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...