Updated Jan 29, 2022

What are C.D.O.s ?

What are C.D.O.s?

A stock market is risky for everyone. It includes newcomers and experienced investors. Everyone must have a buffer to protect themselves against the risks in the stock market. This article is about the CDOs in the stock market. They help to shift risk and capital.

The long-form of CDOs is collateralized debt obligations. It is a product with a complex financial structure. It helps manage risk if your loan defaults. A mang creeper possesses loans into products and sells them to investors in the secondary market. A CDO package includes auto loans, mortgages, credit cards, and corporate debts.

In simple words, a CDO is a popular derivative. It has a backing of a pool of loans and other assets purchased by individual investors. It is because it gets its value from a different, underlying asset. The value of a CDO depends on the promise of loan repayment in the future. The owner of the CDO is now responsible for those loans. People have used derivatives in the stock market for a long time.

How do they work?

If the CDO includes corporate debt, banks call them "asset-backed commercial paper." The name of a CDO becomes "mortgage-backed securities" when the loans are mortgages. If these mortgages belong to individuals with less-than-prime credit, banks call them "subprime mortgages."

Benefits of CDOs

The concept of CDOs has benefited banks and investors a lot. Banks sell the CDOs to investors for the following reasons:

• Banks receive funds after selling CDOs to investors. They use these funds to create new loans and expand their business.

• Banks use CDOs to shift the risky, potential defaulting loans to the investors. Banks free themselves from the responsibility of recovering loans after selling CDOs.

• CDOs allow banks to sell profitable products, thus increasing the revenue of their employees. They can use these additional funds to offer better loan policies to their customers.

• Investors benefit by purchasing CDOs because they get to invest in a CDO compatible with their risk tolerance. There are various CDOs, and investors can pick one that fits their portfolio. With enough study, one can identify a low-risk CDO.

Drawbacks of CDOs

Like anything else in the stock market, CDOs also have drawbacks. CDOs do not pose any danger to banks. However, investors have a lot to lose when investing in CDOs. Investing in a CDO has the following drawbacks:

• After selling CDOs to investors, banks no longer have an incentive to collect loans when the time comes. Due to such a lenient attitude, banks often relax their lending policies after selling CDOs to investors. After all, investors now shoulder the risk of the loan defaulting after purchasing the CDO.

• CDOs are complex things, due to which investors may not understand what they are getting into when they purchase one. It is hard to estimate whether a CDO is worth its price. Such insecurities may lead to market panic. It is always better to seek professional help while purchasing a CDO.

CDOs in India

ICICI Bank was the first one in India to sew a CDO transaction supported by corporate loan receivables. The bank opened the policy in 2002 with an investment of 506cr to help individual investors improve their portfolios. Since then, CDO has evolved as a portfolio management tool for Indian investors. The Indian government came up with the Securitization and Reconstruction of Financial Assets and Enforcement of Security Interest Act in 2002 to resolve the problem of non-performing assets. Thanks to this act, banks could sell their non-performing assets to ARCs.

The trend of securitization got affected due to the subprime crisis in India. Banks that invested in companies like Lehman Brothers and Merrill Lynch suffered significant losses. There was a 60% drop in the ABS volume, but the CDO market experienced a high. The RBI improved and tightened policies to overcome loopholes in the Indian market. Due to the new rules, the securitization market shrunk by March 2014.

Conclusion

CDOs are beneficial for banks in several ways. However, they pose a risk to investors looking for easy money. Studying CDOs is the best way to overcome the risk in the Indian market. The safest way to invest in CDOs to reap maximum benefits is by consulting with a professional.