Since everyone wants to blame today’s whackage on the sub-prime debacle, lets look a little closer at CDOs. Today’s WSJ and Bloomberg each have interesting discussions on CDOs: their history (Bloomberg and how a mortgage becomes a CDO (WSJ):
"CDOs were first set up in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk bond king Michael Milken. Junk, or high-yield, debt are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.
Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating, and are known as the equity tranches because they are first in line for any losses. Investors in the equity portion expect to generate returns of more than 10 percent.
Fees for managers can range from 45 basis points to 75 basis points of the amount of the CDO, GoldenTree’s Wriedt said. For a $500 million CDO, a manager earning a fee of 50 basis points, or half a percentage point, would pocket $2.5 million a year until maturity."
The Journal looked at how CDO’s are built, with this helpful graphic:
Here’s an excerpt:
CDOs are an integral part of Wall Street’s mortgage dicing-and-slicing machine. After mortgages are written, investment banks pool them together and use the cash flows they produce to pay off mortgage-backed bonds, which the investment banks underwrite.
The mortgage bonds, in turn, are often packaged again into CDOs and sold off in slices. Investors can choose to buy the risky pieces of the bonds or purchase slices with less risk.
Last year CDOs soaked up an estimated $150 billion of mortgage-backed bonds, the vast majority of which were underpinned by subprime mortgages, according to Deutsche Bank. In recent weeks, rising defaults among subprime borrowers have sparked worries of a sharp downturn in the U.S. housing market. In December borrowers were at least 60 days late on roughly 14% percent of subprime loans packaged into mortgage bonds, up from just over 8% a year earlier, according to research firm First American LoanPerformance.
Now you know . . .
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Sources:
Mortgage Shakeout May Roil CDO Market
Subprime Defaults Lead to Wavering At Big Street Firms
SERENA NG and MICHAEL HUDSON
WSJ, March 13, 2007; Page C3
http://online.wsj.com/article/SB117371221157234173.html
CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt
Caroline Salas and Darrell Hassler
Bloomberg, March 13 2007
http://www.bloomberg.com/apps/news?pid=20601109&sid=ae1pbMY8FCGM&
1 in 7 are at least 60 days late..that is astounding. Do these borrowers do NO pre-planning to see if they are getting a loan they can actually pay back??
High finance at its best. Its no wonder these guys earn seven figure bonuses.
Obviously there’s a lot more to analyzing these securities than what the WSJ and Bloomberg present (or don’t present).
That’s not to say many CDO traders know what’s going on underneath the hood. Many people joke that a monkey could be making equally as informed trades.
I read an interesting article on MarketWatch which said for the past few years CDOs have actually been the mortgage market – and there is an interesting history of CDOs having loans go bad. At one time CDOs were deeply involoved in the manufatured home markets, until a similar event happened. The end result was that the CDOs walked away from that market, looking for something better. End result, with no one to buy the mortgages, banks and mortgage companies had to hold their own paper, stifling credit.
This may happen again in the home mortgage markets – if CDOs stop buying the paper, banks and mortgage companies will have to hold their own, creating a devastating credit crunch in the real estate markets.
Where will people who have negative savings find money to make the 10 and 20% home down payments the banks will require?
This could get ugly.
“Where will people who have negative savings find money to make the 10 and 20% home down payments the banks will require?”
All these youngsters fresh from college that cost them no small peanuts; or the grads from technical schools with decent jobs. All, bearing the sin of negative savings due to the too short time period since they were born, looking for a home after gaining a modicum of stability at their 1st job.
Man! If they need 20% down just to get a lender to give them the hour of the day, house prices had better take a vertical drop if anyone wants a residential RE market in this country.
Or else…
Francois
Goldman, et.al. have been downplaying the contagion risks on the grounds taht sub-prime is a very small part of the RE assets and an much smaller part of the total set of assets. But consider – CDO’s {Asset -> Securitization -> Bond(s) ==> CDO(s)} have been applied and were originally developed for other assets. The world’s awash in liquidities – what happens if the great unraveling leads to a credit crunch in the markets for other assets ?
It is my understanding that Chris Dodd is trying to pass bill to aid sub prime mortgagees that are in trouble. Just when the market is about to force house prices back into the affordable range, our wonderful government, that created this problem, is about to exacerbate it and make us pay for it with our tax dollars.
The same things that are happening now on the real estate side happened 10 years ago on the automotive side. Go back and look up fly-by nights like Jayhawk Financial and Mercury Financial. The similarities are disturbing.
DenverKen,
Lay off the borrorwer! I work as Real Estate Attorney and my experience has been that most borrowers do not understand the underlying mortgage product they are getting. All they see is the monthly payment because:
1. That is all the mortgage broker is focusing on, and
2. Housing always appreciates!!!! Those borrowers that had sense enough to question the product were told that they could always refinance before their rates reset!
Sorry Borrower, rates are low but your house isn’t worth what you paid for it! And, oh by the way, you are now too much of a credit risk to lend money to!
Fortunately, the Buffalo market is an affordable market for all range of home buyers and ARM’s weren’t that popular.
dave what do you call 100 lawyers at the bottom of the ocean? a good start.
caveat emptor, it’s called accountability. let these morons who can’t read or analyze anything learn the hard way. we don’t need any more brain dead spoon fed, irresponsible grown babies, although i know how much your business depends on them
What percentage of the US adult population is sub-prime, or A-?
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There needs to be a distinction between CDOs that are connected with RMBS and those that have CMBS. The Commercial mortgages are not in the same mess as the residential, but investors are putting all CDOs in one basket and calling it too risky. Every CDO is different, and many have no connection to the sub-prime residential mortgage market where all the trouble is unfolding. Take a look at the Northstar Realty Finance (NRF). Their CDOs have no exposure to residential markets, and their credit ratings have steadily increased over the years. Not all CDOs have the same risk.
Maybe the account managers should give back the multi-million payouts that they received for these accounts. Somebody should have realized the downside and have seen it coming. That should have been the account management who got rich off of the account.