Collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets.

Some news and media commentary blame the financial woes of the 2007 credit crunch on the complexity of CDO products, and the failure of risk and recovery models used by credit rating agencies to value these products. Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Major loss of confidence in the validity of process used by ratings agencies to assign credit ratings to CDO tranches occurred and persists in 2008.

A structured investment vehicle (SIV) is a fund which borrows money by issuing short-term securities at low interest and then lends that money by buying long-term securities at higher interest, making a profit for investors from the difference. SIVs are a type of structured credit product; they are usually from $1 billion to $30 billion in size and invest in a range of asset-backed securities, as well as some financial corporate bonds. An SIV has an open-ended (or evergreen) structure; it plans to stay in business indefinitely by buying new assets as the old ones mature, and the SIV manager is allowed to exchange investments without providing investors transparency/the ability to look through to the structure.

The risk that arises from the transaction is twofold. First, the solvency of the SIV may be at risk if the value of the long-term security that the SIV has bought falls below that of the short-term securities that the SIV has sold. Second, there is a liquidity risk, as the SIV borrows short term and invests long term; i.e., outpayments become due before the inpayments are due. Unless the borrower can refinance short-term at favorable rates, he may be forced to sell the asset into a depressed market.

Source: Wikipedia

(HK Edition 04/15/2008 page2)