Collateralized Debt Obligations (CDO) - Complex products!!!

CDO (Collateralized Debt Obligations) is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also.....

These CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded (before sub-prime crisis) those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept the ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!

Today, the world is blaming complex CDO products for the financial woes of the 2007 credit crunch. Credit rating agencies failed to value these products using their risk and recovery models. Some institutions buying CDOs even lacked the understanding to monitor credit performance and estimate its expected cash flows. As many CDO products are held on a mark to market basis, the steep fall in the credit markets and declining liquidity in CDOs led to substantial write-downs in 2007-08.