FINANCIAL MISCONDUCT: What are collateralized debt obligations?

Steve Lombardi

Attorney
(866) 735-1102 Ext 335

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Collateralized Debt Obligation (CDO)

CDO’s are a way of turning mortgage debt into investments that can be bought and sold on the open market.

Investing in CDO’s involves calculating, using mathematical formulas, the risk involved in the debt going sour or the investment paying off a return on the money invested.

Three levels of risk were identified: Equity, Mezzanine and Senior. Senior holds the least risk of losing money on the investment because if the loans go sour senior gets paid first. Mezzanine level investors have less risk than do equity level investors but more than senior level investors. The equity level investors are like a shield to the mezzanine and senior level investors; if the debtor or mortgage payor defaults then equity level investors take the hit and theoretically shield the mezzanine and senior levels. To attract the front line of this mathematical investor football team the equity guys were promised a high rate of return. This promised was to be fulfilled by dividing up the expected return in a way that paid a low but “guaranteed” rate of return to the senior and mid level investors and then the equity folks get the rest, which was the lion’s share of the mortgage payments.

The banks may retain a stake in the loan sale by holding some or all of the equity portion of the investment.

Problems crept in when the junk loans were being written (liar loans) and the default rates started creeping higher and higher. The higher the default rate went the less money was left to return to the equity investors. Their 16.5% rate of return now plummets to 2% or less and the mezzanine investors get jittery as they see their promised return on money invested may be invaded.

This is in essence a mortgage back security. And as the writer points out it can be used with many types of assets that create cash flow to pay the investors. It can be used with lending to corporations and businesses.

Collateralized debt obligation (Balance Sheet CDO)

So where do things go wrong? Well, not yet; first things first. First we need to learn the basics. Come back to the InjuryBoard for more information. This month, the month of April is financial wrongdoing month. Welcome aboard.