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A collateralised debt obligation, CDO, is a tradeable derivative whose income payments and principal repayments are dependent on a pool of different financial instruments which themselves are loans and are due to pay interest and ultimately be repaid. CDOs are called collateralised because the promised repayment of the loans are the collateral that gives the CDOs value.
In the case of CDOs, mortgages might be packaged with other loans, bonds or instruments. The different financial instruments are gathered together into a special purpose entity or special purpose vehicle and divided into tranches. Senior tranches pay the lowest interest rates but are the safest investment because should there be any default, seniors are paid first. The most junior tranches would attract the highest interest rates but suffer the highest risk should the holder of an underlying loan default. CDOs are effectively promises to pay investors in a prescribed sequence.
Collateralised debt obligations (CDOs) hit the news at the time of the US subprime mortgage crisis of 2006-2007 which precipitated the global financial crisis of 2007-2008. When house buyers – who should never have been offered mortgages because they were unlikely ever to be able to repay their loans – began to default on their loans, losses spread to the collateralised debt obligation market.
In February 2013 the US Department of Justice accused ratings agency Standard & Poor's of defrauding investors in mortgage-related securities out of at least $5bn. In a lawsuit it alleged that from 2004 until 2007, S&P "adjusted and delayed" updates to its ratings criteria and models and continued to churn out Triple A ratings on mortgage related securities including collateralised debt obligations.