CDO Market

Since everyone wants to blame today’s whackage on the sub-prime debacle, lets look a little closer at CDOs. Today’s WSJ and Bloomberg each have interesting discussions on CDOs: their history (Bloomberg and how a mortgage becomes a CDO (WSJ):

"CDOs were first set up in 1987 by bankers at now-defunct Drexel Burnham Lambert Inc., the home of one-time junk bond king Michael Milken. Junk, or high-yield, debt are rated below Baa3 by Moody’s and BBB- by Standard & Poor’s.

Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating, and are known as the equity tranches because they are first in line for any losses. Investors in the equity portion expect to generate returns of more than 10 percent.

Fees for managers can range from 45 basis points to 75 basis points of the amount of the CDO, GoldenTree’s Wriedt said. For a $500 million CDO, a manager earning a fee of 50 basis points, or half a percentage point, would pocket $2.5 million a year until maturity."

The Journal looked at how CDO’s are built, with this helpful graphic:



Here’s an excerpt:

CDOs are an integral part of Wall Street’s mortgage dicing-and-slicing machine. After mortgages are written, investment banks pool them together and use the cash flows they produce to pay off mortgage-backed bonds, which the investment banks underwrite.

The mortgage bonds, in turn, are often packaged again into CDOs and sold off in slices. Investors can choose to buy the risky pieces of the bonds or purchase slices with less risk.

Last year CDOs soaked up an estimated $150 billion of mortgage-backed bonds, the vast majority of which were underpinned by subprime mortgages, according to Deutsche Bank. In recent weeks, rising defaults among subprime borrowers have sparked worries of a sharp downturn in the U.S. housing market. In December borrowers were at least 60 days late on roughly 14% percent of subprime loans packaged into mortgage bonds, up from just over 8% a year earlier, according to research firm First American LoanPerformance.

Now you know . . .


Mortgage Shakeout May Roil CDO Market
Subprime Defaults Lead to Wavering At Big Street Firms
WSJ, March 13, 2007; Page C3

CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt
Caroline Salas and Darrell Hassler
Bloomberg, March 13 2007

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