2010, September 18 Corporate Finance Corporate Finance Essay

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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…

Sources Used in Documents:

References

CDOs in Plain English (2004) Nomura Fixed Income Research 13 Sept 2004. Online available at: http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf

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

Kolb, Robert W. (2010) Lessons from the Financial Crisis: Causes, Consequences, and Economic Future. John Wiley and Sons, 2010

Collateralized Debt Obligations (2010)About.com -- U.S. Economy. Online available at: http://useconomy.about.com/od/glossary/g/CDOs.htm

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