CDOs

Collateralised Debt Obligations

One of the more common hedges banks use is called a collateralised debt obligation, or CDO, a bundle of around 50 corporate loans that is sliced and diced into pieces called tranches. In theory, the resulting product is akin to a mutual fund - one or two defaults don't taint the whole batch. Each tranche carries a degree of risk, from investment grade to - in trader's parlance - 'toxic waste'. That's why safety-conscious insurance companies and pension funds snapped up the higher-rated, lower-yielding tranches, while hedge funds and investors seeking higher returns bought the riskier tiers.

Banks love transforming loans into these derivatives because they don't have to reserve as much capital on their balance sheets, which frees up more money for new loans. CDOs are fairly new, but they're the fastest-growing fixed-income sector. In the past five years the market has swelled from a few billion dollars to more than $500 billion. When all goes as planned, investors love CDOs too - they get a steady stream of interest payments.

But this time around everything didn't go as planned. Banks started ramping up CDO sales in the late 1990s when default and bankruptcy rates were at historic lows; that persuaded less experienced investors to bite. Banks 'became very good at using financial engineering to make credit risk more palatable to the end buyer', says Charles Peabody, a banking analyst at brokerage firm Ventana Capital. 'But that risk just doesn't disappear'. The sharp increase in defaults - from telecom startups to Kmart - caught buyers off guard, thus throwing CDOs into downgrades and losses. American Express' financial advisors group learned that lesson the hard way: It bought a batch of CDOs in 1997 to juice returns and last summer was forced to take an $860 million charge related to that ill-fated purchase.

As the repercussions of the telecom smash unfold, expect to see a lot of angry players.