So, in my last article post on this topic, I talked about Mortgage-Backed Securities AKA Collateralised Mortgage Obligations (click here).
The key points:
- A bank/mortgage-lender builds a pool of mortgages.
- It repackages the cash-flows that it will receive from the mortgage pool, and sells them to investors as Mortgage-Backed Securities (MBSs).
- The MBSs are split into tranches which are then rated by the Ratings Agencies.
- The higher ratings (from A/BBB upwards – depending on the scale being used) are considered Investment Grade.
- The lower ratings are considered Junk Grade.
The real attraction behind a AAA-rated MBS is that they give much higher returns that AAA-rated bonds (measured in basis points, or bps – which is 1/100th of 1% of the face value of the bond/security).
I’ve drawn a rough diagram of what the rating pool would look like:
|The Rated Mortgage Pool – roughly
Note 1: depending on the rating agency, junk status could include or exclude BBB ratings
Note 2: this is very simplified – there are numerous ways of packaging a mortgage pool cash-flows. But the important point is that there are mortgage pool cash-flows, that these are split into different tranches with different risk characteristics, and that these tranches are then rated.
At the same time, the banks would follow the same process as the above for other types of “asset” – like automobile finance loans, and credit card receivables – basically any type of loans/financing extended by the banks. These securities were known as Asset-Backed Securities, or ABS.
In the same way, the ABS tranches would be rated. And again, as with the MBS/CMO, the investment grade securities could be sold off, but the junk grade securities are more difficult to get rid of.
So we have all these investment-grade securities in circulation, but the banks are left holding the junk securities. NOT good for the books – highly risky, and not generating any returns.
Solution: the Collateralised Debt Obligation, or CDO.
A basic cash-flow CDO build-up is as follows:
- the banks collect junk securities together from different types of Asset-Backed Securities (including Mortgage-Backed Securities) in order to build a Debt Obligation Pool.
- Split the Debt Obligation pool into more tranches.
- Get the Ratings Agencies to rate these tranches from investment grade all the way back down to junk status.
Why investment grade despite the fact that the underlying securities have junk status? Because the Ratings Agencies, in their wisdom, decided that the different types of debt obligation created enough risk diversification to be worthy of investment-grade status.
Which is empirically incorrect: because if you bring junk together, it does not make gold. While the types of debt may have been different, the underlying economic risk is the same. In an economic downfall, the junk stuff will go first, regardless of which pool it’s in.
So now we have investment grade CDO securities, but we’re still left with the junk securities. What to do?!
Rinse and repeat.
Take the junk-grade CDO tranches add to more CDO pools. Which would then be re-rated with investment-grade status down to junk, and then they’d go again:
|The creation of a CDO from Four initial ABS and MBS pools
I almost feel like I want to add a disclaimer at this point. Just because it all feels so unreal.
But there we are.
And in perfect hindsight, the stage is perfectly primed for crisis (excuse the pun). We have a collection of really risky assets being sold with investment grade status.
All it needed was a trigger. As it turned out, the Subprime Mortgage was the smoking gun.
The full drama in the next post.