A collaterized debt obligation (CDO) is a structured finance construction that became known for its lack of transparency and its negative role in the financial crisis. Indeed, it is rather complex to understand how a collaterized debt obligation works. To make matters more complicated, those investment tools are not standardized or regulated, so every CDO can be slightly different. A common purpose of a CDO is to bundle assets in a way that makes the outcome attractive for investors with different risk tolerance levels.
A common CDO is a so called special purpose vehicle (SPV) that buys a bundle of usually fixed income assets such as mortgage backed securities. It is not a rare case that the assets a CDO acquires are already bundled assets itself, e.g. individual mortgages on private houses. This adds to the complexity of CDOs. As a next step, the finished construction is divided in different tranches, typically three different tranches. Understanding how those tranches work is crucial for grasping the whole concept of CDOs. Assuming there are three tranches, the most senior tranche, often given a triple A rating, is also the least risky one. The senior tranche could be for example decomposed of the 20% best assets of the CDO, meaning that those investors buying the senior tranche will only have to bear losses if more than 80% of the whole assets in the CDO default. The middle tranche comprises e.g. the next 40% of the CDO, that is to say, money is lost in case more than 40% of the whole CDO default. The third tranche, the equity tranche, has to bear any default that occurs within the CDO and is the riskiest tranche of the construction. Naturally, interest rates differ across the tranches and are highest in the equity tranche and lowest in the most senior tranche.
The explained example is merely one of many and it is not surprising that investors lost touch with those products. It is clearly a sign that financial innovation has gone quite far and the prosperous times have made investors reckless. Another factor were the rating agencies, who obviously did not understand CDOs very well themselves or did not want to do so. They gave them far too positive ratings contributing to the success and acceptance of the product. Many CDOs did, however, default. Not only investors in the equity tranche lost money, but also those in more senior tranches with triple A ratings.