Collateral Debt Obligation – A Perspective


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The rise and fall of CDO\'s

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Collateral Debt Obligation – A Perspective

  1. 1. By - Ajay Rathi<br />Collateral Debt Obligation – A Perspective<br />
  2. 2. What is CDOs<br />Collateralized debt obligations (CDOs) are a type of structured Asset Based Securities (ABS) whose value and payments are derived from a portfolio of fixed income underlying assets<br /><br />Collateralized debt obligations - Toxic financial instruments at the heart of the credit crunch. Banks embraced them as a way of shifting debt off their balance sheets, enabling them to lend more<br /><br />Collateralized debt obligations (CDOs) are complex versions of mortgage-backed bonds. Although they are sold as an alternative to more conventional bonds, evaluating their risks and rewards requires more specialized skills.<br /><br />
  3. 3. History of CDOs<br />The first generation of structural product ABS ( Asset based security) and RMBS ( Residential Mortgage based security) was issued in late 1980 in response to the “ Liquidity challenges of S &L” .<br />The second generation of structural product are CDO ( collateral Debt Obligation). Banks used CDOs to move company loans, bonds and other debts off their balance sheet. <br />Between 2000 -2009 CDOs worth $4.0 Trillion were issued.<br />Bail out cost then $293.3 Billion<br />Bail out cost approx $3.0 trillion<br />
  4. 4. How bank works<br />Traditionally : <br />Bank money was backed by something solid like ‘GOLD”<br />Presently : <br />Bank money is backed by Loans and mortgage. <br />Suppose a bank had gold worth 1K. <br />Let the cash reserve ratio(CRR) be 1:4. <br /> This implies that based on 1K the bank can lend up to 4K. Say A takes a loan of 4K from the bank and pays to B. So the bank have created a cash of 4K on the promise that A will payback to bank. Everything is fine till here.<br /> Things becomes interesting when B deposits the same in the bank. Now based on this cash, the bank keeps 20% as reserve (800) and rest 3200 can be used for giving a loan.<br />And this continues…. Effectively 1 K gets converted to 40 K.<br />So now cash is backed by loans and mortgage.<br />
  5. 5. How Loans and mortgage ballooned.<br />User wants a loan from the bank for his house. <br />He cannot make down payment, <br />His salary is not sufficient as per bank requirement.<br />He has defaulted on his credit card payment.<br />No bank is going to give the loan to the individual.<br />ENTER SUBPRIME( people with poor credit ratings) Loans<br />Why will bank want to lend to poorly rated people ----- Greed<br />Bank thinks and predicts that value of property will go up<br />They charge higher interest rates on subprime mortgages.<br />To further protect themselves, bank packages these mortgages into an investment product and sell it to investment banks…… birth of CDOs. <br />Investment bank further sell to institutional investors, trusts, school etc<br />
  6. 6. CDO Formation<br />1000 users each take a loan of $1M (total = $1B) and pays 10% mortgage (total of $100 M) to bank<br />The bank sells the mortgage to Investment bank and gets its $1B and the interest goes to IB<br />Creates tranches of CDOs, Senior , middle and Junior<br />
  7. 7. CDO payouts.<br />The bottle contains the bunch of mortgages interest receivable<br />Ratings<br />% return<br />2%<br />AAA<br />AA<br />3%<br />BBB<br />5%<br />Equities<br />8%<br />
  8. 8. Different types of CDOs<br />The underline asset for CDO could be.<br />Loans (i.e. CLO; Collateralized Loan Obligations),<br />Bonds (i.e. CBO; Collateralized Bond Obligations) <br />Asset backed securities (i.e. CDO's of ABS), <br />Credit default swaps (Synthetic Collateralized Obligations) <br />CDOs (i.e.CDO of CDOs) or CDO^2<br />
  9. 9. Things became uglier<br />As the property prices rose further, banks started doing a re-mortgage of the same house at higher value. More money flowed into the market.<br />Rating agencies were given a certain percentage of transaction deal for rating the CDOs<br />The rating agencies were compromised to an extend that 93 % of 2006 AAA ratings on the subprime mortgaged based securities were later downgraded to junk.<br />Asset structure in CDOs was influenced. What goes into CDOs was manipulated. Like the ABACUS CDO by Goldman Sach. Wherein  Paulson & Co. paid Goldman Sachs approximately $15mn to structure a transaction in which Paulson & Co. was going to short.<br />
  10. 10. Global CDO Market Size - 2006<br />
  11. 11. The End was Devastating for some<br /> Sep 7-2006 :NourielRoubiniwarns the International Monetary Fundabout a coming US housing bust, mortgage-backed securities failures, bank failures, and a recession.<br />April2-2007: New Century Financial, largest U.S. subprime lender, files for chapter 11 bankruptcy.<br />October 5-2007: Merrill Lynch announces a US$5.5 billion loss as a consequence of the subprime crisis, which is revised to $8.4 billion on October 24.<br />March 16-2008: Bear Stearns is acquired for $2 a share by JPMorgan Chase in a fire sale avoiding bankruptcy.<br />Sep 7-2008: Federal takeover of Fannie Mae and Freddie Mac, which at that point owned or guaranteed about half of the U.S.'s $12 trillion mortgage market, effectively nationalizing them.<br />Sep 14-2008: Merrill Lynch is sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse.<br />Sept 17-2008: The US Federal Reserve lends $85 billion to American International Group (AIG) to avoid bankruptcy.<br /> Sep26-2008: Washington Mutual is seized by the Federal Deposit Insurance Corporation, and its banking assets are sold to JP Morgan Chase for $1.9 billion.<br />And the rest is history……..<br />