A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. Essentialy, they are bundled debt resold to to investors. The complicated nature of CDOs make them difficult to evaluate even for knowledgeable investors.
The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. A collateralized debt obligation is a type of derivative security because its price is derived from an underlying asset. Banks package together assets such as mortgages, bonds, or other types of asset-generating securities into discrete classes of investments. The classes are called tranches, which hold the cash flow of interest and principal payments in sequence, based on seniority.
Banks generally sell CDOs to investors for three reasons. Funds from sales of collateralized debt obligations generate cash, which banks use to make new loans. The loan's risk of defaulting is transferred from the bank to the investors who purchase the CDO. And collateralized debt obligations are a relatively new type of security, created by banks to increase profits and (for public banks) increase their share price.
There are three types of collateralized debt obligations: