You have probably heard a lot about derivatives over the past two years. Derivatives are largely responsible for the fall of banking giants Bear Stearns, Lehman Brothers and Washington Mutual. Derivatives also contributed to the collapse in the housing market and were a big part of the need for government bailouts.

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Warren Buffett refers to derivatives as "financial weapons of mass destructions." They are often traded in secrecy and are the subject of many backroom transactions. Let's shine a little light on one specific type of derivatives known as collateral debt obligations or CDOs. (For a background reading, see Collateralized Debt Obligations: From Boon To Burden.)

Understanding CDOs
CDOs are collateralized debt obligations. If you don't know what that is, you're not alone; no one on Wall Street seems to know what they are, either! PBS does a good job of explaining a CDO. A CDO is an "investment-grade security backed by a pool of various other securities. CDOs can be made up of any type of debt, in the form of bonds or loans." These obligations are then divided into slices that contain debts with various levels of risk. These different slices of risk are referred to as "tranches." Every tranche has its own credit rating.

How It Works
CDOs are constructed as a way of selling cash flows to investors. Good and bad debts are packaged together to get higher ratings from rating agencies thereby making them highly indistinguishable from one another. An investor could purchase a CDO with investment grade debt and junk grade debt all contained in the same portfolio. This makes it nearly impossible for investors to figure out what they are buying. Even the rating agencies have no idea how to rate these things.

Many CDOs receive an AAA rating despite having just a few investment-grade securities mixed in with mostly junk debt. They may as well rate every CDO AAA as long as it has one highly rated security in the whole deal. That's like placing a rose on top of a pile of garbage and calling it a flower bed.

The Problem with CDOs
The main problem with CDOs is that these structured asset-backed securities have so many different layers that no one understands exactly what's in them. Don't just take my word for it. Famed investor Warren Buffett once said, "If you take one of the lower tranches of the CDO and take 50 of those and create a CDO squared, you're now up to 750,000 pages to read to understand one security. I mean, it can't be done. When you start buying tranches of other instruments, nobody knows what the hell they're doing."

There is a serious problem with CDOs if our generation's greatest investor doesn't understand how these financial instruments work. (Learn more in CDOs And The Mortgage Market.)

A Moneymaker for Financial Institutions
If CDOs are such a mess, why do financial institutions sell them? Because they can make money selling them! The origination and securitization of loans is big business for banking institutions. Investment banks that sell CDOs receive huge commissions when the CDO is first sold and residual commissions over the life of the obligation.

The primary focus of CDO issuers is to sell a large quantity of products because that is what makes the money for the firm. Firms pay more attention to the quantity of loans being issued than the quality of loans being written. Who would have thought that investment banks would only be concerned about making money?

OK, you can see why investment banks sell these CDOs, but why do investors purchase them? The simple reason is greed. The more risk a CDO has, the higher the potential payout. Investors want the income generated by the outstanding debt but don't want to purchase the underlying security itself. CDOs were designed to be insurance policies, but instead of reducing risk for investors, they simply spread the risk around to everyone.

CDO Wrap-Up
CDOs are highly technical and complex financial products that were designed for sophisticated investors. That sounds great until you realize that there's no one on the earth sophisticated enough to understand them. (For a detailed look at the role CDOs played in the credit crisis, check out The Fuel That Fed The Subprime Meltdown.)

Feeling uninformed? Check out the financial news highlights in Water Cooler Finance: Greece Is Burning And Buffett's Under Fire.

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