Collateralized Debt Obligation (CDO)
A structured financial product backed by a pool of loans or bonds, divided into tranches with varying risk and return profiles.
What is CDO?
A collateralized debt obligation (CDO) is a structured asset-backed security backed by a pool of debt instruments — mortgages, corporate bonds, auto loans, or other CDOs — divided into tranches sold to different investors. Senior tranches receive priority claim on cash flows and default protection, earning lower yields; junior and equity tranches absorb losses first in exchange for higher potential returns. CDOs were central to the 2008 financial crisis because many were backed by subprime mortgage-backed securities, and widespread defaults caused the senior tranches — many AAA-rated — to suffer unexpected losses, revealing flaws in the rating process and model assumptions about correlated defaults.
Example
A CDO pools 100 different mortgage-backed securities. It issues: $700M senior AAA notes (lowest risk, lowest yield), $200M mezzanine BBB notes, and $100M equity notes. When underlying mortgages default at higher-than-expected rates in 2007–2008, losses first wipe out the equity tranche, then the mezzanine, then unexpectedly begin eroding the senior AAA tranche — triggering massive write-downs at banks worldwide.