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If I had to explain it to my grandmother, I'd imagine the conversation would go something like this (and by the way, if any of this sounds condescending in tone i.e. too dumbed down to be borderline insulting, I apologize - rest assured it wasn't meant to be):Let's breakdown the concept of a CDO into two parts. Let's talk about Part 1.You own/know what a stock mutual fund is, right? Yes.You know how a stock mutual fund lets you buy small amounts of a lot of different stocks? For example, if each share costs $10 right now, and there's a hundred stocks in there, you get a little slice of everything for only $10 instead of having to spend a $1000 to buy a share of every single company. You get that right? Yes.So since you have a little slice of everything, would you say it is fair to say that even if one of the things blows up, since you only own a little slice of everything, you're in a safer spot than had you picked just the one or two individual companies you could buy with your $10? Yes.OK perfect, then you already understand Part 1 of what a CDO is! Think of a CDO as exactly like a stock mutual fund, but instead of stocks, it holds debt/loans/bonds instead of stocks. You follow? Yes.OK great. Now pretend that you hold a share or "slice" of this CDO i.e. a fund of debts/bonds/loans. As mentioned, everything we talked about is actually just the first part or first dimension of what a CDO is. Now I'm going to explain the second dimension or Part 2 of what a CDO is.Now as you probably know, debt/loans/bonds are a bit special relative to stocks because they generate interest income on a regular basis due to the coupon. You know that right? Yes.And you also get that the riskier the bond, the more you typically get paid in interest to compensate you for the risk right? That's why treasuries yield so little, while high yield bonds yield so much. You follow? Yes.Well this second part of what a CDO is, is concerned with how to distribute that income in a fair way.You see, the problem is that the vast majority of people are afraid of risk. They don't like risky bonds. They like safety. Triple-A, double-A, maybe single-A rated stuff. They don't like dinking around in the high yield area where yields are high, but the risk is commensurately higher. Think of your typical single-B to triple-C rated bonds. Most people don't like to touch those.So why am I telling you this?If you split this CDO as it is in equal slices with a little bit of every company, the problem is that the average quality may still be too low for the vast majority of investors.Say for example that the average quality of each company in this pool/CDO/fund (whatever you want to call it) is roughly medium-risk or double-B rated, let's call it.But as I mentioned before, the vast majority of the market (say 75%+) likes to buy and hold assets that are at least triple-B and above. As you can see, there's a big mismatch in what we can produce with this pool of debt/loans/bonds and what most people want. Even though you do get the benefit of having diversification because you hold just a little bit of every company, it only goes so far, and overall, the entire portfolio is still fairly risky. You get that right? Yes.Now how do we fix this? First, let's zoom out for a second from talking about just one share of this CDO of fund of debt/bonds/loans that you current hold and look at the entire "fund" or CDO in aggregate.Let's say that the entire CDO is worth $100: there are 10 investors, each having invested $10. With the proceeds raised from those 10 investors ($100), the CDO goes and buys $100 worth of debts/bonds/loans. And every year, it throws off $10 in interest income from the coupons we are collecting on those debts/bonds/loans for a coupon rate of 10% ($10 earned on $100 invested). You follow? Yes.Now as we know, safer things will compensate you less in this regular interest income since you have less at risk. Riskier things will compensate you more since you are taking on more risk. How do you define risk? Well, the most straightforward and intuitive way is to define risk as what is at stake. What do you have to lose if things go wrong?As we discussed earlier, if you take our CDO as it is, and simply split it into equal slices, everyone has the same risk because they have the same slice. They get an equal split of the income ($10 split among 10 investors/$1 each) earned on their initial investment ($100 also split among 10 investors/$10 each).Now let's look at the risk. What does each investor have to lose? Well if every company in the CDO defaults and we are able to recover nothing from them, the most that any investor could lose is the $10 they invested if everything they invested in goes to $0. And everyone has the same slice, so they all have the same risk. Simple.But again, the problem is that not everyone wants this kind of risk. In fact, the vast majority, as we discussed earlier, does not want this type of risk. Period. They want safety and are willing to accept lower returns for it. As the CDO stands in its current form up to now, it is an unattractive product. We simply don't have enough appetite for this type of risk for it to sell in the marketplace. So how do we solve this problem?The question we need to answer is this: is there a way for us to play around with this structure so that we can offer the majority of people a slice that offers more safety? And since with more safety, we can offer less income/reward, can we then offset this by offering a smaller minority a slice that offers far less safety, but then offer them far more income/reward to compensate them? And can we do this where the economics work out and everyone makes a reasonable amount of money?Turns out, with a lot of complicated math, this is possible. And this is where Part 2 of a CDO comes into play.Part 2 is about distributing the $10 we are earning on our combined investment of $100 in a more creative way than to just split it evenly, all in order to solve the question we asked in (21): how do we take $10 of income and redistribute it so that 75% (as a strawman example) of investors get a level of safety that is better than a simple slice of the current pie of risk?The answer is subordination. In other words, where you stand in relation to the front-line of defense.Imagine you are a king defending a castle with 3 rings of walls. In order to protect your castle, you need to hire soldiers. You offer a salary in exchange for their service and open applications for each of the three rings. As a soldier, you'd obviously prefer to be on the inner most ring, as far away from harm's way as possible and so, when you begin accepting applications, what happens? Everyone applies for the inner ring.This is a problem because you need to man a bare minimum number of soldiers on the outer two rings in order to properly defend the castle.What do you do to fix this problem? You tell everyone who applied for the inner most ring that you will pay them significantly less (since there is way too much supply relative to what you need staffing that ring) and you incentivize anyone who applies for the outer most ring by telling them you will pay them far more.The reality is that even with this offer of far greater riches if you serve on the outer wall, and far less pay if you serve on the inner walls, you still won't get that many people to move to the outer wall, because not losing their lives is such a powerful force and behavioral instinct. The reward relative to the risk is just not worth it to them. But with enough of an incentive, you'll eventually get some guys who applied for the inner wall to volunteer to move to rings further out, and you'll also attract some other people in your kingdom who weren't interested at all to also apply given enough prospective reward. And hopefully, you'll get the bare minimum you need to man the outer walls and properly defend your castle.This is exactly how Part 2 works. With the same amount of income ($10), you offer a majority of people much less than they would earn with a simple slice of the pie (so say $0.30 per $10 investment instead of $1) for serving on the innermost and safest ring of defense, and then you take those savings per head of $0.70 that you would have paid them, and redirect to incentivizing the remaining investors into moving further out towards the front-line of defense.These rings are called tranches in the financial world, but are essentially the exact same concept. The outer-most walls of defense are called equity tranches. The inner-most walls are usually triple-AAA rated tranches. In between are many, many more walls, all along the spectrum of risk. The further out you go, the riskier that wall is; the closer you stay, the safer that wall is.Each wall or tranche then earns a coupon that is more or less than what you would get if you just took an equal slice of the pie, depending on how relatively safe or risky it is compared to this equal slice of the pie. This makes sense since a soldier requires higher compensation for taking on more life-threatening risk, and those that value safety would be willing to pay for greater chance of survival. In the case of the CDO, since the majority of people want a safer slice with below average risk, and below average reward, only a minority remains to take on the greatest risk. The way the math and supply/demand works, you end up paying them a lot more.Up to this point, we've only discussed how the reward gets distributed. But what do these castle walls have to do with the risk of a CDO? What does it mean when I say that you are closer or further away from the 'front line of defense'?Well it funnily enough, works exactly like the castle example. As you know, the biggest risk to debt is that the company or entity goes bankrupt and you lose your principal. In a CDO, while we have a diversified pool of debt/bonds/loans, if we simply split the pie up equally, everyone is exposed to the same amount of risk since any principal loss of default simply gets evenly split amongst all the investors.Instead, and just like how we redistributed the income this pool generates, the many different walls of a castle allow us to redistribute the risk investing in this pool entails. Instead of simply splitting up any default-related principal loss equally among all 10 soldiers (investors), CDOs are set-up whereby the soldiers manning the outer walls get hit first and hardest. They are, after all, the front line of defense and we are certainly paying them a huge amount relative to the vast majority of investors holed up in the safest walls towards the inside, so they better be worth the money.Because of the way the walls are built, only when the outermost wall collapses and the soldiers lose their lives (their investment) do the next set of walls come under attack. They are the next best compensated at the expense of the majority, so they it makes sense that they are next in line to take the brunt of the attack.As you can quickly tell, this is effectively a waterfall system of risk. Until the layer before you falls, you are safe. If the layer before you does fall, you are next in line to get attacked and lose your life (money).In this way, Part 2 of a CDO is able to meet the demands of a majority of investors who seek a spot on the safest walls of the castle, while also making it possible to properly defend the castle with just enough people on the outer walls to man the castle defenses.It is this dynamic that is the reason behind why many CDO and CLO issuers/managers are routinely bottlenecked by the equity tranche. Everyone is looking for the bare minimum amount of soldiers in the outermost wall, and sometimes, you just can't pay anyone enough with the available sacrifice in income by safety-seeking investors to incentivize anyone to take on the outer walls of defense. Or conversely, sometimes, you just can't get enough people willing to pay up enough for safety to make it worthwhile for anyone who wants to hang out in the outer walls.There are other interesting dynamics and clauses built into most CDOs/CLOs that also make CDOs/CLOs more difficult to manage than appears on the surface.For example, many CDOs/CLOs give the equivalent of board seats to the equity tranche as the first layer of defense. Since they are often the deciding factor in whether a CDO/CLO is viable or not and are first to take losses, they get offered a lot of sweeteners other than financial incentives (especially when the financial incentives don't go far enough) and one of the most popular (and basically default nowadays), is the ability to "call a deal". Put another way, it is the right or option to shut down the fund, liquidate everything in it and return the proceeds to all the investors relative to how much they invested. This is the equivalent of giving the soldiers on the outermost wall the power to call when you should surrender/call a truce to avoid unnecessary catastrophic losses in a war.There are many other nuances and detailed clauses that each tranche demands in order to make the whole system work, and I encourage you to read more about them if you have time. It is a truly creative product.In summary, as we have explored, a CDO is composed of two parts: 1) a diversified income stream; and 2) a clever way to distribute that income stream to satisfy the needs of most investors. The first part ensures nobody is exposed to one single big source of risk, as a failure of everything is far less likely than a failure of one thing. The second part redistributes that risk one step further by giving the majority even more safety in exchange for less reward, which then goes to a minority of investors (usually hedge funds) that are willing to take on great risk, if the price is right.I realize this is an insanely long answer with 42 bullet points, but hopefully, this answers your question in a manner that is as layman as possible! Let me know if you have any questions and hope this helps.

A Collateralized Debt Obligation or CDO is a type of structured asset-backed security. Originally it was used in corporate debt markets, but with recent changes it has encumbered to include mortgages as well as credit card debt, student loan debt, auto loan debt, etc. Although CDOs were commonly linked with mortgage loands due to the housing boom and the mortgages being more readily available than other loans to be packaged as collateral. With the recent 2008 market crash, CDOs have been known to be filled with sub-prime mortgages.The image above shows the CDO tranches being packaged and pulled from an MBS package to a CDO package. Creating an near-infinite loop of a circle jerk.Sub-prime mortgages are mortgages that are lent to those with the less than minimally required credit score and down payment in borrowing money for a prime mortgage. Usually to borrow money for a home it was required the borrower was required to have a credit score of around 650 and 30% down. After the markets dried up of quality Mortgage Backed Securities (MBS), the banks wanted more mortgages to package into bonds and sell. So the lenders started bottom feeding and lowered their minimum criteria, now borrowers were required to have (maybe) 500 credit score or less, and no money down. Many sub-prime mortgages were given teaser rates better known as an Adjustable-Rate Mortgage (ARM), so after a year, the interest rate sky rockets, forcing borrowers to pay a much higher monthly payment, which would be about 2 to 3.5 times their initial monthly payments.Now back to CDOs, The CDO was for the investor was like a promise-to-pay pool of mortgages that the investor was given a pre-determined amount of payouts until maturity. The CDOs were fraudulently packaged with mislabeled credit ratings, so investor expected a good return plus the decreased risk.For purchase prices and payouts, higher rated CDOs were more expensive to buy and paid less dividends since there is lower risk of default. While lower rated CDOs were cheaper to buy and the dividends were paid higher dividends since there is a much higher risk of default.Each CDO has a varying amount of risk, which is identified as AAA, AA, A, BBB, BB, B, CCC, etc; with AAA being the most secure. However, pre-2008, even the AAA rated bonds had a lot of subprime debt, with AA and below having an even more immense load of subprime debt.The image above shows how a CDO is created and packaged.Market Facts:The popularity of CDOs sky rocketed almost overnight, between 2003 to 2007, Wall Street issued almost $700 billion in CDOs including MBSs as collateral.The global CDO market is estimated around $1.5 trillion USD.Ratings Chart:AAA: PrimeAA+, AA, AA-: High GradeA+, A, A-: Upper-Medium GradeBBB+, BBB, BBB-: Lower-Medium GradeBB+, BB, BB-: Non-Investment Grade, SpeculativeB+, B, B-: Highly SpeculativeCCC+, CCC, CCC-: Substantial RiskCC: Extremely SpeculativeC: Default ImminentDDD, DD, D: In DefaultHere are the components that exchanges in hands for a CDO:Securities firms: (i.e. Banks) who approve the selection of collateral, structures them into tranches, and sell them to investors.CDO Managers: They are the ones that select the collateral and often than not manage the CDO portfolios.Rating Agencies: (Moodys, Standard & Poor) They are the agencies that rate the bonds and assign them a credit rating ranging from AAA to C.Investors: (The buyers) Hedge Funds, Pension Funds, and Fund-backed Institutional investors.The image above shows the daisy chain of CDOs and its intended market for investors.- AllenIf you enjoyed this answer, please up vote, share, and follow. :DDisclaimer: This answer is for information and illustrative purposes only and does not purport to show actual results. It is not, and should not be regarded as investment advice or as a recommendation regarding any particular security or course of action. Reasonable people may disagree about the opinions expressed herein. All investments entail risks. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those discussed, if any. No part of this document may be reproduced in any manner, in whole or in part, without the prior written permission of Allen Song. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action. You should consult your advisors with respect to these areas. By accepting this material, you acknowledge, understand and accept the foregoing.

All of them all.All Big Companies one way or another are investing in innovation, and at least willing to take a risk buying a product from a raw, young start-up.What’s hard to see on the outside is where they are investing. Big Companies are always investing in security. They have to. Because the threats are constantly evolving.But it can be hard to tell what other areas are priorities for a BigCo.If you have a product that provides insane value, 10x better than what the BigCo has, to an important problem — you can probably get a meeting.Beyond that, almost every progressive CIO’s office these days (and CDO office) is looking to bring a few innovative apps into the company every year. They are on the hunt. They are judged, in part, on how much software innovation they deliver.Your job is to stand out and make it yours.