We explain the terms taking the case of the example of an average US family
The family wants a House
They save for a ‘Down Payment’ and contact a ‘Mortgage Broker’
The Broker gets the family in touch with a Mortgage Lender who gives them a mortgage. The broker makes a commission off the deal
One Day the lender gets a call from an Investment Banker asking him to sell the mortgage to him.
The Investment Banker borrows millions of dollars and buys many such mortgages. He puts these mortgages into a single box.
This means that the bank gets the installments from several such customers
The Bank now figures out another way of making money. It categorizes the mortgages in the box into 3 categories ‘Safe, Okay and Risky’ . This box is now called ‘Collaterized Debt Obligation’ or ‘CDO’
The categories are indicative of the cash flow coming in against the mortgages i.e. the safe ones are the first to receive the payments and then the Okay ones and whatever is left goes into the risky category. This implies that in case there are defaulters, then the loss is felt in the ‘Risky’ mortgages
Now, the bank offers lower interest rates for the Safe mortgages, a little higher for the Okay mortgages and highest for the Risky mortgages. The bank also offers some insurance against these safe mortgages to get better credit ratings for the same. This insurance for the safe mortgages in the CDO is called as ‘Credit Default Swap’ or CDS
The bank sells the safe mortgages to the investors who are looking for risk free investments with higher returns, the Okay ones are sold to other investors and the Risky ones are sold to Hedge Funds
Mortgages given to ‘good’ families are called Prime Mortgages
The ones given to the ‘not-so-well-off’ are called ‘Sub-Prime mortgages’
In this whole eco-system, everyone is happy and making money
But as soon as someone defaults
The bank gets the House of the person defaulting. In this manner there are several houses which the banks gets. This creates more houses in Supply than those in demand.
This brings the price of houses down
Now, the banks have houses that are worth nothing, the investors also have some CDOs which have gone bad and the Lenders have mortgages which are defaulted
Ultimately, the bomb ticks and the system collapses
Now, the investor calls the house owners to let them know that their investments are worth little. Hence, there is this vicious cycle.
Uni credit case
Mortgage Based SecuritiesSubprime SectorCredit Default Swap<br />
Asset-Backed Securities<br />ABS derive their cash flows from a pool of underlying assets<br />MBS = mortgage backed securities<br />CARS = certificates for automobile receivables<br />CARDS = certificates for amortizing revolving debts (Credit Cards)<br />HELS = home equity loan securities<br />
Asset-Backed Securities<br />The underlying assets generate cash flows of principal and interest which can be repackaged and sold to investors.<br />Principal<br />Asset-backed securities<br />Fixed income assets<br />Interest<br />
Asset-Backed Securities<br />In ABS, the underlying assets are collected into a pool.<br />Pool assets are standardized.<br />The asset pool is placed in trust.<br />Claims on the cash flows generated by the asset pool are structured:<br />Pass-through structures<br />Multi-class structures<br />Securities representing these claims are sold.<br />