CDOs and the Sub Prime Crisis

One of the fascinating aspects of the sub prime crisis has been the degree of opaqueness created in the financial system by securitisation. The vehicle which has made this possible is the Collateralised Debt Obligation (CDO). CDOs allow asset backed securities to be mixed with subprime mortgage loans and placed into different risk classes, or tranches, each with its own repayment schedule. Upper tranches receive 'AAA' ratings as they are promised the first cash flows that come into the security. Lower tranches have lower priority but carry higher coupon rates to compensate for the increased default risk. Finally at the bottom, lies the "equity" tranche. Its cash flows may be wiped out if the default rate on the entire ABS creeps above 5 to 7%.

A simple illustration will explain how a CDO operates. Say a bank has granted 1000 subprime mortgage loans with an overall principal value of $ 300 million.

Based on the historical delinquency rates of 4% and average losses for defaulted sub prime mortgages of 25%, the expected loss for the pool would be 4% of 25%, i.e., 1%, or USD 3mn. This loss rate would be too high for the instrument to achieve a AAA credit rating.

So the bank redistributes the cash flows of the underlying mortgages to four different tranches. Tranche 1, the "AAA"-rated tranche, has a senior claim on all interest and principal payments of the mortgage pool. No other tranche may receive any cash-flows till all payments on the AAA tranche are met. Its size equals say 80% of the overall volume of the mortgage pool, or 0.8 x 300 million, i.e., $240 million.

Tranche 2, the "A"-rated tranche, is subordinated to the AAA tranche, but remains senior to all remaining tranches. Its size is 12% of the over-all volume, or 0.12 x 300 million i.e., 36 million.

Tranche 3, the "BB"-rated or High Yield tranche represents another 5% of the overall volume, i.e., $15 million and is subordinated to both higher-rated tranches.

The “Equity tranche” equals 3% of the pool volume, ie., $9 million and receives anything that is left over, after all other tranches are fully serviced.

If the losses remain within $3 million, the equity tranche takes all losses while all other tranches receive the full amount of interest and principal payments. Even with a cyclical rise in default rates, the AAA tranche would be well protected from losses.

Let us assume that if delinquency rates rise to 25%, losses on defaulted subprime mortgages will rise to 50%. This may result in a loss rate of 0.25 x 0.5 = 12.5% i.e., (.125) (300) = $37.5 million. This would erase the Equity tranche (3%, 9 million) and the BB tranche (5%, 15 million) entirely. The remaining losses ($13.5 million) would be absorbed by the A tranche which would lose 37.5% of principal (13.5/36). The AAA tranche would not carry losses, but its buffer for further losses would largely disappear. It would be living at the edge, so to say!

Through the process of tranching, the subprime mortgage lenders found a way to sell their risky debt. Nearly 80% of these bundled securities were rated investment grade ('A' rated or higher), by the rating agencies, who earned lucrative fees for their work in rating the ABSs.
Having found a way to originate and distribute risky mortgages, banks moved into subprime lending very aggressively. Basic requirements like proof-of-income and down payment were waived off by some mortgage lenders. By using teaser rates within adjustable-rate mortgages (ARM), borrowers were enticed into an initially affordable mortgage in which payments would skyrocket in a few years. The CDO market ballooned to more than $600 billion in issuance during 2006 alone - more than 10 times the amount issued just a decade earlier.