Collateralized debt obligation (CDO).

In plain English

A collateralized debt obligation is a bond built from a pool of other debts, cut into layers called tranches that get paid in a fixed order. Cash from the underlying loans flows to the top tranche first, then down the stack. Losses work the opposite way, hitting the bottom tranche first. That structure lets one pool of ordinary loans produce both a low-risk slice and a high-risk slice out of the same borrowers. The rating on any tranche depends on how much cushion sits below it, not on the pool alone.

01Why it matters

The label on a CDO tranche can look safe while the loans underneath are not, so the rating tells you where you sit in the payment line rather than how sound the borrowers actually are.

02The math, step by step

Say a pool holds 100 loans of 100,000 dollars each, so 10 million dollars total. The senior tranche is 7 million, the middle 2 million, the bottom 1 million. If 800,000 dollars of loans default, the bottom tranche absorbs all of it and is wiped out. The senior tranche is untouched until losses pass 3 million.

Illustrative example. The amounts here are hypothetical, chosen to show how the math works, not real quoted rates or figures.

03What this is NOT

04Receipts

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