This type of debt instrument is made up of a pool of debt with predictable income streams. As borrowers repay their debt, corresponding CDO holders earn yields on their investment. CDOs are normally divided into tranches – each with their own level of risk.
Risk is determined by the affect which borrowers defaulting on their debt may have on a specific tranche.
For example, if a CDO were divided into 6 tranches, the first tranche may be responsible to absorb the first 30% of possible defaults, the second tranche may absorb the next 30% of defaults, while the remaining 4 tranches absorb just 10% of defaults each. Because the risk of loss due to possible default is highest in the case of the first two tranches, the yield rates paid out may be higher for those tranches.
The last tranche is generally the safest because borrowers who have paid their debt up until the CDO reached its final tranche are not likely to default.
CDOs played a key role in the financial crisis of 2007. They’ve been heavily criticized due to their complex makeup and the incorrect valuation of these products by rating agencies.
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