Collateralized debt obligations (CDO) are a financial instrument used to spread risk and reward in the market. Using this financial instrument, belonging to the group of the asset backed securities, lenders are able to reach more people in need or want of a loan. This article is going to be very structured in short but abundant parts to ease the exercise of understanding it. We will explore the process of creation of a CDO, from the basic lendee through the financial institution until the final investor is reached. In the picture below, I made a graph that goes from left to right and shows the process of creating the CDO from the original debt.
The debt and the lending company
This part is easy to understand. No financial engineering has happened yet. There is a lending company (Ameriquest Mortgage is a case of a company that used to provide lending solutions for buying houses) that has (in this example) 6 loans to 6 different individuals. Inside the brackets in the graph there are a three-letter code, the amount lended, also called principal and the interest to be payed yearly. The three-letter code is called credit rating (click here for more information) and is assigned by a credit agency. We will talk about these in depth later. We need to know now that the credit rating is inversely proportional to the interest. The higher the rating, the lower the interest, because the theoretical risk of a default (the lendee stops paying their interests and principal) is lower. Thus, higher the risk, higher the reward. The problem faced by our model lending company is that if they only have 6000€ of cash, they cannot keep lending money and so they are left with 6 lending contracts and have to wait for the lendees to pay their interests and principal back before they can start the process again.
This is when the first work of financial engineering takes place. A loan is an illiquid asset, meaning that it cannot be transformed into money in a short span of time. You’re stuck with it until the person you lent your money to pays back. This can take up to 40 years in case of a mortgage.
And so, at this point, the lending company takes its 6 loans, packs them together and makes a Mortgage Backed Security (MBS. The packing process is called “securitization”). This can be imagined as a bag with a certain number of contracts (the 6 original loans) that will yield each month a certain amount of interests (in our model 8,6% annually, taking the average of interest payed). These MBSs are sold to a financial institution like Goldman Sachs for example. Now that the MBS has been sold forward, the lending company gets back the original principal plus a small bonus and can start providing mortgages to new clients. Also, the risk of default has been transferred with the MBS to the new owner, in our case Goldman Sachs.
The Financial Institution and the CDO
The MBSs that the lending companies like Ameriquest sold forward did not get the interest of private investors like hedge funds or pension funds. Hedge funds considered MBSs not yielding enough. Instead, the pension funds found the MBS too risky (they are by law limited to invest in highest rating securities[AAA]). And so now the financial institution is the entity getting payed the interests of that debt but also carrying the risk.
To deal with this risk, they designed a way to pass the risk and the yield forward. This new method was called CDO. Each CDO was composed by different tranches each belonging to different credit ratings. When investing in a CDO, the investor could choose in which tranche to invest, so the pension funds could go for the highest quality tranches and the riskier hedge funds could go for the low-quality/high-yield tranches. Each year, the CDO would collect its interests and principal payments and share them through the investors according to their tranches.
At this point everybody is happy. The lending company sold their 6000€ in loans forward as an MBS to the financial institution, getting their small piece of the interests. The financial institution sold created the CDO and let the investors invest in it, getting their commission from the transaction. The investor money feeds a wheel that powers the lending machine.
But how do they really work?
The reader might ask him/herself what difference is there between having a tranche AAA or a tranche CCC more than the logical alpha difference? Well, the way the cashflow coming from the mortgage payments is spread gives preference to the owners of the triple A tranche, before paying then the second-best quality tranche and so progressively until reaching the worst quality graded tranche. Let’s see a mathematical example:
The total interests to be payed by our model CDO can be easily calculated with Matlab or a calculator:
The code will return us the yield in euros and in form of percentage: 520€ (8,6667% of 6000€). This situation will allow each tranche to get paid the full amount of the interests owed to them. In case some client defaulted from the CCC tranche for example, the investors in the riskier portion of the CDO would not get paid in full.
Let’s say that instead of 520€, the CDO sees an inflow of 450€. Who gets paid? First, the investors who bought AAA tranche are paid. Their interests are 5% of 2000€ = 100€. Now there is only 350€ left. Second the BBB tranche gets paid. Their interests amount to 9% of 2000€ = 180€. Once they get paid there is only 170€ left and so it is turn to tranche CCC receive their fair share of the pie, but there is a problem. The interests of the tranche CCC are 12% of 2000€ = 240€, but they can only be paid 170€. Thus, will suffer the risk of the defaults in the greatest magnitude.
The best way to visualize a CDO is by imagining a skyscraper. Each floor of the building represents a tranche in our CDO. Now imagine there is a flood. The water represents the credit default. As the water keeps rising (more defaults), it will gradually affect a higher floor. Those floors under water will not receive any alpha.
The first CDO was issued in 1987 by Drexel Burnham Lambert Inc for Imperial Savings Association (none of the companies exist anymore). Until the end of the 90’s, the collateral of the CDO was generally corporate and emerging market bonds. In the 2000s the market for CDO skyrocketed from $69 billion in 2000 to $500 billion in 2006. Between 2004 and 2007, $1.4 trillion worth of CDOs were issued.
Early CDOs where very diversified, including corporate bonds from very different industries to student loans and credit card debt. This ensured that if one industry would have a downturn, the CDO would not suffer as greatly as the industry itself. This was used as a selling point. CDOs also returned sometimes 2-3 percentage points higher than corporate bonds with same credit rating.
Bad reputation. Where does it come from?
It is hard not to talk about the CDO’s without talking about the economic crisis of 2007-09 in the US. After the tech bubble burst, amid concerns of a recession, interest rates were lowered by the Federal Reserve. This forced lenders to lend more to get the same amount of money they would make before (if you make 200€ from a 10% interest on a 2000€ principal, you need a 4000€ principal to make 200€ with a 5% interest rate).
Accumulating more debt was not financially intelligent from the risk management point of view and so the lending companies would sell the debt forward to financial institutions and those would create the CDOs. Thus, the CDOs would spread the risk through the financial system. There is a very interesting paper found here written by Raghuram G. Rajan for the National Bureau of Economic Research in 2005 that analyzes the increase in debt inside the financial sector and the risk it adds.
The influx of money into the mortgage business was driven because of banks entering the market, speculation by home buyers and US government policies aimed at expanding homeownership between the working class. I will try and show the different points and how they all collaborated to make the 2007 recession happen.
2007 crisis and the investors
Let’s start by analyzing first from the investors point of view. As the Federal Reserve decreased the interest rates previous to 2006, the investors were forced to lend more money to achieve same alpha in terms of euros or dollars as explained briefly before. To be able to lend more money to more people, credit requirements started to get lowered. Consequently, customer with worse credit ratings started getting loans for their houses. These mortgages became known as subprime mortgages.
Another widely blame factor for the recession was the derogation of the Glass-Steagall act (Banking act). The Banking act was put in place in 1933 after the Wall Street Crash of 1929 to separate deposit banking from investment banking. This act was widely criticized and in 1999 President Clinton publicly declared that the law was no longer appropriate and so decided to derogate it. Since then, commercial banks were allowed to invest and deal in non-governmental and non-investment grade securities for themselves and customers stimulating the influx of capital into the mortgage market.
Other policies by the US government like the creation of Freddie Mac and Fannie Mae (these banks were sponsored by the government but were built long before the crisis. In 1970 and 1938 respectively) also spurred the signing of subprime loans. With the excuse of facilitating house ownership to low and middle-income people, subprime loans were granted like there was no tomorrow, securitized and pushed into the financial system. Michael Lewis, writer of “The Big Short: Inside The Doomsday Machine” (can be found here) made famous the case of a strawberry collector in California that was making $14,000 a year and got a mortgage for approximately $750,000. If he spent 100% of his salary (before taxes) to pay for the house, it would have taken him 53 and a half years to pay it off. The society in general had the feeling that housing was a very solid investment and prices could never fall.
I can’t finish this part without mentioning the fault that credit rating companies had in the events of 2007. These companies get paid by banks and financial institutions to rate the products created by these same financial institutions, and thus face a high conflict of interest. They have to give an objective rating to the same people who are paying them, and we all know what kind of pressure it puts in the rating agencies. The shadow banking community would use the threat of not returning to certain agencies if their products where not generously rated, creating a false hope of security to investors. (Want to know what that shadow banking system is? Click here.
With this fear in mind, rating companies used the argument of great diversification to give high rating to bad loans and NINJA (No Income No Job or Assets) mortgages. Sometimes, even tranches of CDO A where put inside CDO B and then tranches of CDO B where put inside CDO A, and then both where put inside tranches of CDO C. This is an example of how complex and diversified these products are. This complexity and diversification does not make them more secure as the underlying assets are still of very low quality. In a scene of the movie “The Big Short” CDOs are defined as dog shit wrapped in cat shit. This helps understand that even though there are different assets underlying, they are both shit nevertheless (bad quality is not inside the definition of CDOs, but before the financial crisis, most CDOs had a high percentage of bad quality products).
2007 and the home-owners
If we look at the happenings from the home-owners point of view, we can see how the increase in housing prices allowed an orgy of over spending and debt to go on.
As more people were given mortgages, the demand for housing increased, increasing prices. With the revaluation of the owned house, a person would get a second mortgage to buy a second house for speculation or refinance their current mortgage to include their credit card debt or a new car. This refinancing was based in the idea of the house always increasing in value, giving a false sense of wealth. A good example of this is shown in the movie based on the same book by Michael Lewis, when one of the main characters goes to a stripper club to ask the dancer about her finances (found here). The stripper confesses in the scene that she has 5 houses and a condo, and when loan companies ask her about her job, she just writes she is a “therapist”. No further research done in her back-payment capabilities. All this over indebtedness led to people consuming over their possibilities and so it stimulated the economy.
What started the recession?
When the mortgages had been signed, a technique called predatory lending was used. The name is quite self-explanatory. This consisted in unfair, deception and fraudulent practices during the loan origination process. These practices where done by a wide number of lending companies. The most common “trick” done on the lendees consisted in presenting them a contract with an Adjustable-Rate mortgage. This meant that for the first few years, they would pay as an example 5%, and after the 3rd or 4th year, the interest would raise to 14%, increasing monthly payments. Thus, the number of defaults started to raise when the higher rates would start. This was by the end of 2006, start of 2007. The graph does not require further explanation.
With the increase of defaults, more houses entered the market making the supply surpass the demand and consequently home prices decreased very abruptly. Here is another graph showing the evolution of housing prices developed by JP. With the further decrease of price, lendees found themselves without opportunity to refinance their debts and had to return the keys to the banks. As you can see, a domino effect swept across the economy bringing the country into a recession. If you want to see an explanation in video format, I recommend a scene from “The Big Short” movie (found here).
Credit Default Swaps (CDS)
I did not want to finish this article without stopping a second to talk about Credit Default Swaps. This product belongs to the group of derivative products. They are related to CDOs. They can be considered as insurance on the CDO’s payments. Let’s take the case that you buy participations in CDO A sold to you by JP Morgan. For a small yearly fee, you can buy a contract by which you get the guarantee that JP Morgan will pay the money that the CDO has to deliver in case it does not. With the past behind our backs, it is easy to look back and say that it was a stupid idea from JP Morgan (and all other banks) to provide these insurances on products based in bad quality loans. But, as mentioned previously, nobody could imagine that housing prices would go burst and there would be such high default rates around the country. These contracts (CDS) nearly dragged down several banks and insurance companies, being the most famous case AIG. AIG had CDS covering more than $440 billion and they had nowhere close to that amount of money. More information on AIG and their CDS problem here.
So, is it good or bad?
Our economy is based in credit. If every person had to wait until they had saved money to start a company, very few people would do that. With credit for a new factory, for example, we are being advanced future cashflows that the factory will create. We will pay back the credit with the profit generated with the company. We definitely need credit. They present a risk for the lender and lendee, but both parties are able to bear with it.
By the end of the 80’s, lenders found the way to pass that risk allowing them to provide more credit. This is not bad per se. As long as it is used to buy something useful at a reasonable price, credit represent a great advantage to our economy.
The problem arises when lenders and lendees lack the responsibility to evaluate the consequences of their acts. Lenders started spreading risk everywhere that infected the system. On the other hand, lendees went into spending madness stimulated by the increasing prices of their owned homes. This gave a false hope of wealth to the economy that started growing based in debt. I wanted to write the verb own in cursive as the feeling of having a house was quite surreal. The house was ultimately owned by the owner of the CDO in which the debt had been packed into. The years previous to the recession were dominated by a fake feeling of ownership and safety that we have to try and prevent from happening again to the best of our ability.