Collateralized Debt Obligations

A Collaterized Debt Obligation (CDO) is a financial derivative that produces cash flows from underlying fixed income securities such as mortgages, bonds and credit default swaps. CDOs transform a group of securities into a wide variety of investment alternatives, with risk/reward profiles both higher and lower than the underlying assets. Investors purchase the right to these cash flows by investing in different tranches of a CDO. Though there are more, the tranches can typically be classed as one of three groups; the senior tranche, the mezzanine tranche and the equity tranche. Typically the senior tranche of a CDO carried a Aaa rating while the equity tranche was considered below investment grade. For this reason the issuer typically retained the equity tranche.

An example of the structure of a CDO is as follows. A financial institution may have a group of Bbb rated mortgage backed securities (MBS) that it wants to shed from it balance sheet. The institution can make these MBS more attractive to investors by pooling the assets into a CDO. This is accomplished by setting up a special investment vehicle, a trust that actually controls the underlying assets. The CDO would then be structured to create a series of tranches, with the senior tranches having the first claims to the cash flows generated by the underlying assets, the mezzanine the second, and the equity tranche the last.

Planet Money purchased a toxic asset for $1000. This is a link to track their progress, but also tells a lot about the underlying mortgages.

http://www.npr.org/templates/story/story.php?storyId=124578382

Here is an interesting link I found this morning on BP's CDS and the concern that it is in danger because they think the dividend is in danger. The CDS has widened significantly due to it.

http://finance.yahoo.com/news/BP-shares-and-CDS-hurt-by-rb-1137217173.html?x=0&sec=topStories&pos=2&asset=&ccode=

SEC Lawsuit against ICP Asset Management, a firm who was the second largest manager of CDOs insured by AIG. ICP "violated its fiduciary duty by entering into prohibited investments, failing to obtain approvals for trades, misrepresenting the value of holdings and deceiving clients", according to the SEC.

http://www.bloomberg.com/news/2010-06-21/sec-sues-icp-asset-management-founder-priore-for-cdo-fraud.html