The aftermath

Author: | Published: 1 Sep 2007

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...