2010, September 18 Corporate Finance Corporate Finance

2010, September 18 Corporate Finance

Corporate Finance

The CDO market was largely attributed as being central to the sub-prime crisis. By first describing what CODs are and how they operate, identify and assess the failings in risk management practices used to manage the risks posed by these products by the banks involved.

Risk assessment failure has been shown to be the primary causes of the sub-prime crisis in addition to a lack of information on the part of investors by which to assess their investing decisions. The sub-prime crisis was driven by collateralized debt obligations or CDOs which effectively veiled the associated risks contained in the portfolios of investors. The study which follows examines the CDOs and the role that they played in the sub-prime mortgage crisis. As well this study examines the specific factors that served to drive the crisis and the resulting mortgage defaults rates which ultimately has resulted in an extremely large rate of foreclosures on homes and a crash to the housing market not only in the United States but throughout the world as well.

Collateralized Debt Obligations - CDOS

CDOS are 'collateralized debt obligations' which are stated to be similar to a "regular mutual fund that buys bonds, rather than shares." (Nomura Fixed Income Research, 2004)[footnoteRef:1] CDOs are differentiated from mutual funds in that a CDO is "an arrangement that raises money primarily by issuing its own bonds and then invests the proceeds in a portfolio of bonds, loans or similar assets." (Nomura Fixed Income Research, 2004) [footnoteRef:2] Payments on the portfolio are stated to be the primary source of funds for repaying the CDOs own securities." (Nomura Fixed Income Research, 2004) [footnoteRef:3] [1: CDOs in Plain English (2004) Nomura Fixed Income Research 13 Sept 2004. Online available at: http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf] [2: CDOs in Plain English (2004) Nomura Fixed Income Research 13 Sept 2004. Online available at: http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf] [3: CDOs in Plain English (2004) Nomura Fixed Income Research 13 Sept 2004. Online available at: http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf]

How CDOS Operate

The majority of CDOs have actively managed portfolios and in a typical deal the manager collects fees for managing the portfolio somewhat similar to a mutual fund however some of the CDOs have unmanaged, static portfolios which are similar to old-fashioned unit investment trusts. (Nomura Fixed Income Research, 2004, paraphrased) [footnoteRef:4] Other features also exist including a standard feature including what is known as 'credit tranching' which is stated to refer to multiple classes of securities "each of which has a different seniority relative to the others." (Nomura Fixed Income Research, 2004) [footnoteRef:5] The CDO might issue four classes of securities including: (1) senior debt; (2) mezzanine debt; (3) subordinate debt; and (4) equity. (Nomura Fixed Income Research, 2004) [footnoteRef:6] The key players in the sub-prime mortgage crisis included those of: (1) sub-prime borrowers; (2) mortgage brokers; (3) lenders/originators; (4) servicers; (5) trust special purpose entities; (6) underwrites; (7) rating agencies; and (8) investors. (Kirk, nd)[footnoteRef:7] The sub-prime mortgage crisis is the term used to describe "the deterioration of the U.S. mortgage market, and losses from mortgage backed securities and collateralized debt obligations backed by subprime mortgages." (Kirk, nd)[footnoteRef:8] Sub-prime mortgages are those made to borrowers with bad credit histories which included 'alternative mortgage products' or AMPs which were issued to sub-prime residential borrowers between 2003 and 2006. (Kirk, nd, paraphrased) [footnoteRef:9] The AMPs have a higher default rate than do traditional mortgages. The AMPs were characterized by 'teaser rates' which have a fixed rate for the first two to three years of the mortgage followed by the interest rate becoming adjustable semiannually. Mortgages are often securitized by lenders and originators into MBS bonds and then sold to investors. The pools of sub-prime mortgages which are securitized into MBSs are "…divided into tranches or slices of bonds so that cash flow from the bonds may suit particular investment requirements. Each tranch is assigned a credit rating by rating agencies. Through this credit enhancement process, MBSs backed by sub-prime mortgages may obtain investment grade status even though the underlying collateral is of poor quality." (Kirk, nd) The method of payment of MBS bonds is in the order or seniority with the senior bond tranches paying before the lower tranches which "may not be paid if sufficient cash flow is not received from the underlying mortgages." (Kirk, nd) Investment banks are stated to have repackaged lower level tranches of MBS into CDOs and the CDOS create tranches for their bonds resulting in investment banks being able to procure the highest credit rating for senior CDO tranches even though they contain MBS bonds rated below investment grade." (Kirk, nd) [4: Ibid] [5: Ibid] [6: Ibid] [7: Kirk, Edward J. (nd) The Subprime Mortgage Crisis: An Overview of the Crisis and Potential Exposure. Online available at: http://www.rli-epg.com/articles/Subprime-Mortgage-Crisis.pdf] [8: Ibid] [9: Ibid]

During 2006 short-term interest rates rose and the value of homes first leveled and then dropped making it difficult for borrowers with financial problems to refinance or sell their homes when their payments became too high for them to make and in addition the teaser rates on hybrid ARMs expired and payment shock resulted due to interest rates becoming higher due to variable rate mortgages. Default rates on subprime and Alt -- A mortgages significantly increased in 2006 and 2006. Rating agencies downgraded MBS and CDO bonds backed by subprime mortgages due to rise in defaults on sub-prime and Alt -- A mortgages. It is reported that losses from MBSs and CDOs backed by sub-prime mortgages may exceed the amount of $100 billion.

Risk Management Practices by Banks of Sub-Prime Products