There are two types of Collateralized Debt Obligations(CDOs): balance sheet and arbitrage. We will go over the balance sheet CDOs here. They are used to manage risk by offloading the loans on the bank's or insurance company's balance sheet to the CDO, freeing up regulatory capital used to reserve against the loans and get capital. They are used primarily for Collateralized Loan Obligations (CLOs).
The balance sheet CDO can be set up as cash-funded or synthetic. Cash-funded CDOs buy the underlying securities of the portfolio from issuing securities to the investors. The synthetic CDO is more complicated. This CDO does not own any securities. It sells credit default swaps. Then the regular premiums are used to pay the interest on the securities of the CDO. Instead, it issues securities to the investors and the cash received is invested in US Treasuries. The interest earned on them is used to fund any swap payments to the counterparties.
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