(This article appears courtesy of International Financial Law Review, sign up for a free trial on their site)
Daniel Andrews
Features editor
Amid the storm of recrimination over the fallout from the US housing market, many investors were trying to find ways to exit their positions in a timorous and illiquid market. The problem was, many of them didn't understand the exposure contained in instruments such as collateralized debt obligations (CDOs). They could perhaps have benefited from some more nuanced and sophisticated legal advice. But first, let's cover the basics. Collateralized debt obligations transfer ownership and risk from banks to investors. They are structured vehicles that gain exposure to different types of debt then divide that debt package into different risk slices, or tranches, for investors.
In the case of CDOs of mortgage-backed securities, individuals take out mortgages with their banks, which then aggregate many loans and sell on to CDO vehicles. The CDO then packages the securities (which include subprime mortgages and riskier parts of US residential mortgage-backed securitizations) for investors.
Quite how this works in practice is a mystery to most, but what is clear is that these instruments have proved remarkably popular in recent years – data from Thomson Financial show total issuance for the first half of 2007 at $313 billion, up from $233 billion in 2006 and $120 billion in 2005 for the same period.