Banks are required to hold capital reserves against the risk that their investments may go bad. Under the Basel II agreements, riskier investments require higher capital ratios. Widespread downgrades of the ratings of their investments (as well as huge losses) are forcing banks to raise more capital. For example, the downgrading of a CDO from AAA to BB+ would require an increase in capital from 0% to 8% of the face amount. Bloomberg reports here that as ratings of CDOs are downgraded, they are being packaged into CDO-squareds so that a substantial amount of the face value gets a brand new AAA rating, reducing the amount of capital they have to raise.
Work at the Harvard Business School, summarized here, shows that CDO-squareds have much more systemic risk than CDOs with the same ratings.