Securitization Facts

Securitization
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For Securitization in International relations, see Securitization (international relations).
Securitization is the financial practice of pooling various types of contractual debt such as residential
mortgages, commercial mortgages, auto loans or credit card debt obligations (or other non-debt assets which
generate receivables) and selling their related cash flows to third party investors as securities, which may be
described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from
the principal and interest cash flows collected from the underlying debt and redistributed through the capital
structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities
(MBS), while those backed by other types of receivables are asset-backed securities (ABS).
Critics have suggested that the complexity inherent in securitization can limit investors' ability to monitor risk,
and that competitive securitization markets with multiple securitizers may be particularly prone to sharp
declines in underwriting standards. Private, competitive mortgage securitization played an important role in the
U.S. subprime mortgage crisis.[1]
In addition, off-balance sheet treatment for securitizations coupled with guarantees from the issuer can hide the
extent of leverage of the securitizing firm, thereby facilitating risky capital structures and leading to an underpricing of credit risk. Off-balance sheet securitizations also played a large role in the high leverage level of U.S.
financial institutions before the financial crisis, and the need for bailouts.[2]
The granularity of pools of securitized assets can mitigate the credit risk of individual borrowers. Unlike general
corporate debt, the credit quality of securitized debt is non-stationary due to changes in volatility that are timeand structure-dependent. If the transaction is properly structured and the pool performs as expected, the credit
risk of all tranches of structured debt improves; if improperly structured, the affected tranches may experience
dramatic credit deterioration and loss.[3]
Securitization has evolved from its beginnings in the late 18th century to an estimated outstanding of $10.24
trillion in the United States and $2.25 trillion in Europe as of the 2nd quarter of 2008. In 2007, ABS issuance
amounted to $3.455 trillion in the US and $652 billion in Europe.[4] WBS (Whole Business Securitization)
arrangements first appeared in the United Kingdom in the 1990s, and became common in various
Commonwealth legal systems where senior creditors of an insolvent business effectively gain the right to
control the company.[5] There are main players in securitization, they include investors, securiters and corporates.
Contents
[hide]
1 History
2 Structure
o
2.1 Pooling and transfer
2.2 Issuance
2.3 Credit enhancement and tranching
2.4 Servicing
2.5 Repayment structures
2.6 Structural risks and misincentives
3 Special types of securitization

o
3.1 Master trust
3.2 Issuance trust
3.3 Grantor trust
3.4 Owner trust
4 Motives for securitization

o
4.1 Advantages to issuer
4.2 Disadvantages to issuer
4.3 Advantages to investors
4.4 Risks to investors
5 Recent lawsuits
6 See also
7 References
8 External links
History[edit]
Examples of securitization can be found at least as far back as the 18th century.[6] Among the early examples of
mortgage-backed securities in the United States were the farm railroad mortgage bonds of the mid-19th century
which contributed to the panic of 1857.[7]
In February 1970, the U.S. Department of Housing and Urban Development created the first modern residential
mortgage-backed security. The Government National Mortgage Association (GNMA or Ginnie Mae) sold
securities backed by a portfolio of mortgage loans.[8]
To facilitate the securitization of non-mortgage assets, businesses substituted private credit enhancements. First,
they over-collateralised pools of assets; shortly thereafter, they improved third-party and structural
enhancements. In 1985, securitization techniques that had been developed in the mortgage market were applied
for the first time to a class of non-mortgage assets automobile loans. A pool of assets second only to
mortgages in volume, auto loans were a good match for structured finance; their maturities, considerably shorter
than those of mortgages, made the timing of cash flows more predictable, and their long statistical histories of
performance gave investors confidence.[9]
This early auto loan deal was a $60 million securitization originated by Marine Midland Bank and securitised in
1985 by the Certificate for Automobile Receivables Trust (CARS, 1985-1).[10]
The first significant bank credit card sale came to market in 1986 with a private placement of $50 million of
outstanding bank card loans. This transaction demonstrated to investors that, if the yields were high enough,
loan pools could support asset sales with higher expected losses and administrative costs than was true within
the mortgage market. Sales of this type with no contractual obligation by the seller to provide recourse
allowed banks to receive sales treatment for accounting and regulatory purposes (easing balance sheet and
capital constraints), while at the same time allowing them to retain origination and servicing fees. After the
success of this initial transaction, investors grew to accept credit card receivables as collateral, and banks
developed structures to normalize the cash flows.[9]
Starting in the 1990s with some earlier private transactions, securitization technology was applied to a number
of sectors of the reinsurance and insurance markets including life and catastrophe. This activity grew to nearly
$15bn of issuance in 2006 following the disruptions in the underlying markets caused by Hurricane Katrina and
Regulation XXX. Key areas of activity in the broad area of Alternative Risk Transfer include catastrophe bonds,
Life Insurance Securitization and Reinsurance Sidecars.
The first public Securitization of Community Reinvestment Act (CRA) loans started in 1997. CRA loans are
loans targeted to low and moderate income borrowers and neighborhoods.[11]
As estimated by the Bond Market Association, in the United States, the total amount outstanding[clarification needed] at
the end of 2004 was $1.8 trillion. This amount was about 8 percent of total outstanding bond market debt ($23.6
trillion), about 33 percent of mortgage-related debt ($5.5 trillion), and about 39 percent of corporate debt ($4.7
trillion) in the United States. In nominal terms, over the previous ten years (19952004) ABS[clarification needed] amount
outstanding had grown about 19 percent annually, with mortgage-related debt and corporate debt each growing
at about 9 percent. Gross public issuance of asset-backed securities was strong, setting new records in many
years. In 2004, issuance was at an all-time record of about $0.9 trillion.[12]
At the end of 2004, the larger sectors of this market were credit card-backed securities (21 percent), homeequity backed securities (25 percent), automobile-backed securities (13 percent), and collateralized debt
obligations (15 percent). Among the other market segments were student loan-backed securities (6 percent),
equipment leases (4 percent), manufactured housing (2 percent), small business loans (such as loans to
convenience stores and gas stations), and aircraft leases.[12]
Modern securitization took off in the late 1990s or early 2000s, thanks to the innovative structures implemented
across the asset classes, such as UK Mortgage Master Trusts (concept imported from the US Credit Cards),
Insurance-backed transaction (such as those implemented by the insurance securitization guru Emmanuel
Issanchou) or even more esoteric asset classes (for example securitization of lottery receivables).
As the result of the credit crunch precipitated by the subprime mortgage crisis the US market for bonds backed
by securitised loans was very weak in 2008 except for bonds guaranteed by a federally backed agency. As a
result, interest rates rose for loans that were previously securitised such as home mortgages, student loans, auto
loans and commercial mortgages[13]
Recently, securitization has been proposed and used to accelerate development of solar photovoltaic projects.[14]
[15]
For example, SolarCity offered the first U.S. asset-backed security in the solar industry in 2013.[16]
Structure[edit]
Pooling and transfer[edit]
The originator initially owns the assets engaged in the deal. This is typically a company looking to either raise
capital, restructure debt or otherwise adjust its finances (but also includes businesses established specifically to
generate marketable debt (consumer or otherwise) for the purpose of subsequent securitization). Under
traditional corporate finance concepts, such a company would have three options to raise new capital: a loan,
bond issue, or issuance of stock. However, stock offerings dilute the ownership and control of the company,
while loan or bond financing is often prohibitively expensive due to the credit rating of the company and the
associated rise in interest rates.
The consistently revenue-generating part of the company may have a much higher credit rating than the
company as a whole. For instance, a leasing company may have provided $10m nominal value of leases, and it
will receive a cash flow over the next five years from these. It cannot demand early repayment on the leases and
so cannot get its money back early if required. If it could sell the rights to the cash flows from the leases to
someone else, it could transform that income stream into a lump sum today (in effect, receiving today the
present value of a future cash flow). Where the originator is a bank or other organization that must meet capital
adequacy requirements, the structure is usually more complex because a separate company is set up to buy the
assets.
A suitably large portfolio of assets is "pooled" and transferred to a "special purpose vehicle" or "SPV" (the
issuer), a tax-exempt company or trust formed for the specific purpose of funding the assets. Once the assets are
transferred to the issuer, there is normally no recourse to the originator. The issuer is "bankruptcy remote",
meaning that if the originator goes into bankruptcy, the assets of the issuer will not be distributed to the
creditors of the originator. In order to achieve this, the governing documents of the issuer restrict its activities to
only those necessary to complete the issuance of securities. Many issuers are typically "orphaned". In the case
of certain assets, such as credit card debt, where the portfolio is made up of a constantly changing pool of
receivables, a trust in favor of the SPV may be declared in place of traditional transfer by assignment (see the
outline of the master trust structure below).
Accounting standards govern when such a transfer is a true sale, a financing, a partial sale, or a part-sale and
part-financing.[17] In a true sale, the originator is allowed to remove the transferred assets from its balance sheet:
in a financing, the assets are considered to remain the property of the originator.[18] Under US accounting
standards, the originator achieves a sale by being at arm's length from the issuer, in which case the issuer is
classified as a "qualifying special purpose entity" or "qSPE".
Because of these structural issues, the originator typically needs the help of an investment bank (the arranger)
in setting up the structure of the transaction.
Issuance[edit]
To be able to buy the assets from the originator, the issuer SPV issues tradable securities to fund the purchase.
Investors purchase the securities, either through a private offering (targeting institutional investors) or on the
open market. The performance of the securities is then directly linked to the performance of the assets. Credit
rating agencies rate the securities which are issued to provide an external perspective on the liabilities being
created and help the investor make a more informed decision.
In transactions with static assets, a depositor will assemble the underlying collateral, help structure the
securities and work with the financial markets to sell the securities to investors. The depositor has taken on
added significance under Regulation AB. The depositor typically owns 100% of the beneficial interest in the
issuing entity and is usually the parent or a wholly owned subsidiary of the parent which initiates the
transaction. In transactions with managed (traded) assets, asset managers assemble the underlying collateral,
help structure the securities and work with the financial markets in order to sell the securities to investors.
Some deals may include a third-party guarantor which provides guarantees or partial guarantees for the assets,
the principal and the interest payments, for a fee.
The securities can be issued with either a fixed interest rate or a floating rate under currency pegging system.
Fixed rate ABS set the coupon (rate) at the time of issuance, in a fashion similar to corporate bonds and TBills. Floating rate securities may be backed by both amortizing and non-amortizing assets in the floating
market. In contrast to fixed rate securities, the rates on floaters will periodically adjust up or down according
to a designated index such as a U.S. Treasury rate, or, more typically, the London Interbank Offered Rate
(LIBOR). The floating rate usually reflects the movement in the index plus an additional fixed margin to cover
the added risk.[19]
Credit enhancement and tranching[edit]

Unlike conventional corporate bonds which are unsecured, securities created in a securitization are "credit
enhanced", meaning their credit quality is increased above that of the originator's unsecured debt or underlying
asset pool. This increases the likelihood that the investors will receive the cash flows to which they are entitled,
and thus enables the securities to have a higher credit rating than the originator. Some securitizations use
external credit enhancement provided by third parties, such as surety bonds and parental guarantees (although
this may introduce a conflict of interest).
The issued securities are often split into tranches, or categorized into varying degrees of subordination. Each
tranche has a different level of credit protection or risk exposure: there is generally a senior ("A") class of
securities and one or more junior subordinated ("B", "C", etc.) classes that function as protective layers for the
"A" class. The senior classes have first claim on the cash that the SPV receives, and the more junior classes only
start receiving repayment after the more senior classes have been repaid. Because of the cascading effect
between classes, this arrangement is often referred to as a cash flow waterfall.[20] If the underlying asset pool
becomes insufficient to make payments on the securities (e.g. when loans default within a portfolio of loan
claims), the loss is absorbed first by the subordinated tranches, and the upper-level tranches remain unaffected
until the losses exceed the entire amount of the subordinated tranches. The senior securities might be AAA or
AA rated, signifying a lower risk, while the lower-credit quality subordinated classes receive a lower credit
rating, signifying a higher risk.[19]
The most junior class (often called the equity class) is the most exposed to payment risk. In some cases, this is
a special type of instrument which is retained by the originator as a potential profit flow. In some cases the
equity class receives no coupon (either fixed or floating), but only the residual cash flow (if any) after all the
other classes have been paid.
There may also be a special class which absorbs early repayments in the underlying assets. This is often the case
where the underlying assets are mortgages which, in essence, are repaid whenever the properties are sold. Since
any early repayments are passed on to this class, it means the other investors have a more predictable cash flow.
If the underlying assets are mortgages or loans, there are usually two separate "waterfalls" because the principal
and interest receipts can be easily allocated and matched. But if the assets are income-based transactions such as
rental deals one cannot categorise the revenue so easily between income and principal repayment. In this case
all the revenue is used to pay the cash flows due on the bonds as those cash flows become due.
Credit enhancements affect credit risk by providing more or less protection for promised cash flows for a
security. Additional protection can help a security achieve a higher rating, lower protection can help create new
securities with differently desired risks, and these differential protections can make the securities more
attractive.
In addition to subordination, credit may be enhanced through:[18]
A reserve or spread account, in which funds remaining after expenses such as principal and interest
payments, charge-offs and other fees have been paid-off are accumulated, and can be used when SPE
expenses are greater than its income.
Third-party insurance, or guarantees of principal and interest payments on the securities.
Over-collateralisation, usually by using finance income to pay off principal on some securities before
principal on the corresponding share of collateral is collected.
Cash funding or a cash collateral account, generally consisting of short-term, highly rated investments
purchased either from the seller's own funds, or from funds borrowed from third parties that can be used
to make up shortfalls in promised cash flows.
A third-party letter of credit or corporate guarantee.
A back-up servicer for the loans.
Discounted receivables for the pool.
Servicing[edit]
A servicer collects payments and monitors the assets that are the crux of the structured financial deal. The
servicer can often be the originator, because the servicer needs very similar expertise to the originator and
would want to ensure that loan repayments are paid to the Special Purpose Vehicle.
The servicer can significantly affect the cash flows to the investors because it controls the collection policy,
which influences the proceeds collected, the charge-offs and the recoveries on the loans. Any income remaining
after payments and expenses is usually accumulated to some extent in a reserve or spread account, and any
further excess is returned to the seller. Bond rating agencies publish ratings of asset-backed securities based on
the performance of the collateral pool, the credit enhancements and the probability of default.[18]
When the issuer is structured as a trust, the trustee is a vital part of the deal as the gate-keeper of the assets that
are being held in the issuer. Even though the trustee is part of the SPV, which is typically wholly owned by the
Originator, the trustee has a fiduciary duty to protect the assets and those who own the assets, typically the
investors.
Repayment structures[edit]
Unlike corporate bonds, most securitizations are amortized, meaning that the principal amount borrowed is paid
back gradually over the specified term of the loan, rather than in one lump sum at the maturity of the loan. Fully
amortizing securitizations are generally collateralised by fully amortizing assets, such as home equity loans,
auto loans, and student loans. Prepayment uncertainty is an important concern with fully amortizing ABS. The
possible rate of prepayment varies widely with the type of underlying asset pool, so many prepayment models
have been developed to try to define common prepayment activity. The PSA prepayment model is a well-known
example.[19][21]
A controlled amortization structure can give investors a more predictable repayment schedule, even though the
underlying assets may be nonamortising. After a predetermined "revolving period", during which only interest
payments are made, these securitizations attempt to return principal to investors in a series of defined periodic
payments, usually within a year. An early amortization event is the risk of the debt being retired early.[19]
On the other hand, bullet or slug structures return the principal to investors in a single payment. The most
common bullet structure is called the soft bullet, meaning that the final bullet payment is not guaranteed to be
paid on the scheduled maturity date; however, the majority of these securitizations are paid on time. The second
type of bullet structure is the hard bullet, which guarantees that the principal will be paid on the scheduled
maturity date. Hard bullet structures are less common for two reasons: investors are comfortable with soft bullet
structures, and they are reluctant to accept the lower yields of hard bullet securities in exchange for a guarantee.
[19]
Securitizations are often structured as a sequential pay bond, paid off in a sequential manner based on maturity.
This means that the first tranche, which may have a one-year average life, will receive all principal payments
until it is retired; then the second tranche begins to receive principal, and so forth.[19] Pro rata bond structures pay
each tranche a proportionate share of principal throughout the life of the security.[19]
Structural risks and misincentives[edit]

Some originators (e.g. of mortgages) have prioritised loan volume over credit quality, disregarding the longterm risk of the assets they have created in their enthusiasm to profit from the fees associated with origination
and securitization. Other originators, aware of the reputational harm and added expense if risky loans are
subject to repurchase requests or improperly originated loans lead to litigation, have paid more attention to
credit quality.[citation needed]
Special types of securitization[edit]

Master trust[edit]
A master trust is a type of SPV particularly suited to handle revolving credit card balances, and has the
flexibility to handle different securities at different times. In a typical master trust transaction, an originator of
credit card receivables transfers a pool of those receivables to the trust and then the trust issues securities
backed by these receivables. Often there will be many tranched securities issued by the trust all based on one set
of receivables. After this transaction, typically the originator would continue to service the receivables, in this
case the credit cards.
There are various risks involved with master trusts specifically. One risk is that timing of cash flows promised
to investors might be different from timing of payments on the receivables. For example, credit card-backed
securities can have maturities of up to 10 years, but credit card-backed receivables usually pay off much more
quickly. To solve this issue these securities typically have a revolving period, an accumulation period, and an
amortization period. All three of these periods are based on historical experience of the receivables. During the
revolving period, principal payments received on the credit card balances are used to purchase additional
receivables. During the accumulation period, these payments are accumulated in a separate account. During the
amortization period, new payments are passed through to the investors.
A second risk is that the total investor interests and the seller's interest are limited to receivables generated by
the credit cards, but the seller (originator) owns the accounts. This can cause issues with how the seller controls
the terms and conditions of the accounts. Typically to solve this, there is language written into the securitization
to protect the investors and potential receivables.
A third risk is that payments on the receivables can shrink the pool balance and under-collateralize total investor
interest. To prevent this, often there is a required minimum seller's interest, and if there was a decrease then an
early amortization event would occur.[18]
Issuance trust[edit]
In 2000, Citibank introduced a new structure for credit card-backed securities, called an issuance trust, which
does not have limitations that master trusts sometimes do, that requires each issued series of securities to have
both a senior and subordinate tranche. There are other benefits to an issuance trust: they provide more flexibility
in issuing senior/subordinate securities, can increase demand because pension funds are eligible to invest in
investment-grade securities issued by them, and they can significantly reduce the cost of issuing securities.
Because of these issues, issuance trusts are now the dominant structure used by major issuers of credit cardbacked securities.[18]
Grantor trust[edit]
Grantor trusts are typically used in automobile-backed securities and REMICs (Real Estate Mortgage
Investment Conduits). Grantor trusts are very similar to pass-through trusts used in the earlier days of
securitization. An originator pools together loans and sells them to a grantor trust, which issues classes of
securities backed by these loans. Principal and interest received on the loans, after expenses are taken into
account, are passed through to the holders of the securities on a pro-rata basis.[22]
Owner trust[edit]
In an owner trust, there is more flexibility in allocating principal and interest received to different classes of
issued securities. In an owner trust, both interest and principal due to subordinate securities can be used to pay
senior securities. Due to this, owner trusts can tailor maturity, risk and return profiles of issued securities to
investor needs. Usually, any income remaining after expenses is kept in a reserve account up to a specified level
and then after that, all income is returned to the seller. Owner trusts allow credit risk to be mitigated by overcollateralization by using excess reserves and excess finance income to prepay securities before principal,
which leaves more collateral for the other classes.
Motives for securitization[edit]

Advantages to issuer[edit]
Reduces funding costs: Through securitization, a company rated BB but with AAA worthy cash flow would be
able to borrow at possibly AAA rates. This is the number one reason to securitize a cash flow and can have
tremendous impacts on borrowing costs. The difference between BB debt and AAA debt can be multiple
hundreds of basis points. For example, Moody's downgraded Ford Motor Credit's rating in January 2002, but
senior automobile backed securities, issued by Ford Motor Credit in January 2002 and April 2002, continue to
be rated AAA because of the strength of the underlying collateral and other credit enhancements.[18]
Reduces asset-liability mismatch: "Depending on the structure chosen, securitization can offer perfect
matched funding by eliminating funding exposure in terms of both duration and pricing basis."[23] Essentially, in
most banks and finance companies, the liability book or the funding is from borrowings. This often comes at a
high cost. Securitization allows such banks and finance companies to create a self-funded asset book.
Lower capital requirements: Some firms, due to legal, regulatory, or other reasons, have a limit or range that
their leverage is allowed to be. By securitizing some of their assets, which qualifies as a sale for accounting
purposes, these firms will be able to remove assets from their balance sheets while maintaining the "earning
power" of the assets.[22]
Locking in profits: For a given block of business, the total profits have not yet emerged and thus remain
uncertain. Once the block has been securitized, the level of profits has now been locked in for that company,
thus the risk of profit not emerging, or the benefit of super-profits, has now been passed on.
Transfer risks (credit, liquidity, prepayment, reinvestment, asset concentration): Securitization makes it
possible to transfer risks from an entity that does not want to bear it, to one that does. Two good examples of
this are catastrophe bonds and Entertainment Securitizations. Similarly, by securitizing a block of business
(thereby locking in a degree of profits), the company has effectively freed up its balance to go out and write
more profitable business.
Off balance sheet: Derivatives of many types have in the past been referred to as "off-balance-sheet." This term
implies that the use of derivatives has no balance sheet impact. While there are differences among the various
accounting standards internationally, there is a general trend towards the requirement to record derivatives at
fair value on the balance sheet. There is also a generally accepted principle that, where derivatives are being
used as a hedge against underlying assets or liabilities, accounting adjustments are required to ensure that the
gain/loss on the hedged instrument is recognized in the income statement on a similar basis as the underlying
assets and liabilities. Certain credit derivatives products, particularly Credit Default Swaps, now have more or
less universally accepted market standard documentation. In the case of Credit Default Swaps, this
documentation has been formulated by the International Swaps and Derivatives Association (ISDA) who have
for a long time provided documentation on how to treat such derivatives on balance sheets.
Earnings: Securitization makes it possible to record an earnings bounce without any real addition to the firm.
When a securitization takes place, there often is a "true sale" that takes place between the Originator (the parent
company) and the SPE. This sale has to be for the market value of the underlying assets for the "true sale" to
stick and thus this sale is reflected on the parent company's balance sheet, which will boost earnings for that
quarter by the amount of the sale. While not illegal in any respect, this does distort the true earnings of the
parent company.
Admissibility: Future cashflows may not get full credit in a company's accounts (life insurance companies, for
example, may not always get full credit for future surpluses in their regulatory balance sheet), and a
securitization effectively turns an admissible future surplus flow into an admissible immediate cash asset.
Liquidity: Future cashflows may simply be balance sheet items which currently are not available for spending,
whereas once the book has been securitized, the cash would be available for immediate spending or investment.
This also creates a reinvestment book which may well be at better rates.
Disadvantages to issuer[edit]
May reduce portfolio quality: If the AAA risks, for example, are being securitized out, this would leave a
materially worse quality of residual risk.
Costs: Securitizations are expensive due to management and system costs, legal fees, underwriting fees, rating
fees and ongoing administration. An allowance for unforeseen costs is usually essential in securitizations,
especially if it is an atypical securitization.
Size limitations: Securitizations often require large scale structuring, and thus may not be cost-efficient for
small and medium transactions.
Risks: Since securitization is a structured transaction, it may include par structures as well as credit
enhancements that are subject to risks of impairment, such as prepayment, as well as credit loss, especially for
structures where there are some retained strips.
Advantages to investors[edit]
Opportunity to potentially earn a higher rate of return (on a risk-adjusted basis)
Opportunity to invest in a specific pool of high quality assets: Due to the stringent requirements for
corporations (for example) to attain high ratings, there is a dearth of highly rated entities that exist.
Securitizations, however, allow for the creation of large quantities of AAA, AA or A rated bonds, and risk averse
institutional investors, or investors that are required to invest in only highly rated assets, have access to a larger
pool of investment options.
Portfolio diversification: Depending on the securitization, hedge funds as well as other institutional investors
tend to like investing in bonds created through securitizations because they may be uncorrelated to their other
bonds and securities.
Isolation of credit risk from the parent entity: Since the assets that are securitized are isolated (at least in
theory) from the assets of the originating entity, under securitization it may be possible for the securitization to
receive a higher credit rating than the "parent," because the underlying risks are different. For example, a small
bank may be considered more risky than the mortgage loans it makes to its customers; were the mortgage loans
to remain with the bank, the borrowers may effectively be paying higher interest (or, just as likely, the bank
would be paying higher interest to its creditors, and hence less profitable).
Risks to investors[edit]
Liquidity risk
Credit/default: Default risk is generally accepted as a borrowers inability to meet interest payment obligations
on time.[24] For ABS, default may occur when maintenance obligations on the underlying collateral are not
sufficiently met as detailed in its prospectus. A key indicator of a particular securitys default risk is its credit
rating. Different tranches within the ABS are rated differently, with senior classes of most issues receiving the
highest rating, and subordinated classes receiving correspondingly lower credit ratings.[19] Almost all mortgages,
including reverse mortgages, and student loans, are now insured by the government, meaning that taxpayers are
on the hook for any of these loans that go bad even if the asset is massively over-inflated. In other words, there
are no limits or curbs on over-spending, or the liabilities to taxpayers.
However, the credit crisis of 20072008 has exposed a potential flaw in the securitization process loan
originators retain no residual risk for the loans they make, but collect substantial fees on loan issuance and
securitization, which doesn't encourage improvement of underwriting standards.
Event risk
Prepayment/reinvestment/early amortization: The majority of revolving ABS are subject to some degree of
early amortization risk. The risk stems from specific early amortization events or payout events that cause the
security to be paid off prematurely. Typically, payout events include insufficient payments from the underlying
borrowers, insufficient excess spread, a rise in the default rate on the underlying loans above a specified level, a
decrease in credit enhancements below a specific level, and bankruptcy on the part of the sponsor or servicer.[19]
Currency interest rate fluctuations: Like all fixed income securities, the prices of fixed rate ABS move in
response to changes in interest rates. Fluctuations in interest rates affect floating rate ABS prices less than fixed
rate securities, as the index against which the ABS rate adjusts will reflect interest rate changes in the economy.
Furthermore, interest rate changes may affect the prepayment rates on underlying loans that back some types of
ABS, which can affect yields. Home equity loans tend to be the most sensitive to changes in interest rates, while
auto loans, student loans, and credit cards are generally less sensitive to interest rates.[19]
Contractual agreements
Moral hazard: Investors usually rely on the deal manager to price the securitizations underlying assets. If the
manager earns fees based on performance, there may be a temptation to mark up the prices of the portfolio
assets. Conflicts of interest can also arise with senior note holders when the manager has a claim on the deal's
excess spread.[25]
Servicer risk: The transfer or collection of payments may be delayed or reduced if the servicer becomes
insolvent. This risk is mitigated by having a backup servicer involved in the transaction.[19]
Recent lawsuits[edit]
Recently there have been several lawsuits attributable to the rating of securitizations by the three leading rating
agencies. In July, 2009, the USAs largest public pension fund has filed suit in California state court in
connection with $1 billion in losses that it says were caused by wildly inaccurate credit ratings from the three
leading ratings agencies.[1]
See also[edit]
Collateralized debt obligation, securitization vehicle for corporate debt securities

Collateralized fund obligation, securitization vehicle for private equity and hedge fund assets
Collateralized mortgage obligation, securitization vehicle for mortgage-backed securities
Collateralized loan obligation, securitization vehicle for corporate loans
References[edit]
1.
2.
Jump up ^ Michael Simkovic, Competition and Crisis in Mortgage Securitization

Jump up ^ Michael Simkovic, Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal,
Vol. 83, p. 253, 2009
3.
Jump up ^ Raynes, Sylvain and Ann Rutledge, The Analysis of Structured Securities, Oxford U Press, 2003, p. 103.
ISBN 978-0-19-515273-9
4.
Jump up ^ "ESF Securitization Data Report Q2:business
5.
Jump up ^ Claire A. Hill, Whole Business Securitization in Emerging Markets, Duke Journal of Comparative and
International Law 12:2 (2002).
6.
Jump up ^ "Dutch Securities for American Land Speculation in the Late-Eighteenth Century", Rik Frehen, K. Geert
Rouwenhorst, and William N. Goetzmann, 2012.
7.
Jump up ^ "Dj Vu All Over Again: Agency, Uncertainty, Leverage and the Panic of 1857", Timothy J. Riddiough
and Howard E. Thompson, 2012.
8.
Jump up ^ "Asset-Backed securities in Germany: the sale and Securitization of loans by German credit
institutions", Deutsche Bundesbank Monthly Report July, 1997.
9.
^ Jump up to: a b "Asset Securitization Comptroller's Handbook", Comptroller of the Currency Administrator of
National Banks, 1997.
10.
Jump up ^ "Hearing before the U.S. House subcommittee on Policy Research and Insurance in "Asset
Securitization and Secondary Markets" (July 31, 1991), page 13
11.
Jump up ^ Wachovia Press Releases
12.
^ Jump up to: a b "Common Structures of Asset-Backed Securities and Their Risks", Tarun Sabarwal, December 29,
2005
13.
14.
15.
Jump up ^ "Mechanism for Credit Is Still Stuck" article by Vikas Bajaj in The New York Times August 12, 2008
Jump up ^ Alafita, T.; Pearce, J.M. "Securitization of residential solar photovoltaic assets: Costs, risks and
uncertainty". Energy Policy 67: 488498. doi:10.1016/j.enpol.2013.12.045.
Jump up ^ Lowder, T., & Mendelsohn, M. (2013). The Potential of Securitization in Solar PV Finance.
16.
Jump up ^ "Done Deal: The First Securitization Of Rooftop Solar Assets" Forbes - URL:
http://www.forbes.com/sites/uciliawang/2013/11/21/done-deal-the-first-securitization-of-rooftop-solar-assets/
17.
Jump up ^ Financial Accounting Standards Board (FASB) Statement No. 140 "Accounting for transfers and
servicing of financial assets and extinguishments of liabilitiesa replacement of FASB Statement No. 125" September 2000
18.
^ Jump up to: a b c d e f T Sabarwal "Common Structures of Asset Backed Securities and Their Risks, December 29,
2005 Cite error: Invalid <ref> tag; name "sofabs" defined multiple times with different content (see the help page).
19.
^ Jump up to: a b c d e f g h i j k Fixed Income Sectors: Asset-Backed Securities A primer on asset-backed securities,
Dwight Asset Management Company (2005). Cite error: Invalid <ref> tag; name "Dwight" defined multiple times with
different content (see the help page). Cite error: Invalid <ref> tag; name "Dwight" defined multiple times with different
content (see the help page).
20.
Jump up ^ Kim, M. ; Hessami, A. ; Sombolestani, E. (2010, March 24) CVEN 640 - Cash Flow Waterfall [Video
file]. URL: http://www.youtube.com/watch?v=Dw_z56HmLYs
21.
Jump up ^ The Committee on the Global Financial System defined Structured Finance, "The role of ratings in
structured finance: issues and implications", January 2005
22.
^ Jump up to: a b Reis-Roy, Calvin (1998). Journal of International Banking Law 13 (9): 298304. Missing or empty
|title= (help)
23.
Jump up ^ "The Handbook of Asset-Backed Securities", Jess Lederman, 1990.
24.
Jump up ^ Reis-Roy, Calvin (2003). An Analysis of the Law and Practice of Securitisation.
25.
Jump up ^ Tavakoli, Janet. "CDOs: Caveat Emptor" GARP Risk Review (Journal of the Global Association of Risk
Professionals), September/October 2005 Issue 26.
External links[edit]
The Rocket Scientists of Finance BBC Programme: The City Uncovered

[hide]
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In structured finance, a tranche is one of a number of related securities offered as part of the same transaction.
The word tranche is French for slice, section, series, or portion, and is cognate to English trench ('ditch'). In the
financial sense of the word, each bond is a different slice of the deal's risk. Transaction documentation (see
indenture) usually defines the tranches as different "classes" of notes, each identified by letter (e.g., the Class A,
Class B, Class C securities) with different bond credit ratings (ratings).
The term tranche is used in fields of finance other than structured finance (such as in straight lending, where
multi-tranche loans are commonplace), but the term's use in structured finance may be singled out as
particularly important. Use of "tranche" as a verb is limited almost exclusively to this field.
Contents
[hide]
1 How tranching works

o 1.1 Example
2 Benefits
3 Risks
4 See also
5 References
How tranching works[edit]

All the tranches together make up what is referred to as the deal's capital structure or liability structure. They are
generally paid sequentially from the most senior to most subordinate (and generally unsecured), although
certain tranches with the same security may be paid pari passu. The more senior rated tranches generally have
higher bond credit ratings (ratings) than the lower rated tranches. For example, senior tranches may be rated
AAA, AA or A, while a junior, unsecured tranche may be rated BB. However, ratings can fluctuate after the
debt is issued and even senior tranches could be rated below investment grade (less than BBB). The deal's
indenture (its governing legal document) usually details the payment of the tranches in a section often referred
to as the waterfall (because the moneys flow down).
Tranches with a first lien on the assets of the asset pool are referred to as senior tranches and are generally safer
investments. Typical investors of these types of securities tend to be conduits, insurance companies, pension
funds and other risk averse investors.
Tranches with either a second lien or no lien are often referred to as "junior notes". These are more risky
investments because they are not secured by specific assets. The natural buyers of these securities tend to be
hedge funds and other investors seeking higher risk/return profiles.
"Market information also suggests that the more junior tranches of structured products are often bought by
specialist credit investors, while the senior tranches appear to be more attractive for a broader, less specialised
investor community".[1] Here is a simplified example to demonstrate the principle:
Example[edit]
A bank transfers risk in its loan portfolio by entering into a default swap with a ring-fenced special
purpose vehicle (SPV).
The SPV buys gilts (UK government bonds).
The SPV sells 4 tranches of credit linked notes with a waterfall structure whereby:
Tranche D absorbs the first 25% of losses on the portfolio, and is the most risky.
Tranche C absorbs the next 25% of losses
Tranche B the next 25%
Tranche A the final 25%, is the least risky.
Tranches A, B and C are sold to outside investors.
Tranche D is bought by the bank itself.
Benefits[edit]
Tranching offers the following benefits:
Tranches allow for the "ability to create one or more classes of securities whose rating is higher than the
average rating of the underlying collateral asset pool or to generate rated securities from a pool of
unrated assets".[1] "This is accomplished through the use of credit support specified within the transaction
structure to create securities with different risk-return profiles. The equity/first-loss tranche absorbs
initial losses, followed by the mezzanine tranches which absorb some additional losses, again followed
by more senior tranches. Thus, due to the credit support resulting from tranching, the most senior claims
are expected to be insulated - except in particularly adverse circumstances - from default risk of the
underlying asset pool through the absorption of losses by the more junior claims."[2]
Tranching can be very helpful in many different circumstances. For those investors that have to invest in
highly rated securities, they are able to gain "exposure to asset classes, such as leveraged loans, whose
performance across the business cycle may differ from that of other eligible assets."[1] So essentially it
allows investors to further diversify their portfolio.
Risks[edit]
Risk, Return, Rating & Yield relate

Tranching poses the following risks:
Tranching can add complexity to deals. Beyond the challenges posed by estimation of the asset pool's
loss distribution, tranching requires detailed, deal-specific documentation to ensure that the desired
characteristics, such as the seniority ordering the various tranches, will be delivered under all plausible
scenarios. In addition, complexity may be further increased by the need to account for the involvement
of asset managers and other third parties, whose own incentives to act in the interest of some investor
classes at the expense of others may need to be balanced.
With increased complexity, less sophisticated investors have a harder time understanding them and thus
are less able to make informed investment decisions. One must be very careful investing in structured
products. As shown above, tranches from the same offering have different risk, reward, and/or maturity
characteristics.
Modeling the performance of tranched transactions based on historical performance may have led to the
over-rating (by ratings agencies) and underestimation of risks (by end investors) of asset-backed
securities with high-yield debt as their underlying assets. These factors have come to light in the
subprime mortgage crisis.
In case of default, different tranches may have conflicting goals, which can lead to expensive and timeconsuming lawsuits, called tranche warfare (punning on trench warfare).[3] Further, these goals may not
be aligned with those of the structure as a whole or of any borrowerin formal language, no agent is
acting as a fiduciary. For example, it may be in the interests of some tranches to foreclose on a defaulted
mortgage, while it would be in the interests of other tranches (and the structure as the whole) to modify
the mortgage. In the words of structuring pioneer Lewis Ranieri:[4]
The cardinal principle in the mortgage crisis is a very old one. You are almost always better off
restructuring a loan in a crisis with a borrower than going to a foreclosure. In the past that was never at
issue because the loan was always in the hands of someone acting as a fiduciary. The bank, or someone
like a bank owned them, and they always exercised their best judgement and their interest. The problem
now with the size of securitization and so many loans are not in the hands of a portfolio lender but in a
security where structurally nobody is acting as the fiduciary.
See also[edit]
Pooled investment
Privatization
Thomson Financial League Tables
References[edit]
1.
^ Jump up to: a b c I. Fender, J. Mitchell "Structured finance: complexity, risk and the use of ratings" BIS
Quarterly Review, June 2005
2.
Jump up ^ "The role of ratings in structured finance: issues and implications" Committee on the Global
Financial System, January 2005
3.
Jump up ^ The mother of all (RMBS) tranche warfare, Financial Times Alphaville, Tracy Alloway, Oct
11 2010
4.
Jump up ^ The Financial Innovation That Wasnt. Rortybomb, Mike Rorty, transcript of Milken Institute
Conference, May 2008
[hide]
v
t
Structured finance
Securitization
Credit enhancement
Tranche
Credit derivative
Types of Securities
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Structured product

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Categories:
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Fixed income securities
Collateralized debt obligation

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A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS).[1] Originally
developed for the corporate debt markets, over time CDOs evolved to encompass the mortgage and mortgagebacked security ("MBS") markets.[2]
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.
The CDO is "sliced" into "tranches", which "catch" the cash flow of interest and principal payments in sequence
based on seniority.[3] 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.[4]
Separate special purpose entitiesrather than the parent investment bankissue the CDOs and pay interest to
investors. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as "CDOsquared", "CDOs of CDOs" or "synthetic CDOs".[4]
In the early 2000s, CDOs were generally diversified,[5] but by 20062007when the CDO market grew to
hundreds of billions of dollarsthis changed. CDO collateral became dominated not by loans, but by lower
level (BBB or A) tranches recycled from other asset-backed securities, whose assets were usually non-prime
mortgages,[6] and are known as a synthetic CDO. These CDOs have been called "the engine that powered the
mortgage supply chain" for nonprime mortgages,[7] and are credited with giving lenders greater incentive to
make non-prime loans[8] leading up to the 2007-9 subprime mortgage crisis.
Contents
[hide]
1 Market history
o 1.1 Beginnings
1.2 Subprime mortgage boom
1.1.1 Explanations for growth
1.2.1 Explanations for growth
1.3 Crash
1.4 Criticism
2 Concept, structures, varieties

o
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 See also
4 References
5 External links
Market history[edit]
Beginnings[edit]
The first CDO was issued in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc. for the also nowdefunct Imperial Savings Association.[9] During the 1990s the collateral of CDOs was generally corporate and
emerging market bonds and bank loans.[10] After 1998 "multi-sector" CDOs were developed by Prudential
Securities,[11] but CDOs remained fairly obscure until after 2000.[12] In 2002 and 2003 CDOs had a setback when
rating agencies "were forced to downgrade hundreds" of the securities,[13] but sales of CDOs grewfrom $69
billion in 2000 to around $500 billion in 2006.[14] From 2004 through 2007, $1.4 trillion worth of CDOs were
issued.[15]
Early CDOs were diversified, and might include everything from aircraft lease-equipment debt, manufactured
housing loans, to student loans and credit card debt. The diversification of borrowers in these "multisector
CDOs" was a selling point, as it meant that if there was a downturn in one industry like aircraft manufacturing
and their loans defaulted, other industries like manufactured housing might be unaffected.[16] Another selling
point was that CDOs offered returns that were sometimes 2-3 percentage points higher than corporate bonds
with the same credit rating.[16][17]
Explanations for growth[edit]
Advantages of securitization -- Depository banks had incentive to "securitize" loans they originated
often in the form of CDO securitiesbecause this removes the loans from their books. The transfer of
these loans (along with related risk) to security-buying investors in return for cash replenishes the banks'
capital. This enabled them to remain in compliance with capital requirement laws while lending again
and generating additional origination fees.
Global demand for fixed income investments -- From 2000 to 2007 worldwide fixed income
investment (i.e. investments in bonds and other conservative securities) roughly doubled in size to $70
trillion, yet the supply of relatively safe, income generating investments had not grown as fast, which
bid up bond prices and drove down interest rates.[18][19] Investment banks on Wall Street answered this
demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt
obligation (CDO), which were assigned safe ratings by the credit rating agencies.[19]
Low interest rates -- Fears of deflation, the bursting of the dot-com bubble, a U.S. recession, and the
U.S. trade deficit kept interest rates low globally from 2000 to 2004-5, according to Economist Mark
Zandi.[20] The low yield of the safe US Treasury bonds created demand by global investors for subprime
mortgage-backed CDOs with their relatively high-yields but credit ratings as high as the Treasuries. This
search for yield by global investors caused many to purchase CDOs, though they lived to regret trusting
the credit rating agencies' ratings.[21]
Pricing models -- Gaussian copula models, introduced in 2001 by David X. Li, allowed for the rapid
pricing of CDOs.[22][23]
Subprime mortgage boom[edit]
Source: Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the
United States, p.128, figure 8.1
IMF Diagram of CDO and RMBS
Securitization markets were impaired during the crisis.
The volume of CDOs issued globally crashed during the subprime crisis but has recovered slightly. (source:
SIFMA, Statistics, Structured Finance[24]
Main article: Subprime mortgage crisis
See also: Subprime lending and Bear Stearns subprime mortgage hedge fund crisis
Around 2005, as the CDO market continued to grow, subprime mortgages began to replace the diversified
consumer loans as collateral. By 2004, mortgage-backed securities accounted for more than half of the
collateral in CDOs.[7][25][26][27][28][29] According to the Financial Crisis Inquiry Report, "the CDO became the engine
that powered the mortgage supply chain",[7] promoting an increase in demand for mortgage-backed securities
without which lenders would have "had less reason to push so hard to make" non-prime loans.[8] CDOs not only
bought crucial tranches of subprime mortgage-backed securities, they provided cash for the initial funding of
the securities.[7] Between 2003 and 2007, Wall Street issued almost $700 billion in CDOs that included
mortgage-backed securities as collateral.[7] Despite this loss of diversification, CDO tranches were given the
same proportion of high ratings by rating agencies[30] on the grounds that mortgages were diversified by region
and so "uncorrelated"[31]though those ratings were lowered after mortgage holders began to default.[32][33]
The rise of "ratings arbitrage"i.e. pooling low-rated tranches to make CDOshelped push sales of CDOs to
about $500 billion in 2006,[14] with a global CDO market of over USD $1.5 trillion.[34] CDO was the fastestgrowing sector of the structured finance market between 2003 and 2006; the number of CDO tranches issued in
2006 (9,278) was almost twice the number of tranches issued in 2005 (4,706).[35]
CDOs, like mortgage-backed securities, were financed with debt, enhancing their profits but also enhancing
losses if the market reversed course.[36]
Explanations for growth[edit]
Subprime mortgages had been financed by mortgage-backed securities (MBS). Like CDOs, MBSs were
structured into tranches, but issuers of the securities had difficulty selling the more lower level/lower-rated
"mezzanine" tranchesthe tranches rated somewhere from AA to BB.
[B]ecause most traditional mortgage investors are risk-averse, either because of the restrictions of their
investment charters or business practices, they are interested in buying the higher-rated segments of the loan
stack; as a result, those slices are easiest to sell. The more challenging task is finding buyers for the riskier
pieces of at the bottom of the pile. The way mortgage securities are structured, if you cannot find buyers for the
lower-rated slices, the rest of the pool cannot be sold.[37][38]
To deal with the problem investment bankers "recycled" the mezzanine tranches, selling them to underwriters
making more structured securitiesCDOs. Though the pool that made up the CDO collateral might be
overwhelmingly mezzanine tranches, most of the tranches (70[39] to 80%[40][41]) of the CDO were rated not BBB,
A-, etc., but triple A. The minority of the tranches that were mezzanine were often bought up by other CDOs,
concentrating the lower rated tranches still further. (see chart on "The Theory of How the Financial System
Created AA-rated Assets out of Subprime Mortgages")
As one journalist (Gretchen Morgenson) put it, CDOs became "the perfect dumping ground for the low-rated
slices Wall Street couldn't sell on its own."[37]
Other factors explaining the popularity of CDOs include:
Growing demand for fixed income investments that started earlier in the decade continued.[18][19] A "global
savings glut"[42] leading to "large capital inflows" from abroad helped finance the housing boom, keeping
down US mortgage rates, even after the Federal Reserve Bank had raised interest rates to cool off the
economy.[43]
Supply generated by "hefty" fees the CDO industry earned. According to "one hedge fund manager who
became a big investor in CDOs", as much "as 40 to 50 percent" of the cash flow generated by the assets
in a CDO went to "pay the bankers, the CDO manager, the rating agencies, and others who took out
fees."[13] Rating agencies in particularwhose high ratings of the CDO tranches were crucial to the
industry and who were paid by CDO issuersearned extraordinary profits. Moody's Investors Service,
one of the two biggest rating agencies, could earn "as much as $250,000 to rate a mortgage pool with
$350 million in assets, versus the $50,000 in fees generated when rating a municipal bond of a similar
size." In 2006, revenues from Moody's structured finance division "accounted for fully 44%" of all
Moody's sales.[44][45] Moody's operating margins were "consistently over 50%, making it one of the most
profitable companies in existence"more profitable in terms of margins than Exxon Mobil or
Microsoft.[46] Between the time Moody's was spun off as a public company and February 2007, its stock
rose 340%.[46][47]
Trust in rating agencies. CDO managers "didn't always have to disclose what the securities contained"
because the contents of the CDO were subject to change. But this lack of transparency did not affect
demand for the securities. Investors "weren't so much buying a security. They were buying a triple-A
rating," according to business journalists Bethany McLean and Joe Nocera.[13]
Financial innovations, such as credit default swaps and synthetic CDO. Credit default swaps provided
insurance to investors against the possibility of losses in the value of tranches from default in exchange
for premium-like payments, making CDOs appear "to be virtually risk-free" to investors.[48] Synthetic
CDOs were cheaper and easier to create than original "cash" CDOs. Synthetics "referenced" cash CDOs,
replacing interest payments from MBS tranches with premium-like payments from credit default swaps.
Rather than providing funding for housing, synthetic CDO-buying investors were in effect providing
insurance against mortgage default.[49] If the CDO did not perform per contractual requirements, one
counterparty (typically a large investment bank or hedge fund) had to pay another.[50] As underwriting
standards deteriorated and the housing market became saturated, subprime mortgages became less
abundant. Synthetic CDOs began to fill in for the original cash CDOs. Because more than onein fact
numeroussynthetics could be made to reference the same original, the amount of money that moved
among market participants increased dramatically.
Crash[edit]
More than half of the highest-rated (Aaa) CDOs were "impaired" (losing principal or downgraded to junk
status), compared to a small fraction of similarly rated Subprime and Alt-A mortgage-backed securities. (source:
Financial Crisis Inquiry Report[51])
In the summer of 2006, the Case-Shiller index of house prices peaked.[52] In California home prices had more
than doubled since 2000[53] and median house prices in Los Angeles had risen to ten times the median annual
income. To entice the low and moderate income to sign up for mortgages, down payments, income
documentation were often dispensed with and interest and principal payments were often deferred upon request.
[54]
Journalist Michael Lewis gave as an example of unsustainable underwriting practices a loan in Bakersfield,
California, where "a Mexican strawberry picker with an income of $14,000 and no English was lent every
penny he needed to buy a house of $724,000".[54]
As two-year "teaser" mortgage rates common with that made home purchases like this expired, and mortgage
payments skyrocketed. Refinancing to lower mortgage payment was no longer available since it depended on
rising home prices.[55] Mezzanine tranches started to lose value in 2007, by mid year AA tranches were worth
only 70 cents on the dollar. By October triple-A tranches had started to fall.[56] Regional diversification
notwithstanding, the mortgage backed securities turned out to be highly correlated.[10]
Big CDO arrangers like Citigroup, Merrill Lynch and UBS experienced some of the biggest losses, as did
financial guaranteers such as AIG, Ambac, MBIA.[10]
An early indicator of the crisis came in July 2007 when rating agencies made unprecedented mass downgrades
of mortgage-related securities[57] (by the end of 2008 91% of CDO securities were downgraded[58]), and two
highly leveraged Bear Stearns hedge funds holding MBSs and CDOs collapsed. Investors were informed by
Bear Stearns that they would get little if any of their money back.[59][60]
In October and November the CEOs of Merrill Lynch and Citigroup resigned after reporting multibillion-dollar
losses and CDO downgrades.[61][62][63] As the global market for CDOs dried up[64][65] the new issue pipeline for
CDOs slowed significantly,[66] and what CDO issuance there was usually in the form of collateralized loan
obligations backed by middle-market or leveraged bank loans, rather than home mortgage ABS.[67] The CDO
collapse hurt mortgage credit available to homeowners since the bigger MBS market depended on CDO
purchases of mezzanine tranches.[68][69]
While non-prime mortgage defaults affected all securities backed by mortgages, CDOs were especially hard hit.
More than half -- $300 billion worthof tranches issued in 2005, 2006, and 2007 rated most safetriple A -by rating agencies, were either downgraded to junk status or lost principal by 2009.[51] In comparison, only small
fractions of triple A tranches of Alt-A or subprime mortgage-backed securities suffered the same fate. (see
Impaired Securities chart)
Collateralized debt obligations (CDOs) also made up over half ($542 billion) of the nearly trillion dollars in
losses suffered by financial institutions from 2007 to early 2009.[32]
Criticism[edit]
Prior to the crisis, a few academics, analysts and investors such as Warren Buffett (who famously disparaged
CDOs and other derivatives as "financial weapons of mass destruction, carrying dangers that, while now latent,
are potentially lethal"[70]), and the IMF's former chief economist Raghuram Rajan[71] warned that rather than
reducing risk through diversification, CDOs and other derivatives spread risk and uncertainty about the value of
the underlying assets more widely.[citation needed]
During and after the crisis, criticism of the CDO market was more vocal. According to the radio documentary
"Giant Pool of Money", it was the strong demand for MBS and CDO, that drove down home lending standards.
Mortgages were needed for collateral and by approximately 2003, the supply of mortgages originated at
traditional lending standards had been exhausted.[19]
The head of banking supervision and regulation at the Federal Reserve, Patrick Parkinson, termed "the whole
concept of ABS CDOs", an "abomination".[10]
In December 2007, journalists Carrick Mollenkamp and Serena Ng wrote of a CDO called Norma created by
Merrill Lynch at the behest of Illinois hedge fund, Magnetar. It was a tailor-made bet on subprime mortgages
that went "too far." Janet Tavakoli, a Chicago consultant who specializes in CDOs, said Norma "is a tangled
hairball of risk." When it came to market in March 2007, "any savvy investor would have thrown this...in the
trash bin."[72][73]
According to journalists Bethany McLean and Joe Nocera, no securities became "more pervasive -- or [did]
more damage than collateralized debt obligations" to create the Great Recession.[12]
Gretchen Morgenson described the securities as "a sort of secret refuse heap for toxic mortgages [that] created
even more demand for bad loans from wanton lenders."
CDOs prolonged the mania, vastly amplifying the losses that investors would suffer and ballooning the amounts
of taxpayer money that would be required to rescue companies like Citigroup and the American International
Group." ...[74]
In the first quarter of 2008 alone, credit rating agencies announced 4,485 downgrades of CDOs.[67] At least some
analysts complained the agencies over-relied on computer models with imprecise inputs, failed to account
adequately for large risks (like a nationwide collapse of housing values), and assumed the risk of the low rated
tranches that made up CDOs would be diluted when in fact the mortgage risks were highly correlated, and when
one mortgage defaulted, many did, affected by the same financial events.[32][75]
They were strongly criticized by economist Joseph Stiglitz, among others. Stiglitz considered the agencies "one
of the key culprits" of the crisis that "performed that alchemy that converted the securities from F-rated to Arated. The banks could not have done what they did without the complicity of the ratings agencies."[76][77]
According to Morgenson, the agencies had pretended to transform "dross into gold."[44]
"As usual, the ratings agencies were chronically behind on developments in the financial markets and they
could barely keep up with the new instruments springing from the brains of Wall Street's rocket scientists. Fitch,
Moody's, and S&P paid their analysts far less than the big brokerage firms did and, not surprisingly wound up
employing people who were often looking to befriend, accommodate, and impress the Wall Street clients in
hopes of getting hired by them for a multiple increase in pay. ... Their [the rating agencies] failure to recognize
that mortgage underwriting standards had decayed or to account for the possibility that real estate prices could
decline completely undermined the ratings agencies' models and undercut their ability to estimate losses that
these securities might generate."[78]
Michael Lewis also pronounced the transformation of BBB tranches into 80% triple A CDOs as "dishonest",
"artificial" and the result of "fat fees" paid to rating agencies by Goldman Sachs and other Wall Street firms. [79]
However, if the collateral had been sufficient, those ratings would have been correct, according to the FDIC.
Synthetic CDOs were criticized in particular, because of the difficulties to judge (and price) the risk inherent in
that kind of securities correctly. That adverse effect roots in the pooling and tranching activities on every level
of the derivation.[3]
Others pointed out the risk of undoing the connection between borrowers and lendersremoving the lender's
incentive to only pick borrowers who were creditworthyinherent in all securitization. [80][81][82] According to
economist Mark Zandi: "As shaky mortgages were combined, diluting any problems into a larger pool, the
incentive for responsibility was undermined."[21]
Zandi and others also criticized lack of regulation. "Finance companies weren't subject to the same regulatory
oversight as banks. Taxpayers weren't on the hook if they went belly up [pre-crisis], only their shareholders and
other creditors were. Finance companies thus had little to discourage them from growing as aggressively as
possible, even if that meant lowering or winking at traditional lending standards."[21]
Concept, structures, varieties[edit]

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Concept[edit]
CDOs vary in structure and underlying assets, but the basic principle is the same. A CDO is a type of assetbacked security. To create a CDO, a corporate entity is constructed to hold assets as collateral backing packages
of cash flows which are sold to investors.[83] A sequence in constructing a CDO is:
A special purpose entity (SPE) is designed/constructed to acquire a portfolio of underlying assets.

Common underlying assets held may include mortgage-backed securities, commercial real estate bonds
and corporate loans.
The SPE issues bonds to investors in exchange for cash, which are used to purchase the portfolio of
underlying assets. Like other ABS private label securities, the bonds are not uniform but issued in layers
called tranches, each with different risk characteristics. Senior tranches are paid from the cash flows
from the underlying assets before the junior tranches and equity tranches. Losses are first borne by the
equity tranches, next by the junior tranches, and finally by the senior tranches.[84]
A common analogy compares the cash flow from the CDO's portfolio of securities (say mortgage payments
from mortgage-backed bonds) to water flowing into cups of the investors where senior tranches were filled first
and overflowing cash flowed to junior tranches, then equity tranches. If a large portion of the mortgages enter
default, there is insufficient cash flow to fill all these cups and equity tranche investors face the losses first.
The risk and return for a CDO investor depends both on how the tranches are defined, and on the underlying
assets. In particular, the investment depends on the assumptions and methods used to define the risk and return
of the tranches.[85] CDOs, like all asset-backed securities, enable the originators of the underlying assets to pass
credit risk to another institution or to individual investors. Thus investors must understand how the risk for
CDOs is calculated.
The issuer of the CDO, typically an investment bank, earns a commission at the time of issue and earns
management fees during the life of the CDO. The ability to earn substantial fees from originating CDOs,
coupled with the absence of any residual liability, skews the incentives of originators in favor of loan volume
rather than loan quality.
In some cases, the assets held by one CDO consisted entirely of equity layer tranches issued by other CDOs.
This explains why some CDOs became entirely worthless, as the equity layer tranches were paid last in the
sequence and there wasn't sufficient cash flow from the underlying subprime mortgages (many of which
defaulted) to trickle down to the equity layers.
Structures[edit]
CDO is a broad term that can refer to several different types of products. They can be categorized in several
ways. The primary classifications are as follows:
Source of fundscash flow vs. market value
Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the
CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying
portfolio.
Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable
sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's
portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs
are longer-established, but less common than cash flow CDOs.
Motivationarbitrage vs. balance sheet
Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread
between the relatively high yielding assets and the lower yielding liabilities represented by the rated
bonds. The majority, 86%, of CDOs are arbitrage-motivated.[86]
Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions desire to
remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements
and improve their return on risk capital. A bank may wish to offload the credit risk to reduce its balance
sheet's credit risk.
Fundingcash vs. synthetic
Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or
mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special
purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in
reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit
exposure to a portfolio of fixed income assets without owning those assets through the use of credit
default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO,
receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss
on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO,
the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche,
next the junior tranches, and finally the senior tranche. Each tranche receives a periodic payment (the
swap premium), with the junior tranches offering higher premiums.
o
A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the
CDO could have to pay up to a certain amount of money in the event of a credit event on the
reference obligations in the CDO's reference portfolio. Some of this credit exposure is funded at
the time of investment by the investors in funded tranches. Typically, the junior tranches that face
the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the
proceeds provided by the funded tranches are often invested in high-quality, liquid assets or
placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis
points below LIBOR. The return from these investments plus the premium from the swap
counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit
event occurs and a payout to the swap counterparty is required, the required payment is made
from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are
usually unfunded as the risk of loss is much lower. Unlike a cash CDO, investors in a senior
tranche receive periodic payments but do not place any capital in the CDO when entering into
the investment. Instead, the investors retain continuing funding exposure and may have to make
a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded
synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs
take less time to create. Cash assets do not have to be purchased and managed, and the CDO's
tranches can be precisely structured.
Hybrid CDOs have a portfolio including both cash assetslike a cash CDOsand swaps that give the
CDO credit exposure to additional assetslike a synthetic CDO. A portion of the proceeds from the
funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that
may be required under the credit default swaps. The CDO receives payments from three sources: the
return from the cash assets, the GIC or reserve account investments, and the CDO premiums.
Single-tranche CDOs
The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke tranche
CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the
remaining tranches are never sold but held by the dealer based on valuations from internal models.
Residual risk is delta-hedged by the dealer.
Structured Operating Companies
Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their
financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an
active management team and infrastructure. They often issue term notes, commercial paper, and/or
auction rate securities, depending upon the structural and portfolio characteristics of the company. Credit
Derivative Products Companies (CDPC) and Structured Investment Vehicles (SIV) are examples, with
CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.
Taxation[edit]
The issuer of a CDOusually a special purpose entityis typically a corporation established outside the
United States to avoid being subject to U.S. federal income taxation on its global income. These corporations
must restrict their activities to avoid U.S. tax; corporations that are deemed to engage in trade or business in the
U.S. will be subject to federal taxation.[87] Foreign corporations that only invest in and hold portfolios of U.S.
stock and debt securities are not. Investing, unlike trading or dealing, is not considered to be a trade or business,
regardless of its volume or frequency.[88]
In addition, a safe harbor protects CDO issuers that do trade actively in securities, even though trading in
securities technically is a business, provided the issuers activities do not cause it to be viewed as a dealer in
securities or engaged in a banking, lending or similar businesses.[89]
CDOs are generally taxable as debt instruments except for the most junior class of CDOs which are treated as
equity and are subject to special rules (such as PFIC and CFC reporting). The PFIC and CFC reporting is very
complex and requires a specialized accountant to perform these calculations and tax reporting.
Types[edit]
A) Based on the underlying asset:
Collateralized loan obligations (CLOs): CDOs backed primarily by leveraged bank loans.
Collateralized bond obligations (CBOs): CDOs backed primarily by leveraged fixed income securities.
Collateralized synthetic obligations (CSOs): CDOs backed primarily by credit derivatives.
Structured finance CDOs (SFCDOs): CDOs backed primarily by structured products (such as assetbacked securities and mortgage-backed securities).[90]
B) Other types of CDOs by assets/collateral include:
Commercial Real Estate CDOs (CRE CDOs): backed primarily by commercial real estate assets
Collateralized bond obligations (CBOs): CDOs backed primarily by corporate bonds
Collateralized Insurance Obligations (CIOs): backed by insurance or, more usually, reinsurance
contracts
CDO-Squared: CDOs backed primarily by the tranches issued by other CDOs.[90]
CDO^n: Generic term for CDO3 (CDO cubed) and higher, where the CDO is backed by other
CDOs/CDO2/CDO3. These are particularly difficult vehicles to model because of the possible repetition
of exposures in the underlying CDO.
Types of collateral[edit]
The collateral for cash CDOs include:
Structured finance securities (mortgage-backed securities, home equity asset-backed securities,

commercial mortgage-backed securities)
Leveraged loans
Corporate bonds
Real estate investment trust (REIT) debt
Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt)
Emerging-market sovereign debt
Project finance debt
Trust Preferred securities
Transaction participants[edit]
Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral
administrator, accountants and attorneys. Beginning in 1999, the Gramm-Leach-Bliley Act allowed banks to
also participate.
Investors[edit]
Investorsbuyers of CDOinclude insurance companies, mutual fund companies, unit trusts, investment
trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs
and structured investment vehicles. Investors have different motivations for purchasing CDO securities
depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better
yields than those that are available on more traditional securities (e.g., corporate bonds) of a similar rating. In
some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior
tranche and their cost of borrowing. This is true because senior tranches pay a spread above LIBOR despite
their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset
manager, and the credit support built into the transaction. Investors include banks and insurance companies as
well as investment funds.
Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral
portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income
securities. Investors include hedge funds, banks, and wealthy individuals.
Underwriter[edit]
The underwriter of a CDO is typically an investment bank, and acts as the structurer and arranger. Working with
the asset management firm that selects the CDO's portfolio, the underwriter structures debt and equity tranches.
This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality
tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche.
The key economic consideration for an underwriter that is considering bringing a new deal to market is whether
the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating
the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the
CDO's rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the
equityholders.
Other underwriter responsibilities include working with a law firm and creating the special purpose legal
vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDO's
tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading
restrictions that will be included in the CDO's transaction documents and other files.
The final step is to price the CDO (i.e., set the coupons for each debt tranche) and place the tranches with
investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches (A,
BBB, etc.) of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition,
the underwriter was generally expected to provide some type of secondary market liquidity for the CDO,
especially its more senior tranches.
According to Thomson Financial, the top underwriters before September 2008 were Bear Stearns, Merrill
Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities.[91] CDOs are more profitable for
underwriters than conventional bond underwriting because of the complexity involved. The underwriter is paid
a fee when the CDO is issued.
The asset manager[edit]
The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced
manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain
the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on the
underlying assets occur.
In theory, the asset manager should add value in the manner outlined below, although in practice, this did not
occur during the credit bubble of the mid-2000s (decade). In addition, it is now understood that the structural
flaw in all asset-backed securities (originators profit from loan volume not loan quality) make the roles of
subsequent participants peripheral to the quality of the investment.
The asset manager's role begins in the months before a CDO is issued, a bank usually provides financing to the
manager to purchase some of the collateral assets for the forthcoming CDO. This process is called warehousing.
Even by the issuance date, the asset manager often will not have completed the construction of the CDO's
portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend
for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed
drawdown notes, allowing the asset manager to draw down cash from investors as collateral purchases are
made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.
However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role.
During the CDO's "reinvestment period", which usually extends several years past the issuance date of the
CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities.
Within the confines of the trading restrictions specified in the CDO's transaction documents, the asset manager
can also make trades to maintain the credit quality of the CDO's portfolio. The manager also has a role in the
redemption of a CDO's notes by auction call.
There are approximately 300 asset managers in the marketplace. CDO Asset Managers, as with other Asset
Managers, can be more or less active depending on the personality and prospectus of the CDO. Asset Managers
make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and
subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative
business for asset managers. These fees, together with underwriting fees, administrationapprox 1.5 - 2% -- by
virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.
See also: List of CDO Managers
The trustee and collateral administrator[edit]
The trustee holds title to the assets of the CDO for the benefit of the "noteholders" (i.e., the investors). In the
CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator
produces and distributes noteholder reports, performs various compliance tests regarding the composition and
liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall
models.[92] In contrast to the asset manager, there are relatively few trustees in the marketplace. The following
institutions offer trustee services in the CDO marketplace:
ATC Capital Markets

Bank of New York Mellon (note: the Bank of New York Mellon recently also acquired the corporate
trust unit of JP Morgan which is the market share leader),
BNP Paribas Securities Services (note: currently serves the European market only)
Citibank
Deutsche Bank
Equity Trust
Intertrust Group (note: until mid-2009 was known as Fortis Intertrust)
HSBC
LaSalle Bank (Recently acquired by Bank of America Purchased by US Bank late 2010)
Sanne Trust
State Street Corporation
US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia in 2008 and Bank
of America in September 2011)
Wells Fargo
Wilmington Trust: Wilmington shut down their business in early 2009.
Accountants[edit]
The underwriter typically will hire an accounting firm to perform due diligence on the CDO's portfolio of debt
securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral
security. Source documents or public sources will typically be used to tie-out the collateral pool information. In
addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in
compliance with such tests.
The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of
payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity
notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each
payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be
made to the noteholders.
Attorneys[edit]
Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents.
Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory
requirements to disclose certain information to investors. This will be circulated to investors. It is common for
multiple counsels to be involved in a single deal because of the number of parties to a single CDO from asset
management firms to underwriters.
See also[edit]
Asset-backed security
Collateralized mortgage obligation (also known by initials CMO)
Collateralized fund obligation
Inside Job (2010 film), a 2010 Oscar-winning documentary film about the financial crisis of 20072010
by Charles H. Ferguson
List of CDO managers
Credit default swap
Single-tranche CDO
Synthetic CDO
The Big Short (2015 film)
References[edit]
1.
2.
Jump up ^ An "asset-backed security" is sometimes used as an umbrella term for a type of security backed by a
pool of assetsincluding collateralized debt obligations and mortgage-backed securities (Example: "A capital market in
which asset-backed securities are issued and traded is composed of three main categories: ABS, MBS and CDOs". (italics
added) (source: Vink, Dennis. "ABS, MBS and CDO compared: an empirical analysis" (PDF). August 2007. Munich Personal
RePEc Archive. Retrieved 13 July 2013.)
and sometimes for a particular type of that securityone backed by consumer loans (example: "As a rule of thumb,
securitization issues backed by mortgages are called MBS, and securitization issues backed by debt obligations are called
CDO, [and] Securitization issues backed by consumer-backed productscar loans, consumer loans and credit cards, among
othersare called ABS ... (italics added, source Vink, Dennis. "ABS, MBS and CDO compared: an empirical analysis" (PDF).
August 2007. Munich Personal RePEc Archive. Retrieved 13 July 2013.,
see also "What are Asset-Backed Securities?". SIFMA. Retrieved 13 July 2013. Asset-backed securities, called ABS, are
bonds or notes backed by financial assets. Typically these assets consist of receivables other than mortgage loans, such as
credit card receivables, auto loans, manufactured-housing contracts and home-equity loans.)
Jump up ^ Lemke, Lins and Picard, Mortgage-Backed Securities, 5:15 (Thomson West, 2014).
3.
^ Jump up to: a b Koehler, Christian. "The Relationship between the Complexity of Financial Derivatives and
Systemic Risk". Working Paper: 17.
4.
^ Jump up to: a b Lemke, Lins and Smith, Regulation of Investment Companies (Matthew Bender, 2014 ed.).
5.
Jump up ^ McLean, Bethany and Joe Nocera, All the Devils Are Here, the Hidden History of the Financial Crisis,
Portfolio, Penguin, 2010, p.120
6.
Jump up ^ Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the
United States, aka The Financial Crisis Inquiry Report, p.127
7.
^ Jump up to: a b c d e The Financial Crisis Inquiry Report, 2011, p.130
8.
^ Jump up to: a b The Financial Crisis Inquiry Report, 2011, p.133
9.
Jump up ^ Cresci, Gregory. "Merrill, Citigroup Record CDO Fees Earned in Top Growth Market". August 30,
2005. Bloomberg. Retrieved 11 July 2013.
10.
^ Jump up to: a b c d The Financial Crisis Inquiry Report, 2011, p.129
11.
Jump up ^ The Financial Crisis Inquiry Report, 2011, p.129-30
12.
^ Jump up to: a b McLean and Nocera, All the Devils Are Here, 2010 p.120
13.
^ Jump up to: a b c McLean and Nocera, All the Devils Are Here, 2010 p.121
14.
^ Jump up to: a b McLean and Nocera, All the Devils Are Here, 2010 p.123
15.
16.
Jump up ^ Morgenson, Gretchen; Joshua Rosner (2011). Reckless Endangerment : How Outsized ambition, Greed
and Corruption Led to Economic Armageddon. New York: Times Books, Henry Holt and Company. p. 283.
^ Jump up to: a b Morgenson and Rosner Reckless Endangerment, 2010 pp.279-280
17.
Jump up ^ McLean and Nocera, All the Devils Are Here, 2010 p.189
18.
^ Jump up to: a b Public Radio International. April 5, 2009. "This American Life": Giant Pool of Money wins
Peabody
19.
^ Jump up to: a b c d "The Giant Pool of Money". This American Life. Episode 355. transcript. May 9, 2008. NPR.
CPM.
20.
Jump up ^ of Moody's Analytics
21.
^ Jump up to: a b c Zandi, Mark (2009). Financial Shock. FT Press. ISBN 978-0-13-701663-1.
22.
Jump up ^ Hsu, Steve (2005-09-12). "Information Processing: Gaussian copula and credit derivatives".
Infoproc.blogspot.com. Retrieved 2013-01-03.
23.
Jump up ^ How a Formula Ignited Market That Burned Some Big Investors| Mark Whitehouse| Wall Street Journal|
September 12, 2005
24.
Jump up ^ "SIFMA, Statistics, Structured Finance, Global CDO Issuance and Outstanding (xls) - quarterly data
from 2000 to Q2 2013 (issuance), 1990 - Q1 2013 (outstanding)". Securities Industry and Financial Markets Association.
Retrieved 2013-07-10.
25.
Jump up ^ One study based on a sample of 735 CDO deals originated between 1999 and 2007, found the
percentage of CDO assets made up of lower level tranches from non-prime mortgage-backed securities (nonprime means
subprime and other less-than-prime mortgages, mainly Alt-A mortgages) grew from 5% to 36%. (source: Anna Katherine
Barnett-Hart The Story of the CDO Market Meltdown: An Empirical Analysis-March 2009)
26.
Jump up ^ Other sources give an even higher proportion. In the fall of 2005 Gene Park, an executive at AIG
Financial Products division found, "The percentage of subprime securities in the CDOs wasn't 10 percent -- it was 85
percent!" (source: McLean and Nocera, All the Devils Are Here, 2010 (p.201)
27.
Jump up ^ An email by Park to his superior is also quoted in the Financial Crisis Inquiry Report p.201: "The CDO
of the ABS market ... is currently at a state where deals are almost totally reliant on subprime/nonprime mortgage residential
mortgage collateral."
28.
Jump up ^ Still another source (The Big Short, Michael Lewis, p.71) says:
"The `consumer loans` piles that Wall Street firms, led by Goldman Sachs, asked AIG FP to insure went from being 2%
subprime mortgages to being 95% subprime mortgages. In a matter of months, AIG-FP, in effect, bought $50 billion in tripleB-rated subprime mortgage bonds by insuring them against default. And yet no one said anything about it ..."
29.
Jump up ^ In 2007, 47% of CDOs were backed by structured products, such as mortgages; 45% of CDOs were
backed by loans, and only less than 10% of CDOs were backed by fixed income securities. (source: Securitization rankings
of bookrunners, issuers, etc.
30.
Jump up ^ "Moody's and S&P to bestow[ed] triple-A ratings on roughly 80% of every CDO." (source: The Big
Short, Michael Lewis, p.207-8)
31.
Jump up ^ The Big Short, Michael Lewis, pp. 2078
32.
^ Jump up to: a b c Anna Katherine Barnett-Hart The Story of the CDO Market Meltdown: An Empirical AnalysisMarch 2009-Cited by Michael Lewis in The Big Short
33.
Jump up ^ "SEC Broadens CDO Probes". June 15th, 2011. Global Economic Intersection. Retrieved 8 February
2014. [Includes] graph and table from Pro Publica [that] show the size and institutional reach of the Magnetar CDOs
[versus the whole CDO market].
34.
Jump up ^ "Collateralized Debt Obligations Market" (Press release). Celent. 2005-10-31. Retrieved 2009-02-23.
35.
Jump up ^ Benmelech, Efraim; Jennifer Dlugosz (2009). "The Credit Rating Crisis" (PDF). NBER Macroeconomics
Annual 2009,. National Bureau of Economic Research, NBER Macroeconomics Annual.
36.
Jump up ^ The Financial Crisis Inquiry Report, 2011, p.134, section="Leverage is inherent in CDOs"
37.
^ Jump up to: a b Morgenson and Rosner Reckless Endangerment, 2010 p.278
38.
Jump up ^ see also Financial Crisis Inquiry Report, p.127
39.
Jump up ^ 70%. "Firms bought mortgage-backed bonds with the very highest yields they could find and
reassembled them into new CDOs. The original bonds ... could be lower-rated securities that once reassembled into a new
CDO would wind up with as much as 70% of the tranches rated triple-A. Ratings arbitrage, Wall Street called this practice. A
more accurate term would have been ratings laundering." (source: McLean and Nocera, All the Devils Are Here, 2010 p.122)
40.
Jump up ^ 80%. "Approximately 80% of these CDO tranches would be rated triple A despite the fact that they
generally comprised the lower-rated tranches of mortgage-backed securities. (source: The Financial Crisis Inquiry Report,
2011, p.127
41.
Jump up ^ 80%. "In a CDO you gathered a 100 different mortgage bondsusually the riskiest lower floors of the
original tower ...... They bear a lower credit rating triple B. ... if you could somehow get them rerated as triple A, thereby
lowering their perceived risk, however dishonestly and artificially. This is what Goldman Sachs had cleverly done. it was
absurd. The 100 buildings occupied the same floodplain; in the event of flood, the ground floors of all of them were equally
exposed. But never mind: the rating agencies, who were paid fat fees by Goldman Sachs and other Wall Street firms for each
deal they rated, pronounced 80% of the new tower of debt triple-A." (source: Michael Lewis, The Big Short : Inside the
Doomsday Machine WW Norton and Co, 2010, p.73)
42.
Jump up ^ The Financial Crisis Inquiry Report, 2011, p.103
43.
44.
^ Jump up to: a b Morgenson and Rosner Reckless Endangerment, 2010 p.280
45.
Jump up ^ see also: Bloomberg-Flawed Credit Ratings Reap Profits as Regulators Fail Investors-April 2009
46.
^ Jump up to: a b McLean and Nocera, All the Devils Are Here, p.124
47.
Jump up ^ PBS-Credit and Credibility-December 2008
48.
49.
50.
51.
Jump up ^ "Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed
securities ... in the place of real mortgage assets, these CDOs contained credit default swaps and did not finance a single
home purchase." (source: The Financial Crisis Inquiry Report, 2011, p.142)
Jump up ^ The Magnetar Trade: How One Hedge Fund Helped Keep the Bubble Going (Single Page)-April 2010
^ Jump up to: a b Final Report of the National Commission on the Causes of the Financial and Economic Crisis in the
United States, p.229, figure 11.4
52.
Jump up ^ The Big Short, Michael Lewis, p.95
53.
Jump up ^ The Financial Crisis Inquiry Report, 2011, p.87, figure 6.2
54.
^ Jump up to: a b Michael Lewis, The Big Short, p.94-7
55.
Jump up ^ Lewis, Michael, The Big Short
56.
Jump up ^ "CDOh no! (see "Subprime performance" chart)". The Economist. 8 November 2007.
57.
Jump up ^ By the first quarter of 2008, rating agencies announced 4,485 downgrades of CDOs. source: Aubin,
Dena (2008-04-09). "CDO deals resurface but down 90 pct in Q1-report". Reuters.
58.
59.
Jump up ^ "Bear Stearns Tells Fund Investors 'No Value Left' (Update3)". Bloomberg. 2007-07-18.
60.
Jump up ^ Many CDOs are marked to market and thus experienced substantial write-downs as their market value
collapsed during the subprime crisis, with banks writing down the value of their CDO holdings mainly in the 2007-2008
period.
61.
Jump up ^ Eavis, Peter (2007-10-24). "Merrill's $3.4 billion balance sheet bomb". CNN. Retrieved 2010-04-30.
62.
Jump up ^ "Herd's head trampled". The Economist. 2007-10-30.
63.
Jump up ^ "Citigroup chief executive resigns". BBC News. 2007-11-05. Retrieved 2010-04-30.
64.
Jump up ^ "Merrill sells assets seized from hedge funds". CNN. June 20, 2007. Retrieved May 24, 2010.
65.
Jump up ^ "Timeline: Sub-prime losses". BBC. May 19, 2008. Retrieved May 24, 2010.
66.
Jump up ^ http://www.sifma.org/research/pdf/SIFMA_CDOIssuanceData2008.pdf
67.
^ Jump up to: a b Aubin, Dena (2008-04-09). "CDO deals resurface but down 90 pct in Q1-report". Reuters.
68.
Jump up ^ nearly USD 1 trillion in mortgage bonds in 2006 alone
69.
Jump up ^ McLean, Bethany (2007-03-19). "The dangers of investing in subprime debt". Fortune.
70.
Jump up ^ "Warren Buffet on Derivatives" (PDF). Following are edited excerpts from the Berkshire Hathaway
annual report for 2002. fintools.com.
71.
Jump up ^ Raghu Rajan analyses subprime crisis| Mostly Economics| (from a speech given on December 17, 2007)
72.
Jump up ^ Wall Street Wizardry Amplified Risk, Wall Street Journal, December 27, 2007
73.
Jump up ^ Ng, Serena, and Mollenkamp, Carrick. "A Fund Behind Astronomical Losses," (Magnetar) Wall Street
Journal, January 14, 2008.
74.
Jump up ^ Morgenson, Gretchen; Joshua Rosner (2011). Reckless Endangerment : How Outsized ambition, Greed
and Corruption Led to Economic Armageddon. New York: Times Books, Henry Holt and Company. p. 278.
75.
Jump up ^ The Financial Crisis Inquiry Report, 2011, p.118-121
76.
Jump up ^ Bloomberg-Smith-Bringing Down Ratings Let Loose Subprime Scourge
77.
Jump up ^ Bloomberg-Smith-Race to Bottom at Rating Agencies Secured Subprime Boom, Bust
78.
Jump up ^ Morgenson and Rosner, Reckless Endangerment, 2010 p.280-1
79.
80.
Jump up ^ Lewis, Michael (2010). The Big Short : Inside the Doomsday Machine. W.W. Norton & Company. p. 73.
ISBN 978-0-393-07223-5.
Jump up ^ All the Devils Are Here, MacLean and Nocera, p.19
81.
Jump up ^ Mortgage lending using securitization is sometimes referred to as the originate-to-distribute approach,
in contrast to the traditional originate-to-hold approach. (The Financial Crisis Inquiry Report, 2011, p.89)
82.
Jump up ^ Koehler, Christian. "The Relationship between the Complexity of Financial Derivatives and Systemic
Risk". Working Paper: 42.
83.
84.
85.
86.
Jump up ^ http://archives1.sifma.org/assets/files/SIFMA_CDOIssuanceData2007q1.pdf
87.
Jump up ^ PEASLEE, JAMES M. & DAVID Z. NIRENBERG. FEDERAL INCOME TAXATION OF SECURITIZATION
TRANSACTIONS AND RELATED TOPICS. Frank J. Fabozzi Associates (2011, with periodic supplements,
www.securitizationtax.com): 1018.
88.
Jump up ^ Peaslee & Nirenberg. Federal Income Taxation of Securitization Transactions, 1023.
89.
Jump up ^ Peaslee & Nirenberg. Federal Income Taxation of Securitization Transactions, 1026.
90.
^ Jump up to: a b Paddy Hirsch (October 3, 2008). Crisis explainer: Uncorking CDOs. American Public Media.
91.
Jump up ^ Dealbook. "Citi and Merrill Top Underwriting League Tables". January 2, 2008,. New York Times.
Retrieved 16 July 2013.
92.
Jump up ^ Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary
of Wilmington Trust, which offer collateral administration services, but are not trustee banks.
External links[edit]
How a CDO is like a bottle of Champagne. From Marketplace
Global Pool of Money (NPR radio)
The Story of the CDO Market Meltdown: An Empirical Analysis-Anna Katherine Barnett-Hart-March
2009-Cited by Michael Lewis in "The Big Short"
Diagram and Explanation of CDO
CDO and RMBS Diagram-FCIC and IMF
What's a CDO? Interactive Graphic - December 2007
"Investment Landfill"
Portfolio.com explains what CDOs are in an easy-to-understand multimedia graphic
The Making of a Mortgage CDO multimedia graphic from The Wall Street Journal
JPRI Occasional Paper No. 37, October 2007 Risk vs Uncertainty: The Cause of the Current Financial
Crisis By Marshall Auerback
How credit cards become asset-backed bonds. From Marketplace
Vink, Dennis and Thibeault, Andr (2008). "ABS, MBS and CDO Compared: An Empirical Analysis"
[[Journal of Structured Finance|The Journal of Structured Finance]
"A tsunami of hope or terror?", Alan Kohler, Nov 19, 2008.
Collateralized Debt Obligations at Wikinvest

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List of CDO managers


This article needs attention from an expert on the subject. Please add a reason or a talk parameter to
this template to explain the issue with the article. Consider associating this request with a WikiProject.
(March 2011)
Collateralized debt obligations (CDOs) involve several parties. The following is a list of CDO managers and
sponsors.[1][2][3][4][5][6]
CDO managers[edit]
GoldenTree Asset Management [1] [6]

Trust Company of the West [3]
Cohen & Company [3]
Ellington Management [3]
Deutsche Bank [3]
Wharton Asset Management
Credit Suisse [3]
Vanderbilt Capital Advisors [3]
First Tennessee [3]
Deerfield Capital [3]
PIMCO [3]
WestLB [3]
Aladdin Capital [3]
Highland Capital Management [3]
Fortress Investments [3]
Bear Stearns [3]
BNP Paribas
Resource America [3]
Citigroup [3]
MassMutual [3]
Merrill Lynch [3]
Invesco [3]
Rabobank [3]
Intermediate Capital Group [3]
CDO sponsors[edit]
Merrill Lynch [5]

Citigroup [5]
UBS [5]
Deutsche Bank [4]
Wachovia [4]
Cohen Brothers [4]
Capmark [4]
LNR Partners [4]
NorthStar [4]
Newcastle Investments [4]
BlackRock Financial [4]
Sorin Capital Management [4]
Massachusetts Financial Services [4]
ARCap [4]
Capital Trust [4]
CWCapital [4]
Gramercy Capital [4]
Marathon Asset Management [4]
Guggenheim Structured Real Estate [4]
Teachers Insurance [4]
Arbor Realty [4]
Goldman Sachs [4]
Maples Finance [4]
Wrightwood Capital [4]
JE Robert Cos [4]
Brascan Real Estate Financial Partners [4]
CBRE Realty Finance [4]
Legg Mason Real Estate Investors [4]
Attentus Management [4]
Alliance Capital Management [4]
Five Mile Capital [4]
Morgan Stanley [4]
Prima Capital [4]
UNIQA Alternative Investments [4]
Credit Suisse [4]
Fortress Investments [4]
Shinsei Bank [4]
Vertical Capital [4]
Capital Lease Funding [4]
Redwood Trust [4]
Deutsche Genossenschafts-Hypothekenbank [4]
Collineo Asset Management [4]
Arch Commercial [4]
Maples Finance [4]
This list is incomplete; you can help by expanding it.
References[edit]
1.
Jump up ^ http://www.mpzlaw.com/downloads/CDOARTICLEAPRIL12008.pdf A Primer on the

ABCs of CDO litigation, New York Law Journal, Mark P Zimmett, 2008 4 1 Vol 239 No 62
2.
Jump up ^ CDO Due Diligence Q&A IncreMental Advantage interview with Zachary D. Rosenbaum,
2007, via lowenstein.com, accessed 2010 4 14
3.
^ Jump up to: a b c d e f g h i j k l m n o p q r s t u v Top CDO Managers Since 2001, Asset Backed Alert, abalert.com,
date unknown. Via Internet Archive's archive.org, archived page from 2008 01 29.
4.
^ Jump up to: a b c d e f g h i j k l m n o p q r s t u v w x y z aa ab ac ad ae af ag ah ai aj ak al am an ao ap CDO Sponsors Since 2000,

Commercial Mortgage Alert, cmalert.com, date unknown. Via Internet Archive's archive.org, archived page from
2007 09 28]
5.
^ Jump up to: a b c d Wall Street's Next Big Expense: Litigation Costs, Investment Dealers' Digest, 2008
Nov 17
6.
^ Jump up to: a b GoldenTree Asset Management GoldenTree Asset Management Corporate Website,
accessed 2010 09 23

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2.1 Pooling and transfer

2.3 Credit enhancement and tranching

2.5 Repayment structures

2.6 Structural risks and misincentives

3 Special types of securitization

3.1 Master trust

3.2 Issuance trust

3.3 Grantor trust

3.4 Owner trust

4 Motives for securitization

4.1 Advantages to issuer

4.2 Disadvantages to issuer

4.3 Advantages to investors

4.4 Risks to investors

Credit enhancement and tranching[edit]

A third-party letter of credit or corporate guarantee.

A back-up servicer for the loans.

Discounted receivables for the pool.

Structural risks and misincentives[edit]

Special types of securitization[edit]

Motives for securitization[edit]

Collateralized debt obligation, securitization vehicle for corporate debt securities

Collateralized mortgage obligation, securitization vehicle for mortgage-backed securities

Collateralized loan obligation, securitization vehicle for corporate loans

Jump up ^ Michael Simkovic, Competition and Crisis in Mortgage Securitization

Jump up ^ "ESF Securitization Data Report Q2:business

Jump up ^ Wachovia Press Releases

Jump up ^ "The Handbook of Asset-Backed Securities", Jess Lederman, 1990.

The Rocket Scientists of Finance BBC Programme: The City Uncovered

Asset-backed security (ABS)

Mortgage-backed security (MBS)

Credit default swap (CDS)

Collateralized debt obligation (CDO)

Collateralized mortgage obligation (CMO)

Collateralized bond obligation (CBO)

Collateralized loan obligation (CLO)

Collateralized fund obligation (CFO)

Senior stretch loan

Capital structure arbitrage

Equity market neutral

Fixed income arbitrage / Fixed-income relative-value

Commodity trading advisors / Managed futures account

Fund of hedge funds / Multi-manager

Arbitrage pricing theory

Assets under management

BlackScholes model (Greeks (finance): Delta neutral)

Capital asset pricing model (Alpha / Beta / Security

Taxation of private equity and hedge funds

Fund of hedge funds

Sovereign wealth funds

Alternative investment management companies

Hedge fund managers

Financial risk and financial risk management

Consumer credit risk

Commodity risk (e.g. Volume risk, Basis risk, Shape risk,

Holding period risk, Price area risk)

Interest rate risk

Liquidity risk (e.g. Refinancing risk)

Operational risk management

Modern portfolio theory

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