A mechanism whereby various bespoke CDOs (bespoke tranches) can share the total subordination provided by the whole set of bespoke CDOs (tranches). For example, a pool sliced into 10 tranches with attachment points and thicknesses of $5 million results in a total cross-subordination of $50 million. Over the term of the deal, if any tranche incurs losses beyond its thickness ($50 million), these losses will not affect the higher level part (outer set of tranches) of the structure (a CDO-squared) until the total losses of the entire set of bespoke CDOs (the inner set of tranches) exceed $50 million. Inner tranches absorb losses until full exhaustion of the entire set, and as long as exhaustion level is not reached, losses will not be passed to the outer set.

This mechanism implies that the CDO-squared investor avails protection against the risk of a few tranches experiencing losses, but will be exposed to the risk that a large number of tranches experience losses.