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 squared 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 squared is created. This process depends on investors’ confidence in the original collateral by which the CDO securities are backed.