Monday, December 30, 2019

What are the CDOs : The Root Cause of The Financial Crisis & between a CDO and a MBS?

Arguably, the financial crisis was caused in large part by something called a collateralized debt obligation, or CDO. The global financial meltdown, at the cost of over $20 trillion, resulted in millions of people losing their homes and jobs in the worst recession since the Great Depression, and nearly resulted in a global financial collapse. This is the toxic financial product (i.e., CDO - Collateralized Debt Obligation). Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are different concepts with frequent overlap between them. MBS are investments that are repackaged by small regional banks as a means of funding mortgages by reselling them as securities through investment markets. CDO investments are typically used for packaging many mortgages and other loan instruments together by risk level for investors. Many MBS are also CDOs. After a small bank funds a mortgage, the mortgage is then packaged as an investment with real estate backing the security as collateral. A CDO (collateralized debt obligation) can be backed by any debt collateral, including mortgages, bonds, private loans, etc. Mortgage-Backed Security (MBS) is a type of CDO that is explicitly backed by a pool of mortgages. A CDO (Collateralized Debt Obligation) is a type of bond that is sold almost exclusively to institutions. An ordinary Government or Corporate Bond is a loan made to a Government or Company. Terms of the bond determine when it needs to be paid back and at what interest rate. Most Bonds are backed by the authority of the government or the assets of the company. A CDO is a loan to an artificial entity created specifically for the CDO. The CDO is backed by a portfolio of Loans or Mortgages pledged to it. The loans are purchased from the Original Lender. Lenders will frequently sell off discounted, performing loans to brokerage firms so that the Lenders can initiate new loans (and collect the fees that go with new loans). The terms and credit rating of each CDO is based on the rates and quality of the loans pledged to it. Unlike ordinary Corporate Bonds, CDOs generally have pre-payment risk. That is, the people who took the underlying loans may pay them off early. Consequently, CDOs pay typically both principal and interest over the life of the bond. CDO's containing mortgages were among the securities at the root of the 2008 Financial crises. CDOs are improperly given high credit ratings often defaulted, as did the securities used to insure against default. Welcome to The Atlantis Report. In the old system, when a homeowner paid their mortgage every month; the money went to their local lender. And since mortgages took decades to repay, lenders were careful. In the new system, lenders sold the mortgages to investment banks. The investment banks combined thousands of mortgages and other loans, including car loans, student loans, and credit card debt, to create complex derivatives called collateralized debt obligations or CDOs. The investment banks then sold the CDOs to investors. Now when homeowners paid their mortgages, the money went to investors all over the world. The investment banks paid rating agencies to evaluate the CDOs, and many of them were given a triple-a rating, which is the highest possible investment grade. This made CDO is popular with retirement funds; which could only purchase highly rated securities. This system was a ticking time bomb. Lenders didn't care anymore about whether a borrower could repay. So they started making riskier loans. The investment banks didn't care either; the more CDOs they sold, the higher their profits. And the rating agencies which were paid by the investment banks had no liability if their ratings of CDOs proved wrong. There was another ticking time bomb in the financial system. AIG, the world's largest insurance company, was selling vast quantities of derivatives called credit default swaps. For investors who owned CDOs, credit default swaps worked like an insurance policy. An investor who purchased a credit default swap paid AIG a quarterly premium. If the CDO went bad, AIG promised to pay the investor for their losses. But unlike regular insurance, speculators could also buy credit default swaps from AIG in order to bet against CDOs they didn't own. Since credit default swaps were unregulated, AIG didn't have to put aside any money to cover potential losses. Instead, AIG paid its employees huge cash bonuses as soon as contracts were signed. But if the CDOs later went bad, AIG would be on the hook. And then there is the maker of the time bomb, the federal government which, through Fannie, Freddie, and HUD enacted policies that resulted in a dramatic expansion of the subprime market. The subprimes flooded the financial sector. Were it not for government intrusion into the housing market, none of this would have happened. During the bubble, the investment banks were borrowing heavily, to buy more loans, and create more CDOs. The ratio between borrowed money and the banks' own money was called leverage. The more the banks borrowed, the higher their leverage. By 2008, home foreclosures were skyrocketing, and the securitization foodchain imploded. Lenders could no longer sell their loans to the investment banks, and as the loans went bad, dozens of lenders failed. The market for CDOs collapsed, leaving the investment banks holding hundreds of billions of dollars in loans, CDOs, and real estate they couldn't sell. Top executives of the insolvent companies walked away with their personal fortunes intact. The executives had hand-picked their boards of directors, which handed out billions in bonuses after the government bailout. The major banks grew in power and doubled anti-reform efforts. Academic economists had, for decades, advocated for deregulation and helped shape U.S.policy. They still opposed reform after the 2008 crisis. A Collateralized Debt Obligation or CDO is a type of structured asset-backed security. Originally it was used in corporate debt markets, but with recent changes, it has encumbered to include mortgages as well as credit card debt, student loan debt, auto loan debt, etc. Although CDOs were commonly linked with mortgage loans due to the housing boom and the mortgages being more readily available than other loans to be packaged as collateral. With the recent 2008 market crash, CDOs have been known to be filled with sub-prime mortgages. Sub-prime mortgages are mortgages that are lent to those with less than minimally required credit score and down payment in borrowing money for a prime mortgage. Usually, to borrow money for a home, it was required the borrower was required to have a credit score of around 650 and 30% down. After the markets dried up of quality Mortgage-Backed Securities (MBS), the banks wanted more mortgages to package into bonds and sell. So the lenders started bottom-feeding and lowered their minimum criteria, now borrowers were required to have (maybe) 500 credit score or less and no money down. Many sub-prime mortgages were given teaser rates better known as an Adjustable-Rate Mortgage (ARM), so after a year, the interest rate skyrockets, forcing borrowers to pay a much higher monthly payment, which would be about 2 to 3.5 times their initial monthly payments. Now back to CDOs, The CDO was for the investor was like a promise-to-pay pool of mortgages that the investor was given a pre-determined amount of payouts until maturity. The CDOs were fraudulently packaged with mislabeled credit ratings, so investors expected an excellent return plus the decreased risk. For purchase prices and payouts, higher-rated CDOs were more expensive to buy and paid fewer dividends since there is a lower risk of default. While lower-rated CDOs were cheaper to buy, and the dividends were paid higher dividends since there is a much higher risk of default. Each CDO has a varying amount of risk, which is identified as AAA, AA, A, BBB, BB, B, CCC, etc., with AAA being the most secure. However, pre-2008, even the AAA-rated bonds had a lot of subprime debt, with AA and below having an even more immense load of subprime debt. Market Facts: The popularity of CDOs skyrocketed almost overnight, between 2003 to 2007, Wall Street issued nearly $700 billion in CDOs, including MBSs as collateral. The global CDO market is estimated at around $1.5 trillion US Dollars. The very nature of CDOs is the biggest drawback as it is a product of Financial Engineering, which is made by computer models for valuing the product. As the market became more competitive, more complex CDO’s were made to meet the market appetite for CDOs. Slowly by 2007, the mortgage delinquencies started going through the roof because most of the subprime loans were given to people with poor creditworthiness who couldn’t repay, and the home prices started to drop, this sent the values of CDO’s down south. The issue was that derivatives like CDO started multiplying the effect of the housing bubble burst. These were not only held by banks but also by investors around the world, which included individuals, pension funds, hedge funds, and various corporations. Since these instruments derived their values from assets (in our case homes) whose values started to drop, this caused a chain reaction leading to crashing prices of CDO’s. This opaqueness and complexity of CDO’s made banks realize that they cannot value the products held by them as assets. Banks started refusing to lend money as they didn’t want CDO’s in return, overnight the markets for CDO’s vanished. This was the reason for one of the largest banks in the world Lehman Brothers to collapse and file for bankruptcy as the value of assets it held in the form of CDO’s dropped, making it bankrupt in the process. In this process, a considerable amount of wealth was lost by investors around the world. This led to a global recession and lower economic activity, which caused large scale unemployment. The Aftermath. The biggest change in the aftermath of the crisis was the introduction of DFA (Dodd-Frank Wall Street Reform and Consumer Protection Act). Amongst many others, the DFA aims to make the financial system more transparent and to prevent risky practices. It is also interesting to know that the notional value of credit derivatives by 2011 has hit its pre-crisis levels during 2008. For the banks, the DFA has created new restrictions. This includes an amount of capital that needs to be maintained by them as per BASEL-III norms. It also restricts the amount of business the banks can enter into with Hedge Funds and Private Equity Funds. But by knowing Man’s greed for money and our history, we can assume that the banks have already bypassed the DFA in a smart manner. History Repeats Itself. As CDO has become a kind of Taboo or you could say “That Who Must Not Be Named,” the banks and financial institution that are in hunger for higher margins and growth have filled the old wine in new bottle and titled it as “Bespoke Tranche Opportunity” or known as BTO’s which are similar to CDO’s. By the end of 2017, almost $ 50 billion worth, BTO was being sold on an annual basis. This may sound insignificant compared to the global financial market but is growing at an exponential pace. There are striking differences between CDO and BTO in two aspects. A BTO is created as per investor preference, as opposed to CDO, which are designed by the banks and then sold to the market. This circumvents the regulations set in by the government worldwide. These CDOs before the crisis were called as Synthetic CDO, whereas BTO is a Single Tranche CDO. A single tranche CDO is where the entire ownership lies with the investor and is called as full- capital structure, in such a structure, the risk for the banks are minimal. Secondly, BTO’s are derivatives, and not asset-backed securities, as was the case with most CDO’s. This ensures that the value of BTO’s are not directly linked to the performance of the real economy but rather based on the rating given by Rating agencies. At this moment, nothing much is known about the exact structure of each BTO. As more layers of derivatives are created, it will increase the leverage of the underlying asset and cannot cover for the initial losses that occur. Conclusion. CDO’s are not inherently flawed instruments because, in principle, they are powerful risk management devices. They allow diversifying risk, which otherwise would be quite concentrated. During the crisis, CDO was created for improving their profits and were not motivated for risk management. Currently, CDO’s are more in tune with their actual purpose of risk diversification and not risk amplification. Going ahead, the CDO contracts must be more standardized. This was The Atlantis Report. Please Like. Share. And Subscribe. Thank You.

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