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Published on April 15, 2008

These are complex instruments based on pools of debt that have been grouped together and repackaged into new investments. CDOs can contain more than 100 bonds and mortgage debts. They are allocated risk ratings offering different rates of return depending on the risk of default of the assets they are based on.

Why were banks so keen on them?

Banks used them to offload debt from their balance sheets, enabling them to lend more money and do more business. They sold CDO tranches to a range of investors.

Why are they so risky?

Many CDOs are based on high-risk US sub-prime mortgage loans - estimates suggest about a third of the US$600 billion (about Bt19 trillion) in CDOs sold last year contained these debts. But as borrowers stop paying, defaults occur within the CDO tranches. This has slashed the value of many CDOs, making them impossible to sell. Some CDOs use the same mortgage pool as collateral, so any defaults in that pool cause a ripple effect through several investments. A $1-billion portfolio of mortgage defaults, for instance, could cause $5 billion of losses.

Why did investors buy them?

Many investors around the world who bought CDOs did not realise what they were buying or how they were valued. In the booming financial markets of the past few years, credit was very cheap. Some of the CDO tranches were offering relatively high rates of return, but in a downturn they have proved to be extremely risky.

Why did investors not realise they were so risky?

Investors were reassured by credit-ratings agencies that the risk of default on CDO tranches was low. But in many cases, ratings agencies underestimated the risk and were being paid by the banks to help set up CDOs. The products were also designed in a benign financial environment and few tests were conducted on how they would behave in an extreme downturn. It was hard to test all possible outcomes.

What happens to CDOs now?

No CDOs have been sold since the onset of the credit crisis last August. Investors with portfolios of CDOs have had to mark down their value to reflect the downturn in the market. Many banks have had to make successive write-downs to take account of the rapid fall in value of their CDO holdings. It is unlikely CDOs will regain their popularity of recent years.