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

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

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

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

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

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