Definition of CDO-squared

The creation of securities known as CDOs (collateralised debt obligations) formed a new wave in the securitisation process. CDO issuers purchased different tranches of mortgage backed securities (MBS) and pooled them together with other asset-backed securities (ABS) - these are backed by car loans, student loans, credit card payments and other assets.

They were tranched so ‘senior’, CDOs were backed by highly rated MBS and other ABS, while ‘mezzanine’ tranches pooled together a higher proportion of junior tranches.

In contrast to an MBS where the underlying pool of assets was actual mortgages, in the case of CDOs the assets were the securities that received mortgage payments. CDOs, therefore, can be viewed as re-securitised securities.

Once the pool of ABS and MBS were pooled, these then could be tranched and CDO securities could be issued via special purpose vehicles (SPVs) with varying risk-return and maturity profiles.

Following on from this, SPVs could then construct portfolios comprising an array of CDOs and they could issue instruments backed by these portfolios of CDOs – these are known as CDO-squared.

In theory the process could go on and on so long as investors had confidence in the collateral backing the securities. With the onset of the subprime criss and collapse in confidence in collateral valuation (linked to slumping property values) this resulted in a collapse of the CDO-squared and CDO market.  [1]