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Collateralized Debt Obligations

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Collateralized debt obligations (CDO) are a form of an asset-backed security (ABS). Collateralized debt obligations are complex structured investment products that are collateralized by a group of assets (i.e. bonds, business loans, other collateralized debt obligations, etc.). The idea behind collateralized debt obligations is that you can create an investment-grade financial product and create liquidity by pooling assets together. Collateralized debt obligations pool assets which would be more illiquid and/or riskier on their own and therefore not as tradable. Collateralized debt obligations are sold in various tranches. Each tranche of a collateralized debt obligation offers a different risk level and depending on the type of collateralized debt obligations, a different maturity as well. Tranches of collateralized debt obligations with higher credit risk tend to be sold at higher prices than tranches with lower default risk. Once collaterilized debt obligations are sold, the underwriter has no further responsibility in collecting on the debt. As a result, should a default occur, it becomes the responsibility of the holder of the collaterilized debt obligations to collect. Misaligned interests between investors and underwriters of collateralized debt obligations can lead to lower standards when selecting eligible assets to be included within collateralized debt obligations. Collaterilized debt obligations only including bonds are called collaterilized bond obligations (CBO). Collaterilized debt obligations only including commercial loans are called collaterilized loan obligations (CLO). They are both types of collateralized debt obligations. Although collateralized debt obligations include bank loans, collateralized debt obligations do not typically include mortgages. Mortgages are pooled in asset-backed securities called collaterized mortgage obligations (CMO).

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