Collateralized Debt Obligations

In the post-GFC world, Collateralized Debt Obligations (CDOs) have been talked about a lot. The reason for this is obvious – it was the frantic creation of the CDOs that begun to cause the collapse we saw in 2008.

It is important to note that while CDOs certainly played a role in the GFC, they were not the only cause of the crisis.

What is a CDO?

To start off simply, a CDO is simply a way of packaging debt that nobody wants to buy into a form that people are comfortable buying. A simple (yet not entirely accurate) example can be a broken wine glass. Nobody will want to buy a broken wine glass because, well, its broken. However, if you package it up in some nice packaging, perhaps a box, so that you cannot see that it is broken, people may actually buy it.

This is not really how a CDO works, but it is the general idea.

What do mortgages have to do with it?

A mortgage is, essentially, debt. In a technical sense, a mortgage is debt that is secured against a house. It includes, in the contracts, that should the borrower default on their repayments, the house may be seized to recover the losses of the bank.

Now, in general, people represent pretty high risk when it comes to loans. It’s why we must pay interest of up to 20% on credit cards, while banks will only pay us 1% interest on our savings. Big institutions are assumed to be much safer borrowers than individuals.

Banks, however, have an interest in selling mortgages to people. They earn fees on the mortgages they sell, and, if they sell mortgages to the right people, will make money over time as interest is paid on the loans. However, they cannot allow their exposure to mortgages grow too large. The way they deal with this is that they sell the mortgages on their books to others, who have a greater appetite for the risk.

However, a problem quickly develops with this approach. As banks frantically try to sell more and more mortgages, the people who can actually afford a mortgage quickly runs out. Historically, mortgages were only offered to people who had good credit scores, and who were clearly earning enough to pay the mortgages.

Of course, higher risk people could be charged higher interest rates on mortgages, but that presents a challenge in advertising, and even people who know very little about money and have bad credit scores will understand that high interest rates are never good.

The banks therefore, began to create programs wherein mortgages could be given for rates well below what they should be given for in the short term, and then raising those rates. However, they found that these mortgages were difficult to sell on to other  investors.

This is where the CDO comes in. The CDO packages the bad mortgages with the good  mortgages, and splits into tranches. These tranches can be sold as separate securities, and allows certain tranches to be almost guaranteed. This is how it works:

The top tranche receives payouts first, then the payouts will move down in the tranches. So, if the top tranche of the CDO makes up 70% of the investors, then up to 30% of mortgages in the CDO could default, and the top tranche would still get paid. Therefore, investors with lower risk appetites could buy the higher tranches of the CDO, while investors with higher risk appetites could buy the lower tranches. It would take a catastrophic collapse of the housing market to downgrade the rating of the top tranche.

This is essentially what happened during the Financial Crisis of 2008. However, it is important to note that CDOs were not the only cause of the GFC by any means, and that Credit Default Swaps contributed in a large way, and there were many other factors that caused the crash.

If you would like a full explanation of how the GFC happened, and how some people actually profited massively from it, check out the famous book and movie, the Big Short. The Amazon link for both are below.

The Big Short: Inside the Doomsday Machine (Book)

The Big Short (DVD)

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