A Collateralized Debt Obligation (CDO) is a bond, and like many financial instruments the issue is how it is used and regulated, not the instrument itself. This is an attempt to simply explain with a little history and example.
Back in the 1970s the concept of CDOs took off with Mortgage Backed Securities (CDOs) created by FannieMae and FreddieMac. They allowed mortgages to be bundled and sold like bonds to institutional investors--Pension funds etc. They were safe and a good idea. Everyone benefited. The bonds paid interest with acceptable risk, and since banks did not hold the actual loans anymore they were able to make more loans. This resulted in more people being able to buy homes. The problems came much later, when a good idea began to be abused. As an example let's look at another initially good idea, that was twisted into something entirely new and damaging: Junk Bonds.
Way back in the 1970s Michael Milken started working at Drexel, Buhrnam, Lambert, one of the premier Wall Street investment banks. He had a great idea. He had found that certain Junk Bonds were actually good investments. In those days bonds became "Junk" when their credit rating dropped below investment grade. A company that fell on hard times might see their credit rating drop to "Junk" and thus their bonds became less valuable.
Here's an example: Company A issues a block of bonds (debt) through an investment bank. At the time of issue Company A's credit rating is Single A so the bonds are sold at par (100) with a quarterly interest payment of X% for a period of 15 years. Two years later their credit rating drops to Triple C due to poor company performance and changes in their sector of the economy. The interest payment on the bonds stays the same, but in order to compensate a buyer in the market the bond will sell for less than par (100). The amount under par is calculated to return roughly the interest rate the bond should now be paying based on the "Junk" credit rating, plus the initial principle invested in the bond. A buyer comes along and buys the bond at 78 and intends to hold it to the end of its term. So over 13 years the buyer will collect the lower than the market interest rate, but then get 100 for the bonds he paid 78 for when they mature. If the company defaults he loses on the 78 he paid for the bond--maybe all of it. In the event of bankruptcy Bonds (debt) are paid before Stock (equity). If the company fails, chances are he will collect some of the 78 he paid.
Back to Michael Milken. In the 70s Milken found that the Junk Bond market consistently undervalued many companies' bonds. The Junk rating pushed the price of the bonds too low, and a smart investor could buy the bonds of companies that were actually a pretty good risk and because the bonds traded way below par; holding them to maturity could be an investment with a very good return. The companies he found were "fallen angels" and an investment portfolio based on these companies began to return gains similar to stocks. This is what made Milken initially successful and made the Junk Bond market the specialty of Drexel as an Investment Bank. One key thing here to point out: Investment Banks at this time did not issue Junk Bonds. In order for a company to issue debt as bonds they had to have a Triple B rating or better. There was no market for Junk Bonds regardless of the interest rates tied to them. Junk bonds were all bonds from companies whose credit ratings had fallen after the bonds were issued. The mentality of the bond investor preferred safer investments. Principle should never really be at risk, and income was the primary goal. Thanks to floating interest rates and "innovation" in the credit markets, firms like Drexel and Salomon Bros. helped bonds trade more like stocks. Ultimately this is what Wall Street firms wanted people to do--TRADE--buy and hold strategies don't make as much money for Wall Street brokers.
Michael Milken made a great deal of money for his clients. His clients were very appreciative. Many of his clients were S & Ls. He gave them some really good investments in the 1970s that helped improve their bottom line. When he decided that he could create an entirely new market on his own he went to his friends. The next step was that Drexel began selling bonds that were "junk" when they were issued and Milken already had buyers for those bonds. "The Predator's Ball" was a meeting that Milken convened every year as he assembled his investors (S & Ls and others) with his corporate raiders in need of funding (Carl Ichan et al.)The market he created helped fuel the takeover mania of the 80s depicted in Oliver Stone's Wall Street and the reality was that many companies were bought and chopped, jobs were lost, and ultimately many Wall Streeters became rich while the economy went into the tank. The crash of '87 and mini-crash of '89 and then the S & L crisis and Milken's prison term seemed to deliver some kind of verdict on the times. Alas, not. It should be pointed out that Milken ultimately, like a virus, destroyed his host: Drexel, Burnham, Lambert died in the S & L crisis. Moving to the present, clearly the abuses are more prolific and systemically profound.
In recent years, due to changes in laws (Gramm-Leach-Bliley 1999) and a general attitude of Free Market Uber Alles these CDOs were stuffed with the worst kind of crap. I like sausages, and I know they are not good for me, but many Mortgage CDO Sausages were stuffed with shit instead of meat scraps and pig lips. This was because of the overall environment and the lack of regulation. In addition, in '04 the Mortgage CDOs from Freddie and Fannie amounted to about 40%, in '07 it was significantly less than that because everyone wanted to play this game and many filled their CDO sausages with fraudulent loans. The worst thing about it was the Rating Agencies played along and they kept rating the garbage as BBB investment grade similar to Arthur Andersen finding Enron as solvent in 2001. If you really want a single point of failure its the Rating Agencies--Moodys, Standard and Poor, Fitch, etc. They did not want to lose the business so they gave bonds ratings that the issuers wanted.
Credit Default Swaps (CDS) allowed bad loans to continue, because it allowed a CDO holder to "hedge" against loss. The problem there was that the CDS market was unregulated and they (AIG and others) wrote way too many CDS, that they could not possible cover in the event of a significant uptick in defaults.
Unfortunately this is one of the other things that seems to come to pass--if you screw up with enough company you get to go free. Michael Milken stood alone, and he was taken down alone. The current financial mess is the responsibility of many and unfortunately in practical reality-no one. This is our problem--our financial system has cancer from CDOs that metastasized into cancer cells. We can operate, but it may kill the patient.
One last ominous throwaway warning--we are a democracy with a large middle class, yes this is still true. The historical examples pretty clearly show that in our case when the crisis starts to break society, dictatorship will come from the RIGHT and not the LEFT. If Obama fails, we're screwed.
Recommended and interesting recent Wall Street history:
Mortgage Backed Securities & Trading:
Michael Lewis' Most Excellent Recent Essay: