A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds’ prospectus.

The entity which creates a CMO is owner of mortgages, CMOs being entirely separate from the institution. The investors buying CMO issues would receive payments based on pre-decided rules.

Mortgage

Traditionally a mortgage loan involved a bank offering a loan to the borrower/homeowner and the bank retained the default risks. During the boom period from 2000 to 2007, the approval of automated loans damaged the review and documentation system for loans. There were abrupt decline in mortgage standards. A “Giant Pool of Money” ( Source: Peabody Award winning program, NPR) in fixed income securities worldwide was seeking yield higher than the T-bills in the United States. With this in pool growing at rapid rate in this period the supply of relatively safer investments was left behind. New financial instruments and investments were developed by various investment banks with higher and safer credit ratings, Collateralized Debt Obligations (CDO) and Collateralized Mortgage Obligations (CMO) being the prominent ones of those. Thus this pool was connected to the US mortgage market by the Wall Street. The continued demands for these products such as MBS and CDO drive down the lending standards. With the exhausting supply of mortgages at traditional lending standards, these innovations became unsustainable.

Default risks

With the arrival of securitization model, the mortgage loans could now be sold by the banks and distribute credit risk over a pool of investors through these MBS products. By selling motgages the creators of mortgages replenished their funds immediately instead of holding them to maturity. These originating banks could now leverage by generating more loans through the replenished funds. This created increased focus on increasing number of transactions with no concerns to quality. The securities marketing accelerated to triple the amount in the first half of the decade.

In 2007 however, securitization market started to shut down creating a huge unavailability of sources of funds. The flaws in the techniques adopted for evaluating risks did not came out to the market until trillions of dollars of mortgage securities have been sold. By the time the faults were understood and investors halted buying subprime securities, the crisis was already soaring.

Complexity

Investing could get even more dangerous with the growing complexity in the innovative and structured financial products. The complexity of these leveraged products over traditional mortgage models built from simple mortgages contributed to the crisis. Mortgages were sliced and tranched through products like mortgage-backed securities, asset-backed securities, collateralized mortgage obligations  or collateralized debt obligation. This products being so opaque, it is rarely completely comprehensible to common people. This also led to ambiguity in understanding risks by banks and credit rating agencies.

All engineered products have underlying securities which are part of capital markets. The risks of these products are defined by these securities and not on the financial structuring of the products.

CDO

A type of structured ABS whose payments are derived from a portfolio of fixed income underlying assets. These securities are split into different classes based on risk, payments made in order of seniority.

Collateralized debt obligations were considered the boons to the Wall Street, but soon became the burden. CDOs were created to increase customizability in risks and returns on investments. In a basic CDO a bank will purchase these obligations and divide into trenches which are grouped according to their risks and are sold into the market to the investors with higher risk investors getting higher premium.

CDO Market

CDOs are generally made up of various borrowing instruments, but with the false premise of always rising home values, mortgages became the prominent underlying instrument for CDOs. Between 2003 and 2006, the exposure to subprime mortgage bonds increases on new issues of CDOs which were based on ABS and MBS. Wall Street collected these mortgages and pooled them with other debts. The pool would then be sliced into risk levels; top tranches being paid first, and so on.

The ABS CDOs are mainly backed by lower-rated mortgage bonds, and with occurrences of defaults in these subprime mortgages CDOs backed by these underlying carried risk of severe rating downgrades and expected possible future losses.

This model worked good until the housing bubble started to burst around 2007 and residential values fell steeply. With the collapse of the housing bubble house values dipped below original debt levels. The effect multiplied with rising unemployment rates and fuel prices As the underlying of the CDO’s decline in value, banks and other institutions holding CDOs face difficulty in pricing their CDO holdings. Investment started the selling out of the securities based on these. This put a downward pressure on the value of the CDOs as the underlying assets, or collateral, was weakening. There was rapid exiting of CDOs and the active market for these faded away.

CDOs and the Subprime Crisis

The CDO market lost liquidity and ask prices rose too high over bids were too low. These huge differences affected equity balances in the financial institutions marking these securities. Investors in these institutions saw the decline of security. The subprime mortgages were among the first in the pool of CDO tranches to fail, however the housing market along with these were blamed for the recession.

As home prices fell, disposable income of many homeowners disappeared, other credit products also began to default with the decline in savings. This also had an impact on CDOs as they also represented various other types of debts.

From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. Mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds, and in 2006, $200 billion in mezzanine ABS CDOs were issued with an average exposure to subprime bonds of 70%.[citation needed] As delinquencies and defaults on subprime mortgages occur, CDOs backed by significant mezzanine subprime collateral experience severe rating downgrades and possibly future losses.

As the mortgages underlying the CDO’s collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing.[citation needed] The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses. However, in June 2007, two hedge funds managed by Bear Stearns Asset Management Inc. faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral.[citation needed] The now defunct Bear Stearns, at that time the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after unprecedented declines in the value of securities used to bet on subprime mortgages.[15]

On 24 October 2007, Merrill Lynch reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations.[16] A week later Stan O’Neal, Merrill Lynch’s CEO, resigned from his position, reportedly as a result.[17] On 4 November 2007, Charles (Chuck) Prince, Chairman and CEO of Citigroup resigned and cited the following reasons : . as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. As a result of these downgrades, valuations for these instruments have dropped sharply. This will have a significant impact on our fourth quarter financial results. I am responsible for the conduct of our businesses. It is my judgment that the size of these charges makes stepping down the only honorable course for me to take as Chief Executive Officer. This is what I advised the Board.[18]

The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 due to weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was US$ 47.5 billion, a nearly 74 percent decline from the US$ 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of US$ 11.7 billion was nearly 94 percent lower than the US$ 186 billion issued in the first quarter of 2007.[19] Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, not by home mortgage ABS.[20]

This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Investors criticized S&P, Fitch Ratings and Moody’s Investors Service, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didn’t reflect the lax lending standards that caused their backward-looking default rates to be inapplicable to risk level of the loans being made.[citation needed] In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs.[20] Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgages that are experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).[21]

ASSIGNMENT OF CDOS OR THE SECURITIES INCLUDED THEREIN IS NOT ALLOWED UNDER CALIFORNIA LAW IN CERTAIN INSTANCES In 1979 the State of California passed several consumer protection laws. One of those laws is California Business and Professions Code section 17351(BP&C 17351). That code precludes the assignment of a contract secured by real property once one of the parties to the contract is in default. It that a Collateralize Debt Obligation (CDO) is a contract that is secured by multiple properties. Therefore, pursuant the terms of section 17351, once one of the parties went into default on one of the loans that is included in the CDO, the entire CDO package could not have been assigned, i.e. the CDO would have to remain in tact and with the financial instution in which it resides. What is telling about BP&C section 17351 is that it was passed by the California State Legislature to prevent the exact problem that occurred due to the collateralization of the mortgages. An interesting look at BP&C section 17351 is found in an article in 11 Main Law Rev 391. That article states that the reason for the passage of BP&C section 17351 would be to encourage limiting a financial instutions financing transactions to consumers with good credit. I would suspect that the key issue would be whether or not violation of BP&C section 17351 resulted in a void transfer of the Promissory Note or whether it was a voidable transaction. Were the latter to be true it might very well be that foreclosures that have already occurred could be reversed or otherwise the foreclosing party could be sued for damages. Were the former to be true then a party that is subject to foreclosure would have an additional defense in that the party undertaking the forclosure would not be the proper party, were it found that the promissory note that provides standing to foreclose had been assigned after one of the parties to that note were in default OR if one of the parties to one of the other notes that were in a common CDO with the note that is the subject of the foreclosure were in default- at least in California.

Collateralized Debt Obligations: From Boon To Burden

by Dan Mongoose (Contact Author | Biography)

Email Article

Print

Feedback

Reprints

Share

Filed Under: 401K, Bonds, Credit Cards

Collateralized debt obligations (CDOs) were the wizardry of Wall Street, and soon became its burden. Although CDOs were initially created to provide returns on investments with customizable risk, they ended up becoming a liability for all involved. They even contributed to the subprime meltdown.

Basic CDOs are investment-grade securities backed by a pool of bonds, loans and other assets. A financial institution, such as a bank, will purchase these CDOs and divide them intotranches, or pieces of the CDO that are grouped according to risk and are available for purchase. Tranches are then sold to investors based on their desired amount of risk, with a higher risk tranche paying out a higherpremium.

This article is meant to give background and insight into the CDO market. Understanding this financial history may help investors avoid similar pitfalls in the future. (To learn more about how these structured products contributed to keeping borrowing rates low, read CDOs And The Mortgage Market.)

A Brief History of the CDO Market

Although CDOs are made up of many different types of  borrowing instruments, the troubled CDO market made mortgages the main underlying debt instruments. Then, under the false premise that home values always rise, mortgage brokers were putting people in homes that they couldn’t afford. Despite this, interest could be capitalized on the loan value to protect the lender, because loan-to-value (LTV) calculations were below original home values. (For background on the subprime meltdown, check out Who Is To Blame For The Subprime Crisis?)

Wall Street would collect these individual mortgages from the banks and pool them with other forms of debt. As an aggregate, the pool would be sliced into risk levels, or tranches, with the top tranche getting paid first, and so on. Thus, the investment bank could offersynthetic securities to its institutional client base, and the securities would meet whatever risk parameter (investment grade rating) the financial institutions sought.

This method worked well until the housing bubble began to burst in 2007, and home values started to fall precipitously with the increase in five-year adjustable rate mortgages (ARMs). Homeowners who had enjoyed a low interest rate suddenly saw these rates reset, creating significantly higher mortgage payments. This effect was compounded by rising unemployment rates and gas prices, as well as low savings and climbing home-equity debt. This is the backdrop that affected the fixed-income market.

How CDOs Affected the Fixed-Income Market

As the housing bubble collapsed, home values dropped below original LTV parameters; once people started to feel the financial strain, mortgage  increased and foreclosures rose. Investment analysts saw this well before it worked its way through the system, and started the selling. This pushed down the value of the CDOs as the asset backing, or collateral, was showing numerous weaknesses. The exiting of this investment vehicle was so fast that an active market of buyers and sellers no longer existed. This resulted in a bid-ask spread that widened so much that trades ceased, all because of the confusion as to what these CDOs were now worth. (Learn more by reading Conquering the LTV Calculation.)

How CDOs Fit Into the Subprime Crisis

A new accounting rule called mark to market (MTM) accounting added to the already building financial storm. This financial principle dictates that investment securities should be valued every quarter based on prices readily observed in the market. Since the CDO market was no longer liquid, ask prices were too high and bids were too low. When marking these securities to market prices, financial institutions had to mark them down to their bid prices, which affected equity balances in these financial institutions.

As a result, investors in these financial institutions saw the securities decrease in value and continue in a downward spiral. Since the subprime mortgages were the first of the CDO tranches to fail, they were blamed for the financial mess of 2008; however, the housing market and MTM accounting also share the blame. (Learn more about MTM accounting and its place in the subprime meltdown. Read Mark-To-Market Mayhem.)

As home prices fell, foreclosure was not the only problem that arose. For many years, increasing home prices led to an increase in disposable income for many homeowners, as they could leverage their homes for other loans. As housing prices fell and disposable income disappeared, many other credit products began to default as well — particularly consumer credit cards and automobile loans. This had a huge impact on CDOs as they differed from other collateralized securities, such as collateralized mortgage obligations(CMOs), in that they represented many different types of debt.

Bringing It All Together

Let’s take a look at how the credit debacle unfolded: First, commission-based mortgage brokers talked credit-impaired John Doe into a more expensive house (and hence more debt) than he could afford. Banks gave Doe the mortgage since they rarely saw home values depreciate. Since Doe had a house that was appreciating in value, he was able to get more credit and higher loans to purchase other goods. The banks sold these debts to investment banks, which aggregated them and split them into different classes called collateralized debt obligations (CDOs) and sold the different investment classes to financial institutions.

Following this, interest rates went up and home prices went down. Analysts predicted the CDOs would be impaired, but they didn’t know the amount. This valuation quagmire led to very low bid prices on the CDOs, which fanned the flames of loss under MTM accounting. In turn, the investors within financial institutions that had CDOs had to mark down their investments, which led to the subprime mess. Hypothetically, John Doe may face foreclosure, his mortgage broker may be out of a job, his bank may be out of business and his 401(k) may be significantly lower, all because home prices don’t always appreciate. (For an expanded view, check out The Fuel That Fed The Subprime Meltdown.)

Conclusion

CDOs were initially designed to be Wall Street’s next best thing. However, due to the financial industry underpinnings that led to the perfect financial storm, they became the bane of existence for all within their reach. Unfortunately, it is likely that Wall Street will once again put stock in something unrealistic or short-sighted. Therefore, it’s up to investors to understand CDO history and prevent it from happening again.

Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the CMO, and they receive payments according to a defined set of rules. With regard to terminology, the mortgages themselves are termed collateral, the bonds are tranches (also called classes), while the structure is the set of rules that dictates how money received from the collateral will be distributed. The legal entity, collateral, and structure are collectively referred to as the deal.

en.wikipedia.org/wiki/Subprime_mortgage_crisis#cite_note-92[93]

So why did lending standards decline? In a Peabody Award winning program, NPR correspondents argued that a Giant Pool of Money (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade. Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as themortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies. In effect, Wall Street connected this pool of money to the mortgage market in the U.S. with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain. Eventually, this speculative bubble proved unsustainable. NPR described it this way:[94]

The problem was that even though housing prices were going through the roof, people weren’t making any more money. From 2000 to 2007, the median household income stayed flat. And so the more prices rose, the more tenuous the whole thing became. No matter how lax lending standards got, no matter how many exotic mortgage products were created to shoehorn people into homes they couldn’t possibly afford, no matter what the mortgage machine tried, the people just couldn’t swing it. By late 2006, the average home cost nearly four times what the average family made. Historically it was between two and three times. And mortgage lenders noticed something that they’d almost never seen before. People would close on a house, sign all the mortgage papers, and then default on their very first payment. No loss of a job, no medical emergency, they were underwater before they even started. And although no one could really hear it, that was probably the moment when one of the biggest speculative bubbles in American history popped.

Securitization practices

Borrowing under a securitization structure.

Further information: Securitization and Mortgage-backed security

en.wikipedia.org/wiki/Subprime_mortgage_crisis#cite_note-95[96]

en.wikipedia.org/wiki/Subprime_mortgage_crisis#cite_note-brookings.edu-97[98] In February 2009, Ben Bernanke stated that securitization markets remained effectively shut, with the exception of conforming mortgages, which could be sold to Fannie Mae and Freddie Mac.[99]

A more direct connection between securitization and the subprime crisis relates to a fundamental fault in the way that underwriters, rating agencies and investors modeled the correlationof risks among loans in securitization pools. Correlation modeling—determining how the default risk of one loan in a pool is statistically related to the default risk for other loans—was based on a Gaussian copula technique developed by statistician David X. Li. This technique, widely adopted as a means of evaluating the risk associated with securitization transactions, used what turned out to be an overly simplistic approach to correlation. Unfortunately, the flaws in this technique did not become apparent to market participants until after many hundreds of billions of dollars of ABS and CDOs backed by subprime loans had been rated and sold. By the time investors stopped buying subprime-backed securities—which halted the ability of mortgage originators to extend subprime loans—the effects of the crisis were already beginning to emerge.[100]

Nobel laureate Dr. A. Michael Spence wrote: Financial innovation, intended to redistribute and reduce risk, appears mainly to have hidden it from view. An important challenge going forward is to better understand these dynamics as the analytical underpinning of an early warning system with respect to financial instability. [101]

These Financial Products Are Too Complex For The Average Joe

by Ken Hawkins (Contact Author | Biography)

Investing is perilous enough when investing in stocks and bonds or even in plain vanillamutual funds, but it can get downright dangerous with the increase in complexity of many financially engineered investment products. Following the 2007 subprime mortgage meltdown, which affected both Main Street to Wall Street, a lot of blame was being spread around about who or what was responsible. While the meltdown resulted from a combination of factors, many argue that the complexity of the derivatives products, which were developed from relatively simple mortgages, was a major contributor to the subprime crisis.

By slicing and dicing a mortgage, financial engineers created an array of investment products like mortgage-backed securities(MBS), asset-backed securities (ABS),collateralized mortgage obligations (CMO) orcollateralized debt obligation (CDO). These exceedingly complex products are so opaque that very few people really understand them and how they work. Investors, the credit rating agencies and even the big banks and brokerage firm all failed to understand the risks of these investments and all were burned by the following collapse. This outcome should serve as a warning for those investors contemplating the purchase of complex investments. (To read all about the credit crisis and mortgage meltdown, see The Fuel That Fed The Subprime Meltdown.)

The Problems

Underlying all structured investments are securities that are part of the capital markets. The risk and the performance of structured investments are inevitably determined by the investments upon which these complex securities are based, not the financial engineering. (To learn more about structured products, check out Are Structured Retail Products Too Good To Be True?)

The Risks

Complex investments may have risks that are not apparent, or easy to understand. As a result, it might be difficult to determine how the investment will make money. For example, when an investor buys a simple equity mutual fund, the investor will make money if the market goes up. However, in a fund of hedge funds it is next to impossible to determine how the investor will make money. It is essentially unknown. Similarly, principal protected notes(PPNs) are also derivative products, an they include a combination of guarantees andembedded options. As such typical investors have no understanding of how to evaluate a PPN. They do not know whether it is a good investment or if they are paying too much for the product’s underlying features.

The more complicated the product, the less transparent the risks. This was made apparent by the subprime mess. Many investors might have understood the potential for a poor real estate market and the possibility of foreclosures. However, while many investors owned securities that were based on subprime mortgages, they were unaware that these securities were so vulnerable to a poor housing market. As such, they were not able to make the connection that foreclosures in Cleveland, Atlanta or Los Angeles would negatively impact the investments they purchased locally.

The Fees

Buying simple products tends to be much less expensive than buying more complex securities. For example, buying 1,000 shares of a $100 stock might only cost $10 for the transaction with an online broker; with a discount broker, the annual cost of owning the stocks may be $0. Similarly, exchange-traded funds (ETFs) are simple and inexpensive. For example, in 2008, the iShares S&P 500 ETF has an annual management fee of only nine basis points (or 0.09%). If you have this product in your portfolio, a $100,000 dollar investment will only cost you $90 per year. On the other hand, when you buy more complex products like variable annuities or principal protected notes, they may appear inexpensive, particularly if they don’t have any upfront fees or commissions; however you are paying for the products, and they are very profitable to both the advisors who sell them to you and the company that created them. In such cases, the fees are built into the structure of the products, and are therefore not readily apparent to the consumer.

The Image

The companies that manufacture and manage complex products understand them far better than the client who buys them. Asymmetric information exists when sellers know much more about a product or a service than buyers do. For example, used car salesmen have more information about a specific car than the individual who is buying it. When sellers know more than buyers, it creates a situation in which unsophisticated buyers may pay more for products than they are really worth. In addition, the more complex the information about a product is, the more an unsophisticated buyer is willing to pay for it.

In Bruce Carlin’s research paper, Strategic Price Complexity In Retail Financial Markets, one of the conclusions was that consumers … often make purchases without knowing exactly what they are getting or how much they are paying. In fact, they may also be unaware that they are indeed overpaying.  In this paper, Carlin implies that firms deliberately make their products complex thereby gaining market power and the ability to preserve industry profits (December 2006, Social Science Research Network). (Comparing price swings helps traders gain insight into price momentum. Learn more in Divergence: The Trade Most Profitable.)

In Carole Bernard and Phelim Boyle’s research paper titled Structured Investment Products And The Retail Investor (April 2008, Social Science Research Network), it says consumers often select a complex product when a simpler one is preferred. These puzzles are not unrelated since some of the most complicated products are the most overpriced and carry the highest commissions. The research shows what common sense implies: uninformed, naïve consumers can be strategically exploited by producers of financial products.

It is quite likely that many advisors do not fully understand all the products they sell. Although many products are sold with a detailed prospectus, it requires a thorough analysis to understand the products fully. Some advisors might not take the time to read this prospectus, are too busy, or do not have the background to interpret the information and make sense of the product. In the end, this may mean that the advisor is unable to provide adequate due diligence on behalf of his or her clients. (Got a hot stock tip? Follow up on it with the tips found in Due Diligence In 10 Easy Steps to avoid getting burned.)

In addition, complex products generally have higher commissions attached to them, providing the advisor with an incentive to sell these products even though they might not understand what they are really selling. As such, it is important that the investor take the time to understand any product he or she buys into, rather than rely on an advisor to do all of the work.

The Investing Process

The most important place to start with a manufactured product is with the information that is provided to the buyer. Let’s take a look at few investing tips to help you get started.

Ask yourself these questions: How is the money to be invested? Can you understand how the product will generate returns? What would cause you to lose money? Can you duplicate the results in a simpler fashion?

There is nothing to force an investor to buy an investment product he or she does not understand. If you cannot explain it to a friend, then it is probably too complicated.

If an advisor is recommending it, ask questions. Nobody ever loses money by asking too many questions.

If the advisor cannot explain a product adequately, stay clear. The more complicated the product, the more investment knowledge and experience you will need to buy it.

Watch out! The most complicated products are often sold to unsophisticated and unsuspecting investors who cannot adequately evaluate them.

Final Thoughts

For complex products, the devil is in the details. Reading the fine print about any investment product is a necessary requirement. This includes information about guarantees, about the features that limit the upside, about risks to the products, the fees and commission, and the liquidity of the product. Remember that numerical examples that are provided to advertise a product are generally presented in a way that highlights the product’s features but not its limitations. Keep this in mind and don’t let these examples determine your decision to buy in. (Learn a simple way to bring the benefits of derivatives into your portfolio, in Understanding Structured Products.)