Collateralized Debt Obligation Cubed (CDO-Cubed)

What Is a Collateralized Debt Obligation Cubed?

A collateralized debt obligation cubed (CDO-cubed) is a derivative security backed by a collateralized debt obligation squared (CDO-squared) tranche.

A CDO-cubed is essentially a triple derivative, that is a derivative of a derivative of a derivative — which is why it has been called “derivatives on steroids."

Understanding Collateralized Debt Obligation Cubed CDO-Cubed

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset.

These assets become the collateral if the loan defaults. Payments resulting from those bonds, loans, asset-backed securities, and other instruments are then passed on to the holders of the shares of the collateralized debt obligation. It is a way to invest in multiple credit instruments and diversify risk.

A collateralized debt obligation cubed (CDO-cubed) is similar in many respects to a regular CDO, with the exception of the types of assets securing the obligation. Unlike a CDO, which is backed by a pool of bonds, loans, and other credit instruments, CDO-cubeds are backed by CDO-squared tranches, which are derivatives backed by a pool of bonds, loans, asset-backed securities, and other credit instruments.

CDO-cubeds allow banks to resell the credit risk that they have taken once again, by repackaging their CDO-squareds. CDO-squareds and CDO-cubeds can be repackaged countless times to create derivatives that are quite different from the original underlying debt security. These are also referred to as CDO^n to show the unknown depth of some of these securities.

Unlike traditional derivatives, which are used to hedge risk or make leveraged bets, CDO-cubeds are an innovation that has spawned thousands of new investment assets, covering the entire spectrum of risk and return.

Collateralized Debt Obligation Squared (CDO-Squared)

A CDO-cubed uses a collateralized debt obligation squared (CDO-squared) as its underlying security. A CDO-squared is another structured product structured where a bank takes their collateralized debt obligations and structures them into tranches with different maturity and risk profiles. These tranches then fund the payments to the investors in the CDO-squared special purpose vehicle.

The collateralized debt obligation squared itself is backed by the pool of collateralized debt obligation (CDO) tranches and payments to investors are made from payments made into the various tranches.

Since homeowners and consumers stopped making financing payments for many of the assets backing the collateralized debt obligations and therefore the collateralized debt obligations squared, the CDO and CDO-squared market collapsed during the 2008 global financial crisis.