CDOs: Mortgage Fruit Gone Bad What is a CDO?

In 1987, Drexel Burnham Lambert assembled the first collateralized debt obligation, or CDO, out of different companies’ junk bonds. The strategy was to pool together various companies’ junk bonds to reduce investors’ exposure to a bond failing (FCIC Mortgage Machine, 2011). This was a radical and new concept in the financial world and played a significant role in the recent financial crisis. A CDO is a financial security, similar to a bond, which is backed by various forms of debt. Investor compensation is compromised of the interest and principal payments on the debt. CDOs have various tranches with different associated risks and returns. CDOs are organized into a waterfall payment structure. The safer or senior tranches are paid first and followed, in order, by the other tranches. The risk of being exposed to defaults is less within the senior tranches because the lower tranches would absorb the associated costs before the senior tranches. For this reason, senior tranches either cost more or yield a lower return because of the lower relative risk. CDOs can be backed by a variety of debt. In the early 2000s, CDOs were created for debts such as mobile home loans, aircraft leases, and mutual fund fees (FCIC CDO Machine, 2011). CDOs backed by these multi-sector assets performed poorly. The CDO strategy was sound, but lacked stable collateral. This is where mortgage-backed securities came into the picture. In the context of the financial crisis, the CDOs of concern are those based off mortgage-backed securities. These

Mortgage securitizers needed a way to sell off the sub senior level tranches. or MBS. Demand was for the safer investments. Prior to CDOs. MBS were available for investors. Similar to the strategy employed by Drexel Burnham and Lambert. Bankers were incentivized to take these lower tranches from the MBS and convert them into . Conditions were ripe for a product like CDOs before the surge in mortgages and housing. or AAA tranches. This created the incentive for manufacturing CDOs. Demand was there for AAA rated investments and was relatively lacking in the sub AAA tranches. Domestically. Foreign investors largely wanted safe investments. investors were looking for safe places to keep their money after the dot com boom at the beginning of the 21st century. What Made CDOs So Attractive? Investors were needed to keep the “mortgage machine” going. but demand was greatest for the higher rated senior.mortgage-backed securities. Banks wanted AAA rated investments to avoid setting aside additional capital as per requirements and minimize default risk exposure. These lower tranches of MBS were bought and bundled into CDOs with higher investment ratings. were pools of mortgages grouped into a similar waterfall structure of payments and tranches as CDOs. Following the Asian currency crisis towards the end of the 20th century. these CDOs alluded to the notion that the diversification of the debt lowered exposure to default risk. the lower level tranches below the AAA investment rating level had little demand. many foreign investors were looking for safe investments.

The genius. Thus. The fee structure from CDOs was alluring to bankers as well. There was no data supporting defaults across the country. Before. These tranches supplied investment opportunities for risk averse and risk friendly investors.AAA grade investments. securitizers bundled MBS using pools of mortgages from all over the country. was constructing the model for doing this. not many investors wanted sub-senior level tranches. Prior to the crisis. mass defaults on home mortgages had not occurred. Bankers made a fee from securitizing and selling these CDOs and from the spread. Like the MBS. CDOs were appealing to both bankers and investors. Based off this data. data showed that defaults occurred in local clusters. Bankers made money on shear volume of trades and hardly cared about the integrity of these securities as long as they were paying . a huge market was made in a relatively short amount of time. This mortgage diversification was perceived to help shield investors from default risk. At the time. Bankers were happy that the lower-rated MBS tranches had demand. at the time. the innovation that occurred was creating demand for the lower tranches of the MBS. CDOs have been around for a while. The other act of genius was marketing and selling this new product to investors. the CDOs comprised of several tranches. Bankers took the lower tranches of the MBS and repackaged them into CDOs with higher ratings. securitizers began manufacturing CDOs with higher investment ratings than portions of MBS compromising them. The spread is the difference of the interest received for the mortgage and the interest paid on the security. The bankers’ achievement was creating the investor-base for these new MBS-backed CDOs. Using mathematical models to back this logic up.

2009). This model worked well for both sides up until 2007. CDOs and the Financial Crisis CDOs played a pivotal role in the lead up to the financial crisis. Leverage is an essential component in finance and at the crux of the current financial system. These loans were then pooled and then assembled into MBS and then into CDOs. it must still be able to give depositors their desired amount of funds at any given time.interest. CDO’s largely contributed to the crisis by spreading massive amounts of riskier-than-perceived investments globally. Banks and various investors could buy MBS and CDOs using further leverage. Leverage is a ratio of how much debt is held to capital present. increasing leverage across the system. Further money was borrowed to buy these lower tranches. Now. CDOs also allowed banks to free up capital by converting lower level MBS tranches into higher grade CDO tranches (Tambe. It was not uncommon to see banks and institutions borrow money to purchase CDOs. Investors were happy because they had new. for the bank to function. Leverage was introduced when writing loans. secure investments that yielded higher returns than treasury notes. With CDOs. leverage was compounded at every stage of the manufacturing process. The complexity of the crisis makes it difficult to pinpoint the full scope of the influence of CDOs on the crisis. An elementary take on leverage is: loans are issued on the premise that not all depositors would want their all their funds. 134). Simply put. The process of taking the lower tranches of MBS and converting them into CDOs involved considerable leverage as well. where . 2011 p. and encouraging “questionable” mortgages to be written. leverage is “investing borrowed money” (FCIC CDO machine.

Intense demand for CDOs led to a rise in the demand for the asset in which they were backed: mortgages. These large leverage ratios allowed firms to potentially incur enormous losses. As . With option ARMs. There are cases where strategies shorting synthetic CDOs had leverage ratios in excess of 80:1 (Seeking Alpha. Companies like Citigroup.demand was not present before. Mortgage originators did not have to hold on to these liabilities for long and sold them off to securitizers. They cared about transaction volume. These incentives fueled mortgage writers to issue as many loans as possible. Synthetic CDOs were another avenue for compounding leverage. Securitizers needed mortgages to create MBS and CDOs. therefore increasing systematic leverage. and Merrill Lynch incurred massive losses for writing CDOs with little capital on hand (FCIC CDO Machine. A problem with this process is that banks were able to skirt capital requirements by technically holding AAA or investment grade products even though this debt had much more risk. From 2003 to 2006 outstanding option ARMs jumped $65 billion to $255 billion alone. CDO sellers were not so much concerned with integrity aside from the rating standards. 2011). As discussed earlier. Synthetic CDOs invest in credit default swaps and have a similar tranche structure to that of CDOs. people who could never get loans before were able to. Option adjustable rate mortgages were another way to push out loans. Further implications arise when these lower rated MBS are transformed into higher rated CDOs. AIG. par. Soon. This pressure pushed mortgage writers to lax the standards and typical procedure for issuing loans thus fueling the subprime mortgage market. customers could pay a minimum interest amount each month and add the rest to the principal. 1).

. DC: Financial Crisis Inquiry Commission :. DC: Financial Crisis Inquiry Commission :. if any. 2011. "The Definitive Guide to CDOs. "Extreme CDO Leverage to Create Another Deleveraging Storm Seeking Alpha. investors acted in the interests of exiting those positions. It is difficult to isolate the roles of CDOs in the spread nationwide defaults to full out financial contagion. 2012). 2011." Seeking Alpha. CDOs were in high demand. 127-155. Bibliography: Saxena." In The financial crisis inquiry report: final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. "The Mortgage Machine. The CDOs helped fuel the housing bubble by supporting the writing of mortgages." In The financial crisis inquiry report: final report of the National Commission on the Causes of the Financial and Economic Crisis in the United States. In the mid 2000s. David. Washington. Washington. there is no telling what effects they had on various markets across the globe. Investors all over the globe sought these investment products. many of these people could not pay off these loans causing turmoil at the heart of MBS and related CDOs. Official government ed.com/article/102302-extremecdo-leverage-to-create-another-deleveraging-storm (accessed June 19. Few.com/publications/Risk%20Books/200808%20CDOs%20%20Risks%20Challenges%20and%20Market%20Outlook.pdf (accessed June 17. It is certain that CDOs did indeed play a pivotal role in the recent crisis.dmrra. http://www. "The CDO Machine.time has revealed. 2008). Official government ed." David Rowe Risk Advisory (2008). 102-126. This vast marketplace and an assortment of credit derivatives created a complex system that was difficult to grasp (Rowe. people understood the various connections present in the entire system. Once CDO cash flows started to dry up. 2012). http://seekingalpha. With CDOs in portfolios across the globe. Rowe. Rakesh.

Tambe. . Jayant." Jones Day (2009). "Commercial Real Estate CDO Litigation: the Next Wave?.

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