Collateralized Debt Obligations and Tranching

In the previous article, we learned about mortgage backed securities. We learned about how mortgages are pooled and then a special purpose entity is created as a pass through vehicle which allows security holders in the market to fund home owners to buy their homes.

However, in the case of mortgage backed securities, the cash flow from every security was identical in case it belonged to the same issuing entity. Therefore, all the securities from the same pool were fungible i.e. identical and could be exchanged for one another.

However, the needs of the financial market led the creative investment bankers to build further on these ideas. This was the birth of what we now know as collateralized debt obligations (CDO’s). In this article, we will trace the evolution of the collateralized debt obligations (CDO’s).

Different Needs

The mortgage backed securities only catered to the needs of the average investor. The mortgage risk was considered to be an average risk at that time. Therefore the mortgage backed securities were not fit for the needs of extremely risk averse investors such as pension funds.

Pension funds would like to invest in mortgage backed securities only if they had a little less risk. They would not mind if the yield of the securities were compromised too. On the other end of the spectrum there were investors who wanted to take on high risks if the returns were good enough. Hedge funds and other private funds would fall into this category. Once again, the mortgage backed securities did not meet their needs. They were ready to buy these securities if they offered better return and did not mind taking the additional risk.

So, the investment bankers observed that they were catering to the needs of only one type of investors. With the amount of mortgages they were buying, it would be difficult to securitize and sell them off unless they were also catering to the needs of the other two segments. Hence, a new instrument called collateralized debt obligations (CDO’s) was born.

Same Pool Sliced Differently

The logic behind the collateralized debt obligations (CDO’s) is simple. Instead of slicing the entire mortgage pool into similar pieces with the same risk return profile, they could slice the mortgage pool and create at least 3 different kinds of securities that would cater to the needs of these three different types of investors.

Hence, in case of collateralized debt obligations (CDO’s), the process remains the same till the half way mark. The originator makes a loan, sells it to an investment bank, who then moves it into a special purpose entity. Only the last step is different. Here, is where the mortgages are sliced and securities are created.

At this stage, the investment bank does what has come to be known as tranching. Tranche is a French word which means slice. Hence, the investment bank is slicing the mortgages to create different types of securities. The most common way was to create three types of tranches.

  • Equity Tranche: The bottom-most layer was called the equity tranche. If any defaults happened within the mortgage pool, they were first absorbed by the equity tranche. This meant that if any defaults happened they would not be split evenly amongst all the holders of the securities. Rather, the first blows will be taken by the people holding securities belonging to this tranche.

    Hence, they were facing an abnormally high risk of default as compared to members of the other tranches. As a result, they demanded more compensation. Therefore the equity tranche of the CDO’s were for investors with a high risk high return profile. Hedge funds and the other investors were happy to buy these securities as they met their needs.

  • Mezzanine Tranche: The middle layer was called the mezzanine tranche. The mezzanine tranche would remain unaffected by the defaults unless the value of the equity tranche was completely eroded. Once again the losses were not evenly split. The mezzanine tranche was second in the line of facing losses. Since they were relatively protected from these losses, they would get a lower return as compared to the people holding equity tranche securities from the same mortgage pool. The average investors who had an appetite for medium risk medium return profiles were happy to buy these securities.

  • Senior Tranche: Finally, the top most layer was called the senior tranche. The senior tranche would remain unaffected from any losses until the value of the equity and mezzanine tranches was completely eroded. Since senior tranche securities were only a very small part of any issue, the likelihood of that happening was very minimal. Hence, these securities would enjoy a very good credit rating from the agencies. This made these extremely low risk and low return profile. As a result, they became viable investment options for ultra conservative investors like pension funds and sovereign funds.

Hence CDO’s were able to help the mortgage backed securities proliferate every corner of the securities market. No matter what the risk return profile of the buyer, the securities market always had something to sell.

In fact, CDO’s became wildly popular in the years to come. There were even more innovations such as CDO square and CDO cube which were nothing but CDO’s which were created out of a pool of another CDO’s.

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