A short explain about CDO

1. CDO
Collateralized debt obligation

2. What are the CDO’s?
A structured financial product that pools together cash flow-
generating assets and repackages this asset pool into discrete
tranches that can be sold to investors. A collateralized debt
obligation (CDO) is so-called because the pooled assets – such
as mortgages, bonds and loans – are essentially debt
obligations that serve as collateral for the CDO. The tranches in
a CDO vary substantially in their risk profile. The senior
tranches are relatively safer because they have first priority on
the collateral in the event of default. As a result, the senior
tranches of a CDO generally have a higher credit rating and
offer lower coupon rates than the junior tranches, which offer
higher coupon rates to compensate for their higher default risk.
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3. Market History and Growth
The first CDO was issued in 1987 by bankers at now-
defunct Drexel Burnham Lambert Inc. for Imperial Savings
Association. A decade later, CDOs emerged as the fastest
growing sector of the asset-backed synthetic securities
market.
A major factor in the growth of CDOs was the 2001
introduction by David X. Li of Gaussian copula models,
which allowed for the rapid pricing of CDOs
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4. How CDOs Work
Bundling debt into a CDO changes the riskiness of investing in
debt in two ways:
Reduction of Statistical Outliers
First, CDOs reduce the effect of statistical outliers. Lending
someone money to buy a house is risky, because that person
either defaults or they don't - even if there's only a one in
5,000 chance of someone defaulting on their mortgage, if you
happened to be the lender for the person who defaults, you're
out of luck.
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5. Tranches
Second, CDOs are created in tranches - portions of the
underlying debt that vary in their riskiness, despite being
backed by a generic pool of bonds or loans.
Typically, a pool of debt is divided into three tranches, each
of which is a separate CDO. Each tranche will have different
maturity, interest rates and default risk. This allows the
CDO creator to sell to multiple investors with different
degrees of risk preference.

6. CDO Market
According to data from Securities Industry and Financial
Markets Association global CDO issuance increased from $157
billion in 2004, to $503 billion in 2007. The total outstanding
CDO is estimated to be over $2 trillion.
CDOs are structured by investment banks and are bought by
all types of asset managers, including hedge funds, insurance
companies, banks and pension funds. CDOs can also be
purchased through most retail brokerage accounts.
For an example of CDO prospectus look at Triaxx Prime CDO
2006-1.
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