CDOs)
are a type of structured asset-backed secur-
ity (ABS) whose value and payments are de-
rived from a portfolio of fixed-income under-
lying assets. CDOs are assigned different risk
classes,
or
tranches, whereby
"senior"
tranches are considered the safest securities.
Interest and principal payments are made in
order of seniority, so that junior tranches
offer higher coupon payments (and interest
rates) or lower prices to compensate for addi-
tional default risk.
A few academics, analysts and investors
such as Warren Buffett and the IMF’s former
chief economist Raghuram Rajan warned that
CDOs, other ABSs and other derivatives
spread risk and uncertainty about the value
of the underlying assets more widely, rather
than reduce risk through diversification. With
the advent of the 2007-2008 credit crunch,
this view has gained substantial credibility.
Credit rating agencies failed to adequately
account for large risks (like a nationwide col-
lapse of housing values) when rating CDOs
and other ABSs.
Many CDOs are valued on a mark to mar-
ket basis and thus have experienced substan-
tial write-downs on the balance sheet as their
market value has collapsed.
Market history and
growth
The first CDO was issued in 1987 by bankers
at now-defunct Drexel Burnham Lambert Inc.
for Imperial Savings Association, a savings
institution that later became insolvent and
was taken over by the Resolution Trust Cor-
poration