CDO’s or in long term collateralized debt obligations are investment products sold to investors which are backed by the number of loans (auto loans, mortgages, corporate debt). It is the specific type of derivative because it derives value from another underlying asset. The underlying assets of CDOs are collateral which essentially and gives the value to the CDOs, and therefore that is why the CDOs are called “collateralized”.
Type of CDOs
The CDOs types usually come from that kind of underlying assets it is made of. For instance, if the CDOs are made of mortgage loans, then it is called mortgage-backed securities (MBS), and the Asset-backed securities (ABS) are made of auto loans, corporate debt or credit card debt.
How does it work?
To begin with, all the cash flow generating assets (mortgages, loans, bonds CDO’s are pooled into one group. Afterwards, the bank diversifies various debt assets and sell them and then afterwards separated into various risk level tranches. All of those tranches have particular rating whether they are going to return payments, and does it have a big probability to default.
Creating the structure of CDO’s
CDO’s tranches are usually grouped by the risk profiles and the Yield or interest. For instance, as in this example illustrated the structure of CDO (the structure would differ due to the individual product) contains senior debt, mezzanine debt and junior debt with S&P credit ratings.
As needed to point out that the lower the coupon rate (annual payments paid by issuer relatively to the face value of the bond) the greater is the credit rating. This means that if the loans defaults, then the bondholders of the highest credit ratings are going to be paid first and the lowest rating is going to be paid last. Hence, the Senior Debts is safest as they are going to be paid first due to the highest credit rating and the Junior is going to be paid last because of the lower credit rating. However, although the Seniors debts are the safest, they also have the lower coupon rates and the Junior debts have a bigger chance to default, thus, to compensate that they provide higher coupon rates.
Why were banks selling CDOs?
The CDOs were useful for banks for several reasons. One of them was that by selling CDOs to investors, it generated income which could be used to issue new loans. Not only that, but this way the risk of the loan to default would be shifted from the bank to investors because they would acquire those loans. Furthermore, it helped them to earn more from the products which at the end increased share prices and managers’ bonuses.
Who buys them?
The usual investors of CDO’s are investments banks, pension funds, insurance companies, banks and hedge funds. The main reason why they buy CDOs is to outperform treasury yields while minimizing the risk exposure. When the economy is doing great, adding more risk can yield better returns. However, this is not the case when the economy is not in the best shape as the losses can occur with a higher risk.
The problem with the CDOs in crisis
The main problem was how the Banks were calculating the risk of CDOs. The main focus was on calculating the probability of the potential loss of the pool assets not on the individual creditworthiness of each individual borrower. The banks did not care whether the borrowers would be able to pay off their debts because they sold the loans to investors and they would receive these losses if debtors could not pay their debts. The problem with that was that the banks were lending money to people who had low credit scores and at the end could not pay their debts. Thus, the investors of CDOs received shocking losses. The usual investors, as previously mentioned, were insurance companies, hedge, pensions funds. For instance, Merrill Lynch reported 2.2$ billion and Citigroup reported 6.5$ billion in losses in the third quarter of 2007. Some of the banks even went bankrupt such as Lehman Brothers or American home mortgage investment corp. Such losses threatened to destabilize the entire economy.
The USA Congress wanted to avoid the total downfall of the economy so approved a 700 billion bailout program called Troubled Asset Relief Program (TARP) to buy all the toxic CDOs from the struggling financial institutions. In simple words, from the financial institutions, the government bought the toxic loans using taxpayer’s money to stabilize the credit market.
What’s next for CDO or conclusion
Even though the market of CDOs used to be worth more than 200 billion it is now worth only around 70 billion, and it is starting to emerge once again as such players as Citigroup and Deutsche Bank are once again getting involved into CDOs. However, with the regulations such as that banks are required to have more cash in their reserve and loans with the higher quality. Therefore, these actions can minimize the effects of the loans defaulting in the future.