Thursday, March 31, 2011

CDO: Collateralized Debt Obligation

Well, isn't that a fun word? Collateralized! It means that the loan is backed with collateral, typically a house. CDOs are most of the reason that we are where we are economically. For an in depth understanding of CDOs start reading the CDO Wikipedia page and then read the references. For starters, let's call this the The Two Trillion Dollar Meltdown (and I'll offer another opportunity for you to buy an Amazon book).

File:Securitization Market Activity.png
$2 Trillion in Lost Money
The other figures that you see aside from CDOs are Asset-Backed Security (student loans, credit cards, car loans, etc), Commercial Mortgage-Backed Security (commercial mortgages for Target and Starbucks and the like), and Residential Mortgage-Backed Securities (your parents mortgage). All of these things are related, specifically the CDO was typically composed of MBS (either RMBS or CMBS). It was basically hundreds to tens of thousands of MBS bundled together. As long as the people were paying their mortgages, everything was fine. 

Then some people got greedy or "smart" and decided to split the CDOs based on the ability of the homeowners to pay, based on their credit score more or less. The advantage of this is that while the people are paying you are making more money on the sub-prime CDOs than the prime CDOs. Secondly, there is a little thing a called selling short, which means you borrow shares to sell then at a later date you buy those shares back and return them to the lender. In other words you make money when stock prices go down. With so many sub-prime CDOs available when the market started to go south just about anyone on Wall Street would probably have the insight to sell short on bad CDOs, even though other financial institutions. In other words, people got rich using CDOs and then by watching the market like a hawk, they  stayed rich while people across the county lost their homes and retirement savings. 

In short, when Warren Buffet says it's a bad investment, it probably is. 

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