We’ve all heard about CDO. But what is it exactly? CDOs got popular during the 2008 sub-prime crisis. It is basically a pool of securities bundled together and sold as shares.
Let’s say a person
needs a home loan or a car loan and he goes to the bank for asking for a loan.
The bank might get ‘n’ number of customers asking for such loans, securitized by
either collateral or a mortgage, which they can sell in case of default. The
bank transfers all of these loans to a special purpose vehicle (SPV). An SPV is
basically a pool of all these securities. The shares of this special purpose
entity are then sold to interested investors. This SPV gives the investors a
higher rate of return as compared to the bank returns and lends to the
borrowers a rate lower than that of the bank.
But how does this
differ from a Mortgage-Backed Security (MBS), where similar asset-backed
securities’ shares are offered, with a pool of securities being the underlying
asset? In a CDO, there are 3 types of securities based on the risk-appetite and
the yield. This means that CDOs
can give different investors, different levels of risk, and returns with the
same underlying assets. The three types of securities are called CDO tranches.
Different tranches have different ratings, based on how risky they are. The first tranche is ‘Senior’ offering the lowest return out of the three tranches, but
assured returns, with low risk. The senior tranche is the safest. The second
tranche is the ‘Mezzanine’ offering a yield higher than the ‘Senior’ tranche,
but being riskier as well. The third tranche is ‘Equity’, giving the highest
return. This is because, in case of default, the Senior tranche gets paid first,
then Mezzanine, and whatever is left is paid to the Equity tranche, which means the Equity tranche has the highest risk involved.
If there is no default, the Equity tranche is the one that
earns the highest returns and the other 2 safer tranches will get their fixed
percentage of returns.
So basically, CDOs, or collateralized debt obligations, are
financial tools used by investment banks to repackage individual loans
into a product sold to investors on the secondary market. They are called
collateralized because the promised repayments of the loans are the collateral
that gives the CDOs their value.
But, CDOs were a major reason for the 2008 financial
crisis.
In the 2000s, the US housing sector was booming and
investors were throwing their money in this sector. But, financial instruments
like mortgage-backed securities (MBS) and CDOs earned them a higher return.
This increased the demand for these instruments. Now, since the demand was
rising, banks started giving out loans to people who did not have the
appropriate credit score and the income to pay for the loan. This is called subprime mortgages. Based on past data, credit rating agencies had given the
MBSs and CDOs a very good rating and investors too were happy with the
performance up until now. In the US, senior citizens can only invest their
pension funds in AAA rates bonds/shares. A lot of pension funds, too was invested
in the senior tranche of these CDOs.
Around the same time, government introduced policies which
decreased the rate of interest, due to which the prices of houses rallied. This
encouraged more people to invest in the MBSs.
But this bubble had to burst at some point, borrowers had
stopped paying their loans and thus, their homes went back for sale on the
market. After this point, there were too many houses for sale in the market, due
to which the prices started coming down. Due to this, there were many borrowers
who owed more to the bank, as compared to their house’s value. Naturally, these
people started defaulting as well.
Many big companies had purchased these MBS and CDOs in tonnes
and had gone bankrupt. Some companies had also taken debts to invest in these
risky investments. Lehman Brothers, which was deemed too big to fail, had to be
bailed out by the government.
So basically, these sub-prime mortgages, caused a major
meltdown in the economy. When investing in any of these securities, it is very
important to know the quality and the credit ability of these underlying
assets.
Thank you.
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