A collateralized debt obligation (CDO) that is backed by other collateralized debt obligations. Differently stated, it is an asset-backed security (ABS) that is backed by securities held by one or more CDOs. The asset backed-securities are typically issued on pools made up of auto loans, student loans, credit card payments, etc. The CDO issuer usually buys different tranches of mortgage-backed securities, and then pools the tranches with other asset-backed securities.

As in the standard CDO, the CDO-2 allocates the risk of the underlying instruments among the tranches which are typically divided into senior and junior layers. Senior CDOs are backed by highly rated ABSs and MBSs (mortgage-backed securities), while junior or mezzanine CDOs are mainly pools of junior (low-quality) tranches. However, unlike MBSs which pool actual mortgages, in CDOs the assets are the securities that receive mortgage cash flows. In this sense, CDOs can be conceptually viewed as re-securitized securities.

By and large, the CDO securities are issued via special purpose vehicles (SPVs) with specific risk-return profiles and maturity dates. And then, SPVs set up portfolios out of these securities. It is when SPVs issue instruments backed by CDO portfolios that the CDO-2 is created. This process depends on investors’ confidence in the original collateral by which the CDO securities are backed.