Collateralized Debt Obligations

The attitude leading up to the Great Recession was lower interest rates, create credit, increase the money supply and spend, spend, spend. This mentality led us to seek new markets and create new financial vehicles to tap markets, create liquidity in the economy, and allow banks to sell off debt to free up capital to invest or loan. Thus Collateralized Debt Obligations are born.

With the attitude of the go, go 2000s banks began to issue credit to risky borrowers; they issued credit for everything from car loans, credit card debt, and mortgages. When banks began to heavily issue risky mortgages, they started to use risky borrowers.

One tool used to securitize these risky lines of credit called Subprime RMBS (Residential Mortgage-Backed Security). Subprime RMBSs are a type of security whose cash flow comes from residential debt. Many RMBSs are backed by credit card debt, auto debt, and yes mortgage debt. In the case of Subprime RMBS, subprime mortgages are used to create cash flows. Holders of Subprime RMBS would receive interest and principal payments from money paid into the RMBS through debt.  Risky borrowers were generally poor and disproportionally minorities. Most of these borrowers had insufficient funds for down payments, credit issues, an inability to document proof of income, and sometimes just an overall lack of information.

With all these issues in risky borrowers, banks had to utilize mortgages designed for this market; hence banks began to increase their issuance of subprime mortgages. Subprime mortgages were designed to be short term with an emphasis on refinancing. The interest rates for these mortgages were fixed and then stepped up to a floating mortgage rate, and had a prepayment clause attached to them, which would dock you for early repayment.

At this point, banks began to take on excessive risk when they began to dabble in subprime mortgages. Banks were tying more and more capital into these loans, securitization allowed banks to free up these assets by pooling them and selling them off. At a glance of how much money was tied into these securitization, in 2005 and 2006 $1.2 trillion dollars were in subprime loans, and 80% of that $1.2 trillion were through securitization.

Securitization pooled all this interest baring assets together. Then a financial instrument, a type of securitization called a Collateralized Debt Obligation was used to sell off huge pools of these toxic assets as viable and safe investments.

There were many types of CDOs created to handle different types of debts. Subprime mortgages were thrown into a majority of these CDOs. CDOs were then converted into tranches which offered buyers of these risky assets options for maturity dates and risk. Within CDO tranches were these types: Senior tranches, Mezzanine tranches and equity tranches.

To get into the hands of investors, these CDOs were purchased by market value off balance sheet vehicles. Off-Balance sheet vehicles ultimately created shadow banking which involves: Derivatives, Securitization, and REPO (repurchase agreements). All of this however is a different story.

As stated earlier, there are many types of CDOs, all of them deal in different forms of debt and were offered by these shadow banks. Again, CDOs issue long dated liabilities in the form of rated tranches in capital markets. Then the proceeds of these tranches were used to purchase structured products for asset. One important type of CDO is the ABS or asset-backed security CDO, purchased such products as Subprime RMBS.

These RMBS would be bundled and then turned into tranches with different ratings. One of the ratings, Senior Tranches, had little risk, smaller payouts, but first to be paid back if the debt were to default. Senior Tranches were given an “AAA” rating by Moody and other rating systems. The next rating was in Mezzanine Tranches; they are little riskier than Senior Tranches. They had a little bit bigger payouts, less likely to get paid back if shit hits the fan. Given a “BBB” rating. The last rating is Equity Tranches; they had huge risk along with a chance of huge payoff. However, they were the first one to lose everything if they defaulted. Equity Tranches were generally not rated or labeled as junk bonds.

However, marketing was able to repackage Mezzanine and Equity Tranches to make them more appealing to investors. Many times the Subprime RMBS Mezzanine and Equity tranches would be skimmed off and then pooled again to create CDOs. Thus CDOs are born out of low quality Subprime RMBSs.

The creation of CDOs begins with mortgages that were warehoused by the originator before they are turned into securities. Once the pool of mortgages is big enough, they are then transferred to an underwriter who turns them into things such as tranches of RMBSs. Then debts (mortgages in the case of RMBS) that are not attractive to investors are skimmed off and pooled again. Thus resulting in CDOs.

The CDOs were then tranched again. They were made into High Grade CDOs and Mezzanine Grade CDOs. And again, the Mezzanine group can be skimmed again to make a CDO Square. Thus CDOs are essentially large pools of debt that pay interest and principle off of payments made to that debt. Increasing in the make up of the CDO debt were subprime mortgages. These subprime mortgages were less attractive and marketable in RMBS securitizations, but once put into CDOs they soon became “AAA” bonds. Thus when large amounts of this debt began to default, their unattractiveness increased and people started to jump ship.

Finally, in the result of the recession the question remains, where did all these CDOs go? The sad fact is that they were either left in poor performing government debt bought by bailouts or they disappeared all together. They were a flawed creation with asymmetric information at the heart of the CDO’s creation. CDOs removed the lines of communication between borrower and original lender, leaving a big mess of asymmetric information.
[The Tranches of CDOs]