Definition of obligation
- made an obligation to pay their children's college expenses
- Unable to meet its obligations, the company went into bankruptcy.
- felt an obligation to vote
- returned the favor as an obligation
She believes that all people have a moral obligation to defend human rights.
He argues that people in a community have certain obligations to each other.
She failed to fulfill her obligations as a parent.
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An obligation is a legal requirement to fulfill a responsibility. In the finance world, this often involves making specific payments by specific dates and/or ensuring that a company meets certain performance requirements.
A borrower, for example, has an obligation to make payments of an agreed-upon size on an agreed-upon date. A company may have an obligation to provide certain disclosure to the Securities and Exchange Commission (SEC). A board may have an obligation to pay an executive a certain amount of money if certain events occur, and a lender may have an obligation to charge a certain amount of loan interest for a fixed period of time, even if it can get a higher interest rate later on other loans.
In the finance world, obligations are everywhere, and the fulfillment or lack of fulfillment (or even speculation about the lack of fulfillment) of those obligations has a significant impact on the value of the entities that must meet or depend on the obligations. When a party does not fulfill an obligation, the other party to the contract generally has the right to seek recourse in court.
A collateralized debt obligation (CDO) is a security that repackages individual fixed-income assets into a product that can be chopped into pieces and then sold on the secondary market. They are called collateralized because the assets being packaged -- mortgages, corporate debt, auto loans or credit card debt- - serve as collateral for investors.
CDOs are described as structured asset-backed securities because they pay cash flows to investors in a prescribed sequence, based on how much cash flow is collected from the package of assets owned.
The CDO is split into different risk classes known as tranches. Interest and principal payments are made in order of seniority so that senior tranches have the least risk. Junior tranches, which have higher default risk, usually have higher coupon payments.
The Class A senior tranche will offer investors the lowest yield since it has the highest S&P rating. The equity tranche would have the highest yield since it is the most risky component of the deal structure.
Collateralized debt obligations allow banks and corporations to sell off debt and free up capital to re-invest or loan. The downside of CDOs is that the loan originators have little incentive to collect when loans in the package come due since these loans are now owned by other investors. This may make originators less disciplined in adhering to strict lending standards.
Another downside of CDOs is the complexity of these products. Buyers may not know exactly what they are buying or whether the package is really worth the price. The opaqueness and complexity of CDOs can result in a market panic if investors lose confidence and CDOs become more difficult to re-sell. This was the scenario during the Sub-Prime Crisis of 2007 when many banks were forced to take sizable write-downs on their CDO holdings.
When an investor purchases a CMO, he or she purchases some class or tranche of the security whose risk depends on the maturity structure of the mortgages backing it. These tranches are usually designated as A, B, C, etc. and increase in degree of risk as the letters ascend.
To illustrate, Class A of a CMO would be the highest risk tranche offering the highest rate of return based on mortgages that still have a long term until full repayment by the borrowers. For this reason, they are exposed not only to interest rate and default risk but also to prepayment risk, the risk that borrowers will pay off the mortgage in advance of the mortgage term (e.g. 15 years, 30 years, etc.). Class A in this CMO will be the first of all of the tranches to absorb losses from borrowers' failure to make payments. Class A will, however, also be the first to receive money from prepayments.
By contrast, Class C of a CMO would carry the least risk for the holder, but offer a much lower rate of return. This is because the mortgages backing it are likely approaching their full repayment, meaning that the holder is solely receiving interest, and perhaps some principal payments from the remainder of the mortgage term. For this reason, Class C CMOs will receive little or no returns from prepayments.
Collateralized mortgage obligations offer investors an opportunity to profit from a diversified, and therefore risk-reduced, set of mortgage-backed securities. CMOs subdivisions into graduated classes of risk cater to the risk preferences of prospective investors. Moreover, similar to collateralized loan obligations (or CLOs), CMOs provide a way for lending institutions to reduce interest and default risk and increase their lending power by transferring debt to investors in the form of structured securities.
: something that you must do because of a law, rule, promise, etc.
: something that you must do because it is morally right
See words that rhyme with obligation Thesaurus: All synonyms and antonyms for obligation Spanish Central: Translation of obligation Nglish: Translation of obligation for Spanish speakers Britannica English: Translation of obligation for Arabic speakers Britannica.com: Encyclopedia article about obligation
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