Guys, does anyone know the answer?
get which among the following pays out cash flows from subprime mortgage-backed securities in different tranches, if there were losses on the mortgage-backed securities with highest-rated tranch paying out first, while lower ones paid out less. from screen.
Collateralized debt obligation
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Collateralized debt obligation
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A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The last to lose payment from default are the safest, most senior tranches. Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior"); Junior AAA; AA; A; BBB; Residual.
Separate special purpose entities—rather than the parent investment bank—issue the CDOs and pay interest to investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDO-Squared", "CDOs of CDOs" or "synthetic CDOs".
In the early 2000s, the debt underpinning CDOs was generally diversified, but by 2006–2007—when the CDO market grew to hundreds of billions of dollars—this had changed. CDO collateral became dominated by high risk (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages. These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to the 2007-2009 subprime mortgage crisis.
1 Market history 1.1 Beginnings
1.1.1 Explanations for growth
1.2 Subprime mortgage boom
1.2.1 Explanations for growth
1.3 Crash 1.4 Criticism
2 Concept, structures, varieties
2.1 Concept 2.2 Structures 2.3 Taxation 2.4 Types
2.5 Types of collateral
2.6 Transaction participants
2.6.1 Investors 2.6.2 Underwriter
2.6.3 The asset manager
2.6.4 The trustee and collateral administrator
2.6.5 Accountants 2.6.6 Attorneys 3 In popular media 4 See also 5 References 6 External links
In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first MBS (mortgage-backed security), based on FHA and VA mortgages. It guaranteed these MBSs. This would be the precursor to CDOs that would be created two decades later. In 1971, Freddie Mac issued its first Mortgage Participation Certificate . This was the first mortgage-backed security made of ordinary mortgages. All through the 1970s, private companies began mortgage asset securitization by creating private mortgage pools.
In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. In 1977, the Community Reinvestment Act was enacted to address historical discrimination in lending, such as 'redlining'. The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans).
Securitisation and tranching
Securitisation and tranching
Securitisation and tranching
Home Students Study resources Advanced Financial Management (AFM) Technical articles Securitisation and tranching
Securitisation became a topical issue during the credit crunch, and still remains a relevant issue for financial management and studentsPlease note:
This is an updated version of the 'Toxic Assets' technical article
Securitisation through Collateralised Debt Obligations (CDOs)
One common use of securitisation occurs when banks lend through mortgages, credit cards, car loans or other forms of credit, they invariably move to ‘lay off’ their risk by a process of securitisation. Such loans are an asset on the statement of financial position, representing cash flow to the bank in future years through interest payments and eventual repayment of the principal sum involved. By securitising the loans, the bank removes the risk attached to its future cash receipts and converts the loan back into cash, which it can lend again, and so on, in an expanding cycle of credit formation.
Securitisation is achieved by transferring the lending to specifically created companies called ‘special purpose vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively purchases a bank’s mortgage book for cash, which is raised through the issue of bonds backed by the income stream flowing from the mortgage holder. In the case of sub-prime mortgages, the high levels of risk called for a different type of securitisation, achieved by the creation of derivative-style instruments known as ‘collateralised debt obligations’ or CDOs.
Securitisation may be also appropriate for an organisation which wants to enhance its credit rating by using low-risk cash flows, such as rental income from commercial property, which will be diverted into a "ring-fenced" SPV.
CDOs are a way of repackaging the risk of a large number of risky assets such as sub-prime mortgages. Unlike a bond issue, where the risk is spread thinly between all the bond holders, CDOs concentrate the risk into investment layers or ‘tranches’, so that some investors take proportionately more of the risk for a bigger return and others take little or no risk for a much lower return.
Each tranche of CDOs is securitised and ‘priced’ on issue to give the appropriate yield to the investors. The investment grade tranche of CDOs will be the most highly priced, giving a low yield but with low risk attached. At the other end, the ‘equity’ tranche carries the bulk of the risk – it will be very lowly priced but with a high potential, but very risky, yield. There is more detail on this in the next section.
CDOs are, therefore, a mechanism whereby losses are transferred to investors with the highest appetite for risk (such as hedge funds), leaving the bulk of CDOs’ investors (mainly other banks) with a low risk source of cash flow.
The structure of CDOs
An example of a possible structure for a CDO is as follows. For a pool of mortgages taken over by the SPV, three tranches of CDOs are created:Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising about 10% of the value of the mortgages in the pool. Throughout the CDOs’ life, the equity tranche will absorb any losses brought about by default on the part of mortgage holders, up to the point that the principal underpinning the tranche is exhausted. At this point the investment is worthless.Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the principal and will absorb any losses not absorbed by the equity tranche until the point at which its principal is also exhausted.Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will absorb any residual losses.
The proportion of the principal held in each tranche is known as the CDO ‘structure’, and if there is perceived to be little risk of default then the percentage of value in the mortgage pool forming the equity and mezzanine tranches will be quite small. However, if the risk is high then CDOs will be created with a greater proportion of the principal in the equity and mezzanine tranches and a relatively smaller proportion in the senior tranche.
When cash flows are received from borrowers in the form of interest payments and loan repayments, these payments are paid to tranche 3 first until their obligation is fulfilled, then tranche 2, and anything left over is paid to the equity tranche. Any defaults hit tranche 1 first, then tranche 2 and so on. The repayments represent a ‘waterfall’ of cash with the investors holding the tranches like buckets. The senior tranches get filled first, the mezzanine holders get filled next and anything left falls into the equity pools at the bottom.
A bank has made a number of mortgage loans to customers with a current total value of $350 million. The mortgages have an average term to maturity of ten years. The net income from the loans is 7% per year. The bank will use 85% of the mortgage pool as collateral for a securitisation with the following structure:
75% of the collateral value to support a tranche of A-rated loan notes offering investors 6% per year.
15% of the collateral value to support a tranche of B-rated loan notes offering investors 11% per year.
10% of the collateral value to support a tranche of subordinated certificates which are unrated.
Collateralized Debt Obligation (CDO) Definition
A collateralized debt obligation (CDO) is a complex financial product backed by a pool of loans and other assets and sold to institutional investors.
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Collateralized Debt Obligation (CDO)
By CARLA TARDI Updated March 08, 2022
Reviewed by SAMANTHA SILBERSTEIN
Fact checked by PETE RATHBURN
What Is a Collateralized Debt Obligation (CDO)?
A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.
A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.
A collateralized debt obligation is a complex structured finance product that is backed by a pool of loans and other assets.
These underlying assets serve as collateral if the loan goes into default.
Though risky and not for all investors, CDOs are a viable tool for shifting risk and freeing up capital.
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A Primer On Collateralized Debt Obligation (CDOs)
Understanding Collateralized Debt Obligations (CDOs)
The earliest CDOs were constructed in 1987 by the former investment bank, Drexel Burnham Lambert—where Michael Milken, then called the "junk bond king," reigned.
The Drexel bankers created these early CDOs by assembling portfolios of junk bonds, issued by different companies. CDOs are called "collateralized" because the promised repayments of the underlying assets are the collateral that gives the CDOs their value.
Ultimately, other securities firms launched CDOs containing other assets that had more predictable income streams, such as automobile loans, student loans, credit card receivables, and aircraft leases. However, CDOs remained a niche product until 2003–04, when the U.S. housing boom led CDO issuers to turn their attention to subprime mortgage-backed securities as a new source of collateral for CDOs.
Collateralized debt obligations exploded in popularity, with CDO sales rising almost tenfold from $30 billion in 2003 to $225 billion in 2006.
But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions. These losses resulted in the investment banks either going bankrupt or being bailed out via government intervention and helped to escalate the global financial crisis, the Great Recession, during this period.
Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured finance investing. CDOs and the even more infamous synthetic CDOs are still in use, as ultimately they are a tool for shifting risk and freeing up capital—two of the very outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.
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The CDO Process
To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.
These tranches of securities become the final investment products, bonds, whose names can reflect their specific underlying assets. For example, mortgage-backed securities (MBS)are comprised of mortgage loans, and asset-backed securities (ABS) contain corporate debt, auto loans, or credit card debt.
Other types of CDOs include collateralized bond obligations (CBOs)—investment-grade bonds that are backed by a pool of high-yield but lower-rated bonds, and collateralized loan obligations (CLOs)—single securities that are backed by a pool of debt, that often contain corporate loans with a low credit rating.
Collateralized debt obligations are complicated, and numerous professionals have a hand in creating them:
Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors
CDO managers, who select the collateral and often manage the CDO portfolios
Rating agencies, who assess the CDOs and assign them credit ratings
Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments
Investors such as pension funds and hedge funds
The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt—pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.
Image by Sabrina Jiang © Investopedia 2020
In the table, note that the higher the credit rating, the lower the coupon rate (rate of interest the bond pays annually). If the loan defaults, the senior bondholders get paid first from the collateralized pool of assets, followed by bondholders in the other tranches according to their credit ratings; the lowest-rated credit is paid last.