From Kimberly Amadeo,
Your Guide to US Economy.
FREE Newsletter. Sign Up Now!

Definition: CDO's, or Collateralized Debt Obligations, are sophisticated financial tools that repackage individual loans into a product that can be sold on the secondary market. These packages consist of auto loans, credit card debt, or corporate debt. They are called collateralized because they have some type of collateral behind them.

CDO's are called asset-backed commercial paper if the package consists of corporate debt, and mortgage-backed securities if the loans are mortgages. If the mortgages are made to those with a less than prime credit history, they are called subprime mortgages.

CDO's were created to provide more liquidity in the economy. It allows banks and corporations to sell off debt, which frees up more capital to invest or loan. The creation of CDO's is one reason why the U.S. economy has been so robust in the last five years.

However, the downside of CDO's is that it allows the originators of the loans to avoid having to collect on them when they become due, since the loans are now owned by other investors. This may make them less disciplined in adhering to strict lending standards.

Another downside is that they are so complex that often the buyers aren't really sure what they are buying. They often rely on their trust of the bank selling the CDO without doing enough research to be sure the package is really worth the price.

The opaqueness and complexity of CDO's can cause a market panic if something happens to make sellers lose their trust in the product. This then makes the CDO's difficult to resell. This helped cause the 2007 Banking Liquidity Crisis.

Also Known As: Collateralized Debt Obligation

Examples: CDO's are so complex that the average individual investor should not include them in their portfolio.