Collateralized Debt Obligation (CDOs)
This is best explained in the 2015 movie the "Big Short". "I'm a chef on a Sunday afternoon, setting the menu at a big restaurant. I ordered my fish on Friday, which is the mortgage bond that Michael Burry shorted. But some of the fresh fish doesn't sell. I don't know why. So, what am I going to do? Throw all this unsold fish, which is the BBB level of the bond, in the garbage, and take the loss? No way. Being the crafty and morally onerous chef that I am, whatever crappy levels of the bond I don't sell, I throw into a seafood stew. See, it's not old fish. It's a whole new thing! And the best part is, they're eating 3-day-old halibut. *That* is a CDO."
Quotes from the Big Short (2015)
Key points of CDO's
A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets.
These underlying assets serve as collateral if the loan goes into default.
The tranches of CDOs indicate the level of risk in the underlying loans, with senior tranches having the lowest risk.
CDOs backed by risky subprime mortgages were one of the causes of the financial crisis between 2007 and 2009.
Though risky and not for all investors, CDOs are a viable tool for diversifying risk and creating more liquid capital for investment banks.
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