The genesis of structured finance CDOs is quite obvious—as arbitrage transactions search for assets which provide relatively higher rate of returns with a given rating, a structured finance security is an ideal choice. Quite often, the spreads on a BBB ABS are substantially higher than those on a BBB bond. Besides putting up structured finance, CDOs also served the motive of investment banks to have adequate supply of liquidity in the lower-rated tranches of securitization transactions.

In the 2007 subprime crisis, structured finance CDOs have been the prime victims. This is obviously because these CDOs have made substantial investments in subprime mortgage loan securitization transactions.

The typical assets of structured finance CDOs are mezzanine (BBB or BB rated) ABS. Many CDOs have acquired investments in subprime mortgage securitizations.

A CDO², or CDO-squared, is a CDO (issuing CDO) that invests in other CDOs (sub-CDOs). Each sub-CDO is itself a pool of assets or entities. Quite often, there is an overlap in entities (i.e., common entities in the sub-CDOs).

In CDO² as well as other structured finance CDOs, there is obviously a high degree of correlation. In the case of CDO²s, there is perfect correlation to the extent of common names. In the case of other structured finance CDOs, assuming a CDO invests in BBB tranches of 20 home equity securitizations, if the home equity sector starts exhibiting problems, each of those BBB investments might realize losses. Since the losses arise from a common source, that is, home equity sector, the issuing CDO realizes a leveraged impact of the losses.