Securitization and Growth of CDO Markets

Securitization offers easier access to mortgage assets for institutional investors; direct holdings of home mortgage loans are difficult for them to procure because of uncertain credit quality of the loans and problems with servicing them. The pooling of assets achieves diversification as long as the assets are not perfectly correlated. By packaging together the mortgages from various areas, diversification would reduce the risks measured in terms of variance.

Furthermore, slicing the mortgage pool into different tranches according to credit quality makes them more acceptable to institutional investors: the riskiest claims against the mortgage pool could be sold to those who could tolerate high risk, while the safest AAA-rated portions could be held by more risk-averse investors. Because of the demand for AAA paper, the lower-quality securities that were issued against the initial package of mortgages were repackaged together with similar securities from other packages to create new AAA securities as portions of CDOs.

2.1 Securitization and CDO Structure

In the manner described above, structuring tranches with different levels of seniority reallocates risk across different securities. In the real world, as opposed to a Modigliani-Miller world characterized by perfect markets, there would be gains from tranching because of transaction costs, market incompleteness, and asymmetric information. As shown by DeMarzo (2005), a financial intermediary having superior information on his/her assets would like to sell the assets in a structured manner. When the number of assets is large and their returns are imperfectly correlated, the intermediary maximizes his/her revenue from the sale by pooling and tranching, as opposed to simply pooling or selling the assets individually. Tranching allows the intermediary to concentrate the default risk in one part of the capital structure, rendering a large share of the liabilities almost riskless; this, in turn, leads to a lower overall lemons discount that buyers demand.

Slicing through repeated securitizations of the original pools created very complicated structures of securities. The underlying difficulties in valuing these securities were not evident when the housing prices were rising and interest rates were low; these factors, in turn, kept the default rate unusually low. Once housing prices began to decline and the default rates began to rise as a result, concerns over the pricing and true value and risk of these securities became apparent.

CDOs contain many underlying assets, and modeling the payoffs of these securities require sophisticated cash flow models. Investors rely heavily on credit ratings in their valuation. At the time, however, there was little public information on how these ratings were calculated and how ratings on CDO securities were related to the underlying collateral quality.³

2.2 Growth of CDO Markets and Ratings

CDOs are special-purpose vehicles that hold portfolios of assets and issue securities backed by the cash flows from those assets. The collateral assets bear credit risk and are legally sold to a special-purpose entity to ensure bankruptcy remoteness from the issuer. The first CDOs were created in the 1980s, but the growth of the CDO markets did not accelerate until the early 2000s and it peaked in the first half of 2007. CDOs were regarded as “one of the most important new financial innovations of the past decade” (Longstaff and Rajan 2008).

Figure 1 [ PDF 121.4KB | 1 page ] presents the summary data of the amount of CDO issuances by type of underlying assets. The total amount of issuances peaked in the first half of 2007; the heavily used underlying collateral comprised structured financial products that included assets such as residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), ABS, collateralized mortgage obligations (CMOs), CDOs, CDSs, and other securitized/structured products. Since mid-2008, issuances have almost ceased. Hereafter, the CDOs backed by ABS (such as subprime RMBS) are referred to as ABS CDOs; these are typically resecuritized products. Sometimes, CDO-squared were created by further securitization of CDOs.

The defining feature of CDOs is their multi-tiered liability structure. As shown in Figure 2 [ PDF 60.3KB | 1 page ], CDOs typically issue multiple classes of financial claims with differing levels of seniority, against a diversified pool of assets. As funds to make interest and principal payments are generated by the underlying collateral, proceeds are distributed to the CDO investors in a prespecified manner, in order of seniority. When assets in the collateral pool miss payments, or default, the subordinated tranches are the first ones to absorb the losses.

One important aspect of these structured financial product markets is the extent to which investor demand is driven by credit ratings.⁴ A large fraction of the securities issued by CDOs were rated AAA: as shown in Figure 2, approximately 80% of the value of securities issued by CDOs was estimated to be rated AAA. In order to create a large share of safe securities from a pool of very risky assets, various tools of credit enhancements have been employed. These tools include overcollateralization and subordination, excess spread, and active management of the pool.

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