Final answer:
A Collaterized Debt Obligation (CDO) is a structured financial product that includes tranches of subprime mortgages, often associated with high risk and issued to borrowers of questionable creditworthiness. The complex structuring of CDOs allowed for the expansion of subprime lending, leading to the housing bubble and the financial crisis. CDOs were incorrectly rated as safe by credit rating agencies, misleading investors.
Step-by-step explanation:
A Collaterized Debt Obligation (CDO) is a complex structured financial product that pools together various loans, often including subprime mortgages, and then issues tranches with varying levels of risk and return to investors. The subprime mortgages in a CDO are of the type known as subprime loans, characterized by high-interest rates and issued to borrowers with lower creditworthiness, often with little scrutiny of the borrower's income and high risk of default. These loans were also sometimes referred to as NINJA loans, which stood for 'No Income, No Job, or Assets.'
During the mid-2000s, financial institutions packaged and sold these subprime loans, securitizing them into CDOs, in a way that some investors would only face losses after significant devaluation, which contributed to the expansion of such risky lending practices. This process incentivized the origination of more subprime loans, contributing to the housing bubble and eventual financial crisis. The higher tranches of these securities were often mistakenly rated as very safe investments by credit rating agencies.