The suspicion is that American know-how and talent made the disaster worse. Of all the financial instruments to have failed, newfangled collateralised-debt obligations (CDOs) have turned out to be among the most devastating. One way of thinking about CDOs, says Raghuram Rajan, a professor at the University of Chicago, is as a mechanism for converting mortgage securities and corporate bonds from huge, illiquid assets owned by local investors into liquid financial instruments that could be flogged across the world. Philip Lane, of Trinity College Dublin, thinks that sophisticated American financial services combined dangerously with relatively unsophisticated financial services elsewhere.  source:  http://www.economist.com/printedition/displayStory.cfm?Story_ID=12957709#

(CDOs). The principle is simple enough. Imagine a waterfall of mortgage payments: the AAA investors at the top catch their share, the next in line take their share from what remains, and so on. At the bottom are the “equity investors” who get nothing if people default on their mortgage payments and the money runs out.

Despite the theory, CDOs were hopeless, at least with hindsight (doesn’t that phrase come easily?). The cash flowing from mortgage payments into a single CDO had to filter up through several layers. Assets were bundled into a pool, securitised, stuffed into a CDO, bits of that plugged into the next CDO and so on and on. Each source of a CDO had interminable pages of its own documentation and conditions, and a typical CDO might receive income from several hundred sources. It was a lawyer’s paradise.  source:  http://www.economist.com/specialreports/displaystory.cfm?story_id=12957753

more..

CDO's are issued by investment banks and then bought by other banks, pension funds, and hedge funds.  CDO's/CMO's are the pooling of like debt/mortgages and then selling off the risk in to strips each with its own risk/reward structure. (The lower the risk, the lower the return.)  The use of MBS (CDOs/MBOs/Strips/etc...) isn't so much a way to "finance" as it is to reduce their risk. Because its a security that can be bought or sold, people can make or lose money on them.   CDOs are not used to finance deals. CDOs are capital raising technique which are also used to manage your risk and also to move assets from balance sheet and hence manage the exposure limits.

The big problem is that these MBSs are off balance sheet (OBS) derivatives, and are harder to evaluate. Banks usually have ALCO meetings (Asset / Liability Committee meetings) where they evaluate their risk(s) and do what is known as a Mark To Market. The OBS derivatives have risk and exposure that can go beyond the "price" of the asset. (Its a hedge) Some of the tools in risk management run Monte Carlo simulations to help determine their risks when things like the interest rates move on a product.

Definition from Wikipedia:

In financial markets, collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product. CDOs gain exposure to the credit of a portfolio of fixed-income assets and divide the credit risk among different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added risk. CDOs serve as an important funding vehicle for portfolio investments in credit-risky fixed-income assets.  read more...

Who Uses CDO's?

Below are the top issuers of CDOs so far this year,

according to Bernstein Research (value in billions of

dollars): TOP GLOBAL CDO ISSUERSBookrunners Value Market share (%)

1 Merrill Lynch $32.176 17.2

2 Citi 26.578 14.2

3 UBS 21.151 11.3

4 Wachovia 12.505 6.7

5 ABN AMRO 10.849 5.8

6 Goldman Sachs 10.075 5.4

7 Banc of America 8.634 4.6

8 Deutsche Bank 8.231 4.4

9 RBS 7.154 3.8

10 Lehman Brothers 6.575 3.5

11 Morgan Stanley 6.277 3.3

Sources: Corporate Reports, Bernstein Analysis

If you are referring to arbitrage CDOs, here is a good link explaining the differences between them and balance sheet CDOs and how arbitrage CDOs can help increase assets under management for hedge funds and asset managers (and, therefore, help them finance *their* business):

http://www.pwmnet.com/news/fullstory.php/aid/301/CDO_issuers_promise_portfolio_diversification.html

The article also explains the difference between market value and cashflow credit structure. It claims that 9 out of 10 CDOs use cashflow credit structure so this is the bulk of the CDOs and I thought this might be a good differentiating point for your previous question on CDOs.