Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are different concepts with frequent overlap between them. MBS are investments that are repackaged by small regional banks as a means of funding mortgages by reselling them as securities through investment markets. CDO investments are typically used to package many mortgages and other loan instruments together by risk level for investors. Many MBS are also CDOs. After a small bank funds a mortgage, the mortgage is then packaged as an investment with real estate backing the security as collateral.
Collateralized debt obligations are often created from risky mortgages as a means of spreading risk across multiple products and borrowers. Groups of CDO investments, known as tranches, are sold in pieces to investors with the riskiest securities commanding higher rates of return for investors. The best pieces of tranches are typically funded first, as they have less risk. CDO instruments offer synthetic securities with a customized level of risk. As synthetic securities, CDO instruments have the characteristics of many different investment types. Synthetic investments are made by pooling together different types of assets and loans. This results in complex investments with custom characteristics. Many MBS assets are used, along with other types of debts, in the creation of CDO instruments.
Some MBS are CDOs; in other words, as they are funded using the creation and exchange of synthetic financial instruments. Many financial professionals argue that the widespread use of high-risk synthetic investments contributed significantly to the worldwide recession experienced in 2007 and shortly after.