Structure of a CDO

In Chapter 10, we analyzed one RMBS in great depth. RMBSs were a money machine for Wall Street, as we explained in Chapter 2, but there was a problem: It was easy to sell the AAA-rated tranches to the institutional investors of the world and to sell the lower-rated, high-yielding tranches to hedge funds and other yield-seeking investors (also known as "yield whores" because they'd sell their mothers for an extra 50 basis points of yield), but the BBB and A tranches were harder to sell because they didn 't have a high-enough interest rate to attract the yield-seeking investors, yet had a low-enough rating that institutional investors weren 't interested, either.

The solution: a CDO, which is structured just like an RMBS, but instead of owning actual loans, it owns tranches of other asset-backed securities like RMBSs. As Table 12.2 shows, there are many different types of CDOs, just as there are many different types of asset-backed securities, because Wall Street securitizes many different types of debt: not just mortgages, but also credit card debt, student loans, auto loans, corporate debt, commercial real estate, and so forth. Our analysis of MBIA will focus on CDOs that are comprised of tranches from RMBSs.

Figure 12.4 shows what a typical mezzanine CDO looks like, comprised nearly entirely of BBB-rated tranches (a CDO comprised mostly ofA-rated tranches is known as a high-grade CDO—that name will go down in the oxymoron hall of fame).

Note that the CDO is comprised of low-rated tranches, yet the rating agencies were willing to give as much as 95 percent of a typical CDO an AAA rating (we 're not making this up). Voilà! Nearly all of a collection of low-rated, barely investment-grade tranches from RMBS pools were turned into an AAA-rated product that could easily be sold.

Credit Rating Cdo

Figure 12.4 Structure of a Typical RMBS and CDO

Source: T2 Partners.

Figure 12.4 Structure of a Typical RMBS and CDO

Source: T2 Partners.

Thanks to the magic ofWall Street alchemy and the foolishness and/or corruption of the rating agencies, turds were turned into gold.

CDOs are second-derivative products, which makes them highly leveraged and unstable. Because the tranches that comprise a CDO are usually very thin—each are a mere 1 to 3 percentage points of the underlying RMBS—they are likely to suffer either 0 percent losses or 100 percent losses. And if the RMBSs whose tranches comprise the CDO are correlated, as is the case with bubble-era U.S. mortgage pools, then the CDO is likely to have only one of two outcomes: Either the underlying RMBSs perform well enough such that the BBB and A tranches are protected, in which case the CDO will likely suffer almost no losses, or the RMBSs deteriorate to a point where the BBB and A tranches are wiped out, in which case the CDO is as well.

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Responses

  • carmen douglas
    What a cdo looks like?
    8 years ago

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