Final answer:
An ABS CDO is created by bundling different types of debt and then selling them as tranches with different risk levels to investors, aiming to diversify risk and profit from higher interest rates. The optimistic ratings by credit agencies and the subsequent financial crisis highlighted issues in the transparency and risk assessment of these financial instruments.
Step-by-step explanation:
An ABS CDO (Asset-Backed Securities Collateralized Debt Obligation) is created through a process where investment banks bundle various types of debt, such as subprime mortgages, credit card debt, and other loans, into a single financial product. This aggregated collection of debt is then divided into different tranches, each with varying degrees of risk and potential return, and sold to investors. The motivation behind creating ABS CDOs was to diversify the risk of holding individual loans and to capitalize on higher interest rates from riskier debts. By pooling together various assets, the risk could be spread across many investors, and this diversification was thought to reduce the likelihood of a collective default.
However, the financial institutions had a substantial financial incentive to promote these products, often resulting in credit rating agencies granting them overly optimistic ratings. The complex structure of CDOs and the lack of transparency about the underlying assets' quality led to the financial crisis when actual default rates exceeded expectations.