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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

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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 21stcentury.

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

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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

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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

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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

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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-extreme-cdo-leverage-to-create-another-deleveraging-storm (accessed June 19, 2012).

"The CDO Machine." In The financial crisis inquiry report: final report of the NationalCommission 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 theNational 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).

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