Definition
CDOs package various debt instruments (bonds, loans, MBS) and create tranches with different risk-return profiles. Senior tranches receive payments first and have highest credit ratings; equity tranches absorb first losses and earn highest potential returns. CDOs became infamous during the 2008 financial crisis when CDOs of subprime MBS suffered catastrophic losses.
lightbulb Example
A $500M CDO pools corporate loans into senior (70%, AAA, 4% yield), mezzanine (20%, BBB, 7% yield), and equity (10%, unrated, 15%+ target yield) tranches. First $50M of losses wipes out the equity tranche entirely.
Warning
CDOs magnify credit risk through leverage. CDO-squared products (CDOs of CDOs) amplified losses dramatically in the 2008 crisis.
verified_user Key Points
- Tranching creates varied risk-return profiles
- Senior tranches protected by subordination
- Central to the 2008 financial crisis
- Cash CDOs vs synthetic CDOs (using CDS)