Collateralized debt obligations (CDOs) are asset-backed securities formed from bundles of residential mortgages. These structures provided the capital delivery mechanism that helped inflate the Great Housing Bubble. CDOs are merely a tool. If used appropriately, they can speed the delivery of capital and create a more efficient capital market. If used inappropriately, they can be a financial weapons of mass destruction, and they can threaten our entire capitalist system.
Collateralized debt obligations, like other asset-backed securities, are divided in segments known as tranches (rhymes with launches). These tranches are typically titled: senior, mezzanine and equity based on their risk exposure. There is no single structure or formula for a CDO, and many contain numerous subdivisions resulting in more segments than the three described.
Similar to the lien order of mortgage obligations, these tranches are paid in order of priority. The senior tranche is paid first, the mezzanine tranche is paid next, and finally the equity tranche is paid any remainder. Since these obligations are paid in order, the senior tranche has the least risk exposure and lowest returns, and the equity tranche has the highest risk and greatest potential for return. To further lessen risk (and make the transaction even more complicated) insurance policies are often issued to insure the buyer of a senior tranche against loss. These policies known as credit default swaps were a very lucrative business during the Great Housing Bubble. It was such good business that many insurers took excessive risks and lost a great deal of money when house prices declined.
The real magic of structured finance is its ability to take assets of low investment quality and turn it into something viable. George Soros aptly titled his book, "The Alchemy of Finance." Like the alchemists of medieval Europe, modern investment bankers try to turn lead into gold. The syndicators who create and manage collateralized debt obligations assess the risk of loss on the underlying asset and break it down into three categories corresponding to the three tranches.
The equity tranche in a CDO assumes the expected risk of loss. For example, if subprime loans expect an 8% loss from defaults, then the equity tranche will be 8% of the CDO. The syndicator typically keeps this equity tranche as part of their incentive fee, but practically speaking, the discount would be so steep it is hardly worth selling. If defaults losses are less than 8%, they see tremendous profits, and if it is over 8%, they see nothing.
The Mezzanine tranche assumes the risk beyond the expected risk. If the average default loss is around 8%, and the highest default loss ever recorded is 24%, the mezzanine tranche exists to take on this risk. There is a very good chance they will see most or all of their money because the average default loss is being absorbed by the equity tranche.
The senior tranche is supposed to have no risk from default loss. The line between mezzanine and senior is at or beyond the highest default loss rate ever recorded. This is not to say there is no risk, but it would take an unprecedented event to see any losses in this tranche: something like the collapse of the Great Housing Bubble.
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at: http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog: http://www.irvinehousingblog.com/
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