Collateralized Debt Obligation (CDO)

A CDO is created by a special purpose vehicle that buys a portfolio of debt and funds the purchase by issuing notes to investors. Payments from the underlying debts flow to investors through a waterfall: senior tranches are paid first and are the safest, while junior tranches absorb losses first but offer higher returns.

CDOs allowed banks and investors to repackage risk, offering highly rated securities to investors who wanted safety and riskier tranches to those seeking higher yields.

Before the 2008 financial crisis, many CDOs were built from subprime mortgage-backed securities, and some were built from tranches of other CDOs. Many senior tranches received top credit ratings. When US house prices fell and mortgage defaults rose, losses spread far beyond what models predicted, and many highly rated CDO tranches suffered heavy losses.

For example, an investor holding a AAA-rated CDO tranche backed by subprime mortgage securities could have lost much of its value. CDOs backed by mortgages largely disappeared after the crisis, although related structures, such as collateralized loan obligations, remain widely used.