By - Ajay Rathi

Collateral Debt Obligation – A Perspective

What is CDOs• 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

• en.wikipedia.org/wiki/CDOs• 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

• www.guardian.co.uk/business/2008/oct/08/creditcrunch.shortselling

• 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.

• https://online.citibank.com/US/JRS/pandt/article.do

History of CDOs• 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” .

• 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.

• Between 2000 -2009 CDOs worth $4.0 Trillion were issued.

Bail out cost then $293.3 Billion

Bail out cost approx $3.0 trillion

How bank works

• Traditionally : Bank money was backed by something solid like ‘GOLD”

• Presently : Bank money is backed by Loans and mortgage. Suppose a bank had gold worth 1K. Let the cash reserve ratio(CRR) be 1:4. 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.

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.

And this continues…. Effectively 1 K gets converted to 40 K.

So now cash is backed by loans and mortgage.

How Loans and mortgage ballooned.

• User wants a loan from the bank for his house. • He cannot make down payment, • His salary is not sufficient as per bank requirement.• He has defaulted on his credit card payment.• No bank is going to give the loan to the individual.

• ENTER SUBPRIME( people with poor credit ratings) Loans• Why will bank want to lend to poorly rated people ----- Greed• Bank thinks and predicts that value of property will go up• They charge higher interest rates on subprime mortgages.• To further protect themselves, bank packages these mortgages into an investment product

and sell it to investment banks…… birth of CDOs. • Investment bank further sell to institutional investors, trusts, school etc

CDO Formation

1000 users each take a loan of $1M (total = $1B) and pays 10% mortgage

(total of $100 M) to bank

The bank sells the mortgage to Investment bank and gets its $1B

and the interest goes to IB

Creates tranches of CDOs, Senior ,

middle and Junior

CDO payouts.The bottle contains the

bunch of mortgages interest receivable

AAA

AA

BBB

Equities

Ratings % return

2%

3%

5%

8%

Different types of CDOs

• The underline asset for CDO could be.• Loans (i.e. CLO; Collateralized Loan Obligations),• Bonds (i.e. CBO; Collateralized Bond Obligations) • Asset backed securities (i.e. CDO's of ABS), • Credit default swaps (Synthetic Collateralized

Obligations) • CDOs (i.e.CDO of CDOs) or CDO^2

Things became uglier• 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.• Rating agencies were given a certain percentage of transaction deal for rating the CDOs• 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.• 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.

Global CDO Market Size - 2006

The End was Devastating for some• Sep 7-2006 :Nouriel Roubini warns the International Monetary Fund about a coming US housing bust, mortgage-

backed securities failures, bank failures, and a recession.

• April2-2007: New Century Financial, largest U.S. subprime lender, files for chapter 11 bankruptcy.

• 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.

• March 16-2008: Bear Stearns is acquired for $2 a share by JPMorgan Chase in a fire sale avoiding bankruptcy.

• 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.

• Sep 14-2008: Merrill Lynch is sold to Bank of America amidst fears of a liquidity crisis and Lehman Brothers collapse.

• Sept 17-2008: The US Federal Reserve lends $85 billion to American International Group (AIG) to avoid bankruptcy.

• 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.

• And the rest is history……..