CDO: Collateralized Debt Obligation

A CDO is basically an investment that is backed by debt. This debt can include one or more of the following sources: bonds, loans and other assets that have collateral. Mortgage loans (including subprime loans) have been popular inclusions in CDOs for a number of years.

Financial institutions invest in them to generate more cash. Unfortunately, like all investment, CDOs come with risk. And that is what is getting some in the financial sector into trouble.

Instead of fully disclosing what kinds of investments they had, some banks glossed over the details of CDOs. When the full impact of losses came to light in terms of earnings, well, investors were disappointed to see the results.

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Investors interpreted Citi’s move as a sign that financial institutions were repairing the damage from a meltdown in the U.S. subprime mortgage market and the resulting credit crunch, which has been a big factor behind recent dollar weakness.

Unfortunately, just because things look good for the financial sector today, doesn’t mean that they’ll look the same tomorrow. Fortune on CNN Money points out something that has yet to really hit the fan in the financial sector:

One likely new trouble spot: Conduits, the opaque structures banks set up to provide debt funding to borrowers. Often, the debt issued by the conduits is collateralized with assets, like mortgages.

Conduits typically aren’t consolidated on a bank’s balance sheet. But banks are often on the hook to fund them if investors stop buying the debt they’ve issued. When that happens, a lot of risk can get moved onto the balance sheet.

This is a continuation of the disclosure issues plaguing the financial sector. In Quarter 3, it was losses due to under-disclosed CDOs (collateralized debt obligations) that blindsided investors and added an extra helping of blood to the bloodbath following the subprime mortgage mess.

So, are the financial sector problems really at an end? Or have we just seen the tip of a rather large iceberg? Only time will really tell, but I think that more substantial changes to the way companies in the financial sector do things are needed. A “cash infusion” from a foreign investor is really band-aid.

The good news is that eventually the financial sector will probably recover. Just choose carefully which stocks you buy at a bargain price, and make sure you have the risk tolerance to hold onto them for the next couple of years. It’s going to be a bumpy ride.

Disclaimer: I am not an investing professional, merely an enthusiastic amateur. All investment carries risk, and you should do your own research and/or seek advice from an investment professional.

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