Russian doll that could turn toxic for Diamond

They were once memorably referred to as the "toxic waste" of the capital markets by Sir Howard Davies, the former chairman of the Financial Services Authority. However you choose to describe them, collateral debt obligations, or CDOs as they are known, are certainly complex beasts.

They were once memorably referred to as the "toxic waste" of the capital markets by Sir Howard Davies, the former chairman of the Financial Services Authority. However you choose to describe them, collateral debt obligations, or CDOs as they are known, are certainly complex beasts.

CDOs belong to the family of financial instruments known as credit derivatives. These are essentially contracts under which one party insures another against default by a debtor. At the most esoteric end of the spectrum exist CDOs - portfolios of credit risk which are packaged together and then sold to investors through the issue of notes secured against the bonds and loans from which the portfolio is constructed.

They are marketed in tranches - the higher the risk of default, the greater the return. Some CDOs contain investments in other CDOs - which is why they are sometimes known in the industry as "Russian dolls". To complicate things, some CDOs are "actively managed" - which means that the asset manager can move different credit risks in and out of the portfolio.

Barclays Capital marketed 16 CDOs. In the case of the two sold to HSH Nordbank, one of them had investments in seven other CDOs and the other had exposure to 15 other CDOs. Ordinarily, the purpose of investing in a CDO is to obtain higher returns while spreading the risk. However, the more cross-shareholdings that exist between CDOs, the more the risk is concentrated. No wonder they are a grey area as far as regulation is concerned and why the FSA advises only sophisticated investors to get involved.