What exactly is a Collateralized Debt Obligation (CDO) and how does it work?

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Investment Banking giant Goldman Sachs was accused by the US Securities and Exchange Commission (SEC) of not fully disclosing the facts regarding a certain collateralized debt obligation (CDO) they sold.  The CDO was named ABACUS 2007-AC1.  Which prompts the question, what exactly is a CDO and how do they work?

Louis M. Viceira, a professor at the Harvard Business School says of CDO's: "they are not very different, in essence, to the balance sheet of any company: it (the CDO) holds assets on the left hand side of the balance sheet, and it issues claims against those assets and the cash flows they produce. Like in any corporation, these claims have different seniority rankings: there is equity, there is junior debt, and there is senior debt. Senior debt holders have top priority on the assets of the firm (e.g., CDO), but in exchange for that, they accept lower interest payments than holders of more junior claims. Mezzanine debt is next, junior debt is next, and finally equity is at the bottom of the priority chain. If we think of a balance sheet as an apartment building, the equity holders live in the lower floors, while the senior debt holders live in the upper floors. When the flood comes in, the first ones to suffer losses are those living in the lowest floors. Only as the flood becomes worse, "those living in the upper floors start to suffer losses.''

CDO's were very popular leading up to the financial crisis in 2008. Many investors purchased mutual funds and other financial products not realizing these complex investments were part of their investment. The experienced securities fraud attorneys at Colling Gilbert Wright & Carter have successfully represented investors who purchased CDO's and CDO related investments based on incomplete or misrepresented information.  If you have suffered losses as a result of omissions or misrepresentations during the purchase of a security, please contact us for a free case evaluation.