File:CDO Diagram - Simplified.png

In simple terms, think of a CDO as a promise to pay cash flows to investors in a prescribed sequence, based on how much cash flow the CDO collects from the pool of bonds or other assets it owns. If cash collected by the CDO is insufficient to pay all of its investors, those in the lower (equity) layers (tranches) suffer losses first. The different layers typically received different credit ratings from rating agencies and different interest yields.^[1] This diagram illustrates the cash flows of a CDO once it has been created. It does not illustrate the initial investment from the investors that the CDO/SPV (Special purpose vehicle) uses to acquire bonds and other assets. The diagram also does not show various intermediaries that may be involved, such as mortgage servicers that collect mortgage payments, for example. It basically shows how debtor payments are accumulated and then distributed to investors in various tranches in a priority sequence. One analogy is to think of the cash flow from the CDO's portfolio of securities (say mortgage payments from mortgage-backed bonds) as water flowing into the cups of the investors in the senior tranches first, then mezzanine tranches, then equity tranches. If a large portion of the mortgages enter default, there is insufficient cash flow to fill all these cups and equity tranch investors face the losses first.

References:

Similar diagrams:

• Bionic Turtle-CDO Diagram
• FCIC-IMF Diagram of RMBS and CDO