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.

IN PICTURES: 10 Tips For The Successful Long-Term Investor

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.

Related Articles
  1. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  2. Fundamental Analysis

    Calculating Return on Net Assets

    Return on net assets measures a company’s financial performance.
  3. Savings

    How Volatile Exchange Rates Affect Your Vacation

    Those ever-changing fluctuations can make a difference in anything from your hotel room to an ATM transaction.
  4. Credit & Loans

    Can Corporate Credit Cards Affect Your Credit?

    Corporate cards have a hidden downside. If the company fails to pay its bills, you could be liable for the amount and end up with a damaged credit rating.
  5. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  6. Investing News

    What Is The New Credit Card Chip Good For?

    Under current U.S. credit card requirements, credit card issuers are required to issue chip cards as of October 1, 2015. Instead of swiping your card as you do now, you will slide the card into ...
  7. Professionals

    Are Hedge Fund ETFs Suitable for Your Portfolio?

    Are hedge fund ETFs right for you? Here's what investors need to consider.
  8. Credit & Loans

    5 Ways to Maximize Your Credit Card Points

    How to get the most bang for your rewards buck.
  9. Economics

    How Do Asset Bubbles Cause Recessions?

    Understand how asset bubbles often lead to deep, protracted recessions. Read about historical examples of recessions preceded by asset bubbles.
  10. Investing

    How to Effectively Compare Credit Card Rewards

    There are so many different reward credit cards that are available. Understanding how each type work will help you pick the best card for your needs.
RELATED TERMS
  1. Derivative

    A security with a price that is dependent upon or derived from ...
  2. Real Estate Investment Trust - ...

    A REIT is a type of security that invests in real estate through ...
  3. Transferable Points Programs

    With transferable points programs, customers earn points by using ...
  4. The New Deal

    A series of domestic programs designed to help the United States ...
  5. Hunting Elephants

    The practice of targeting large companies or customers.
  6. Ginnie Mae Pass Through

    A type of investment issued by the Government National Mortgage ...
RELATED FAQS
  1. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
  2. Where can I buy penny stocks?

    Some penny stocks, those using the definition of trading for less than $5 per share, are traded on regular exchanges such ... Read Full Answer >>
  3. How are American Depository Receipts (ADRs) priced?

    The price of an American depositary receipt (ADR) is determined by the bank or other financial institution that issues it. ... Read Full Answer >>
  4. How are American Depository Receipts (ADRs) exchanged?

    American depositary receipts (ADRs) are bought and sold on regular U.S. stock exchanges, either in the over-the-counter market ... Read Full Answer >>
  5. How does the risk of investing in the industrial sector compare to the broader market?

    There is increased risk when investing in the industrial sector compared to the broader market due to high debt loads and ... Read Full Answer >>
  6. How can I hedge my portfolio to protect from a decline in the retail sector?

    The retail sector provides growth investors with a great opportunity for better-than-average gains during periods of market ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!