A CDO (Collateralized Debt Obligation) is a financial product that bundles multiple debts together and slices them into layers (tranches) with different risk levels. Banks package loans, bonds, and mortgages into a CDO, then sell pieces to investors who want different levels of risk and return.
The tranches work like a waterfall: senior tranches (rated AAA) get paid first — safest but lowest returns. Mezzanine tranches (BBB) get paid next — medium risk, medium return. Equity tranches get paid last — highest risk but potentially highest returns. If borrowers default, equity holders lose first.
CDOs became infamous during the 2008 financial crisis. Banks packaged toxic subprime mortgages into CDOs, rating agencies slapped AAA ratings on them, and investors worldwide bought them without understanding the underlying risk. When housing prices crashed, CDO losses exceeded $500 billion, triggering the global financial meltdown.