CDOsquared

CDO squared, also known as collateralized debt obligation squared or CDO^2, refers to a type of synthetic collateralized debt obligation where the underlying assets are not individual loans or bonds, but rather the equity or junior tranches of other CDOs. In essence, it is a CDO backed by the riskier portions of other CDOs. This structure was designed to repackage and further tranche the credit risk of underlying securitized assets.

The creation of CDO squared instruments amplified the complexity and opacity of the securitization market. Investors in CDO squared products were exposed to the credit performance of the original underlying assets, but through a highly convoluted and indirect chain. The junior tranches of CDOs, which were the primary components of CDO squared, were typically the first to absorb losses in the event of defaults. By pooling these already risky tranches, CDO squared concentrated and magnified that risk.

The widespread use of CDO squared, particularly in the years leading up to the 2008 financial crisis, contributed significantly to the systemic risk within the global financial system. The interconnectedness and opacity of these instruments made it difficult for investors and regulators to assess the true level of risk exposure. When defaults on the underlying mortgages and other assets increased, the losses cascaded through the various tranches of CDOs and subsequently impacted the CDO squared structures, leading to substantial financial losses and exacerbating the crisis.