What are CDOs anyway?

As another wave of writedowns crashes over investment banks, "CDO" is replacing "MBS" as the TLA of choice in subprime lingo.

We’ve been hearing about subprime mortgage backed securities (MBS) for quite some time now.

Most of us have become comfortable with the concept of securitization, where subprime mortgage are pooled together, tranched into different risk categories and re-issued as subprime bonds – or subprime MBS.

Collateralized Debt Obligations represent the next level of complication when it comes to structured securities.

As investment banks link their writedowns to CDO’s, the three letter acronym (TLA) has risen to media darling status.

CDO’s are the bubble and squeak of structured debt. Standard corporate or municipal bonds, subprime mortgage backed bonds, subprime mortgages, adjustable rate mortgages, prime mortgages, you name it – and it can go into the make up of a Collateralized Debt Obligation basket.

To give the whole basket a cohesive factor, as well as an investment grade rating, the bank would write a put option under the basket.

The put is like an insurance policy that the CDO can exercise when things sink below a predetermined level of bad.

This explains why Structured Investment Vehicles (SIVs), that took CDOs off the bank’s balance sheets and funded them by issuing short term paper into the money markets, are able to call in the favor.

When a SIV executes the put option, it forces the bank to take responsibility for the CDO basket.

This put option structure explains why the recent wave of writedowns by major investment banks have all been linked to CDO exposure.

If it feels like understanding CDOs is like trying to identify the yolk and egg-white portions in the omelet, you are not alone.

The lack of transparency and understanding has led banks closer to the realization that bundling CDOs with Uncle Angelo's Credit Crunch cereal may be the only way to rid themselves of the instrument.