Editing Derivative (finance) (section)

===Collateralized debt obligation===
A '''[[collateralized debt obligation]]''' ([[Collateralized debt obligation|CDO]]) is a type of [[structured finance|structured]] [[asset-backed security|asset-backed security (ABS)]]. An "asset-backed security" is used as an umbrella term for a type of security backed by a pool of assets{{snd}}including collateralized debt obligations and [[Mortgage-backed security|mortgage-backed securities (MBS)]] (Example: "The capital market in which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs".<ref>{{cite web|last=Vink|first=Dennis| title=ABS, MBS and CDO compared: An empirical analysis|url= http://mpra.ub.uni-muenchen.de/10381/2/MPRA_paper_10381.pdf| work=August 2007 |publisher=Munich Personal RePEc Archive|access-date=July 13, 2013}}</ref>){{snd}}and sometimes for a particular type of that security{{snd}}one backed by consumer loans (example: "As a rule of thumb, securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called CDO, [and] [[Securitization]] issues backed by consumer-backed products{{snd}}car loans, consumer loans and credit cards, among others{{snd}}are called ABS.) <ref>{{cite web|last=Vink|first=Dennis|title=ABS, MBS and CDO compared: An empirical analysis|url=http://mpra.ub.uni-muenchen.de/10381/2/MPRA_paper_10381.pdf|work=August 2007|publisher=Munich Personal RePEc Archive|access-date=July 13, 2013}}; see also {{cite web|title=What are Asset-Backed Securities?|url=http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=16&id=10#sthash.roSaSia3.dpuf|publisher=SIFMA|access-date=July 13, 2013|quote=Asset-backed securities, called ABS, are bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.|archive-date=June 29, 2018|archive-url=https://web.archive.org/web/20180629101514/http://www.investinginbonds.com/learnmore.asp?catid=5&subcatid=16&id=10#sthash.roSaSia3.dpuf|url-status=dead}})</ref> Originally developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgage-backed security (MBS) markets.<ref name="Lemke 2013">Lemke, Lins and Picard, ''Mortgage-Backed Securities'', §5:15 (Thomson West, 2014).</ref>

Like other private-label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. The CDO is "sliced" into [[tranche|"tranches"]], which "catch" the cash flow of interest and principal payments in sequence based on seniority.<ref>{{cite journal| last1=Koehler| first1=Christian| title=The Relationship between the Complexity of Financial Derivatives and Systemic Risk |journal=Working Paper| pages=17|ssrn= 2511541| date=May 31, 2011}}</ref> If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, [[coupon (bond)|coupon]] payments (and interest rates) vary by tranche with the safest/most senior tranches paying the lowest and the lowest tranches paying the highest rates to compensate for higher [[default risk]]. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.<ref name="Lemke 2014">Lemke, Lins and Smith, ''Regulation of Investment Companies'' (Matthew Bender, 2014 ed.).</ref>

Separate [[Special-purpose entity|special-purpose entities]]{{snd}}rather than the parent [[investment bank]]{{snd}}issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration called "[[CDO-Squared]]" or the "CDOs of CDOs".<ref name="Lemke 2014"/> 
In the early 2000s, CDOs were generally diversified,<ref>Bethany McLean and [[Joe Nocera]], ''All the Devils Are Here, the Hidden History of the Financial Crisis'', Portfolio, Penguin, 2010, p. 120</ref> but by 2006–2007{{snd}}when the CDO market grew to hundreds of billions of dollars{{snd}}this changed. CDO collateral became dominated not by loans, but by lower level ([[Credit ratings#Corporate credit ratings|BBB or A]]) tranches recycled from other asset-backed securities, whose assets were usually non-prime mortgages.<ref name="FCIR-p127">[http://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf "Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the United States"], a.k.a. "The Financial Crisis Inquiry Report", p. 127</ref> These CDOs have been called "the engine that powered the mortgage supply chain" for nonprime mortgages,<ref name="FCIR-130">''The Financial Crisis Inquiry Report'', 2011, p. 130</ref> and are credited with giving lenders greater incentive to make non-prime loans<ref name="FCIR-133">''The Financial Crisis Inquiry Report'', 2011, p. 133</ref> leading up to the 2007–09 [[subprime mortgage crisis]].