1. What is a collateralized debt obligation?

A collateralized debt obligation (CDO) is the security created when Wall Street pools loans, mortgages or bonds, and sells off the rights to the cash flow from the pool to investors.

These investment vehicles also sometimes are referred to as CLOs (collateralized loan obligations), CBOs (collateralized bond obligations) or CMOs (collateralized mortgage obligations), depending on the type of underlying debt instruments that are being pooled and securitized.

2. What is a CDO tranche?

The CDO securities are divided and sold in "tranches" (French for "slices"), each having a different claim on the flow of cash from the loan pool: The senior tranche gets a AAA rating because it has the first call on cash flows. Successively more junior tranches (rated AA to BB or lower) have a subordinate claim on the cash flows, bringing higher risk and a higher expected return. The bottom slice gets paid last, and it is not rated at all.

3. What is an equity tranche?

Bankers call the bottom, unrated tranche of a CDO the "equity tranche." These most junior tranches will earn the highest profits if things go well, but they are the most vulnerable to losses. In the securities industry these equity tranches are referred to as the "toxic waste," because much of the risk of the loan pool as a whole has been shifted to this tranche. In the case of serious defaults, investors in the equity tranche can lose their entire principal even while other tranches are partly repaid.

4. Who gives the ratings?

The rating of the tranches in CDOs are given by rating agencies such as Moody's or Standard & Poor's, which provide this service for a fee to the bankers and managers who create the CDOs.

5. What do the ratings mean?

The original impression was that a AAA rating for the top rated tranche of a CDO meant the same as the AAA rating the agencies give the top U.S. or corporate bonds. However, that assumption has been called into question by the performance of CDOs and by statements from the rating agencies. In some cases, CDO tranches issued with AAA ratings when sold were downgraded to "junk" status within only a few months.

Congress, the SEC and some state attorneys general are investigating the rating agencies and underwriters of CDOs, and this may be an area that undergoes major changes and additional regulation in 2009.

6. Who were CDO tranches sold to?

The purchasers of rated tranches typically were institutions--pension funds, universities, school districts, municipalities, insurance companies, hedge funds, and mutual funds. These institutions often were required by law to purchase primarily highly rated fixed income assets.

The equity tranches were marketed to high net worth individuals. To make the bottom tranche attractive, it is typically promoted as a fixed income security that for small additional risk will produce much higher returns than ordinary bonds.

7. How can I tell if a CDO investment has lost value?

If a CDO investment is supposed to make regular payments, the first warning sign is usually a reduction, delay or suspension of those payments. Another indication is a ratings downgrade or a ratings watch. These are announced on the websites of the ratings agencies, and the most dramatic and substantial downgrades are often in the headlines of the financial news. However, since there is no ready market for CDO investments, they often are listed at book (purchase) price, which makes it very difficult to determine whether or not there has been a decline in current market value.

There is every indication that most of the losses in CDOs are as yet unrecognized and unrealized, because many investors who own tranches in CDOs have no way to calculate their current value.

8. Is it possible that I own an interest in a CDO and do not know it?

Yes. For example, many hedge funds invested in CDOs and some are now sustaining very large losses as a result. Unfortunately, hedge funds frequently do not disclose their investment strategy, let alone specific holdings, so their CDO exposure is hidden. Even when losses occur, the managers may use the uncertainties in valuing CDOs to avoid reporting some declines.

In addition, many hedge funds, banks, and even mutual funds purchased or wrote insurance on CDOs, called "credit default swaps." These derivative securities are simply agreements to reimburse a third party or be reimbursed in case a CDO tranche suffers unexpected losses. CDO losses now have affected the financial strength and returns of institutions that engaged in this type of insurance transaction.

If you are having difficulty determining you exposure to CDOs or the value of your CDO investment, we can make inquiries on your behalf to determine the status of your investment. Please contact us.

9. I own mutual and money market funds, so I am safe from CDO losses, right?

Wrong. CDO problems have even hit investors who thought their money was safely positioned in high quality and well diversified mutual funds. Many, it turns out, were investing in CDOs or writing credit default swaps on CDOs in order to increase investor returns. That practice has resulted in very significant losses.

10. How do I determine if losses from a CDO investment are recoverable?

Each case will require its own fact intensive inquiry. In many cases, the record will show that CDOs, especially the high risk, unrated tranches, were not fairly and accurately presented, and were sold as if they were ultra safe income-producing investments, and not speculative equity-like securities. It is likely that Wall Street will be required to give back at least a part of the astonishing returns it enjoyed, and will be forced to compensate investor losses.

If you want more information about potential losses from the purchase of a CDO tranche, call 415.217.7300, and ask to speak to a lawyer in our office, or email info@cdolawyers.com.

11. Where can investors bring suit?

Depending on the circumstances, remedies may be available in state or federal court in any state. Many individual investors will be required to arbitrate claims against their brokers. Whether or not a case is required to be arbitrated typically is spelled out in the account agreements. Sparer Law Group has represented individual and institutional investors in the U.S. and Great Britain in investor lawsuits and arbitrations.