CDOs are constructed from a portfolio of fixed income assets. CDOs are divided by the issuer into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated) It’s an asset backed security (ABS) and structured credit product.
Losses are applied in reverse order of seniority and so junior tranches offer higher coupons “interest rates” to compensate for the added default risk. CDOs have become an important funding vehicle for fixed-income assets.
During the credit bubble of the mid-2000s, a few academics, analysts and investors such warned that financial derivatives such as CDOs and other ABSes were greatly increasing risk in the financial markets, but their views were dismissed. With the advent of the 2007-2008 credit crunch, it has become clear that CDOs, like all ABSes, suffer from a fundamental flaw that causes all tranches to be extremely high risk for investors.