Collateralized Debt Obligation
What is the relationship between collateralized debt obligation and sub prime mortgage loans? Although it is true that the two are intertwined, the apocalyptic economic scenarios which dominate the headlines today may be somewhat overstated. Some people seem ready to throw in their investment towels, resigned to inevitable and cascading losses. No person can predict the future, of course, but perhaps a closer look is warranted before giving way to hysteria or rushing to liquidate assets.
First of all, a general understanding of sub prime mortgages is necessary. Sub prime lending involves financing loans to those who may have trouble meeting conventional loan requirements. Some may have a low credit score, or excessive debt. Others may have even more serious credit issues, like foreclosures and bankruptcy, on their records. Sub prime mortgage loans are available for these types of borrowers, but due to the increased risk involved in these loans, higher interest rates or additional fees may be imposed. Also, there may be stricter requirements in the loan to value ratio. In other words, one may get less loan money in return for the value of the property held as collateral. Surprisingly, the requirements for income documentation may actually be less stringent for these loans than for a conventional loan. Some borrowers with income which is difficult to document may find it necessary to pursue one of these loans, even if their credit is good.
Next, a brief overview of collateralized debt obligation would be helpful. Collateralized debt obligations (CDOs) were first issued in the 1980's, and became a growing sector of the securities market. These investments are put together in a wide variety of ways and are made up of different assets, but the principles behind a CDO remain essentially the same. Assets (such as mortgage-backed securities, high yield business loans, etc.) are held as collateral in a special purpose vehicle (SPV) and the cash flow from the investment is distributed to the investor. The SPV issues different classes of bonds and equity. There are several tiers(tranches) of investors, ranging from senior tiers which are designed to have little risk, to the lower rungs, which have a far greater potential of loss. The returns on the investment are designed to correspond to the level of risk; lower tiers receive higher rates of return to compensate for the risk involved. The senior tranche receives less return, yet is paid first from the cash flow.
The collateralized debt obligation is different from a regular mortgage or mortgage-backed security because investment is actually made in this cash flow rather than in the asset itself. There are different levels of risk and reward, yet the same portfolio of securities generates the cash flow. In a sense, then, the investor is relying on (or investing in) their belief in the system or mathematical model which is behind the construction of the various tranches. One factor in the growth of CDOs was the development of the Gaussian copula model by banker David Li in 2000. He came up with a computerized model to determine whether a given group of companies would default on bond debt one after the other. Interestingly, the model is based on a concept known as the 'broken heart'. Actuaries noticed that at times there is a correlation between a death of a spouse and his/her partner, where a person is more likely to die soon after the death of a beloved spouse. Mr. Li saw default as the 'death' of a company, and used these principles to come up with a model which made pricing collaterallized debt obligations faster and easier. Li's model used copulas, particularly one named after Carl F. Gauss, a 19th century German statistician. Copulas are mathematical models which predict the likelihood of events occurring when these events are interrelated.
Using this Gaussian copula model, investors can estimate risk and return, and devise strategies accordingly. If there is a high default correlation (high likelihood that all the companies in a particular sector will have losses at once), the difference between returns for risky vs. conservative investments might be small. However, if the pool of bonds had a low risk of default (low risk of the companies suffering losses all at once) the spread could be wider. Huge amounts of money are invested using this model or its variations. Even though this system has resulted in market growth, it is not foolproof. Investors who use such models without fully understanding them may think that they have taken sufficient precautions against loss when actually the system guarantees nothing. Not only are such investors suffering loss, but also there may be collateral damage to other markets which can trigger a loss avalanche.
How does this all relate to sub prime mortgage loans? Well, such sub prime mortgage debt is often a significant part of the investments bundled together in a collateralized debt obligation. Some large investment firms had great fortunes tied up in securites based on sub prime mortgage loans. In fact, one well known firm's recent collapse (even after assistance was given by the Federal Reserve) seemed due to the sub prime mortgage loan crisis which devalued its assets. Some believe that the government should not be involved at all in giving assistance in such matters, while others want the government to purchase foreclosed properties in order to stop falling housing prices. Others warn of upcoming waves of foreclosures and look for interest rate cuts. The government points to the many people already assisted by current programs and awaits the impact of billions of tax rebates due in upcoming months upon the economy. The uncertainty of future events provides a bleak background against which the light of God's Word in I Timothy 6:17 shines even more brightly: Charge them that are rich in this world, that they be not highminded, nor trust in uncertain riches, but in the living God, who giveth us richly all things to enjoy... That is a model which will never fail.
First of all, a general understanding of sub prime mortgages is necessary. Sub prime lending involves financing loans to those who may have trouble meeting conventional loan requirements. Some may have a low credit score, or excessive debt. Others may have even more serious credit issues, like foreclosures and bankruptcy, on their records. Sub prime mortgage loans are available for these types of borrowers, but due to the increased risk involved in these loans, higher interest rates or additional fees may be imposed. Also, there may be stricter requirements in the loan to value ratio. In other words, one may get less loan money in return for the value of the property held as collateral. Surprisingly, the requirements for income documentation may actually be less stringent for these loans than for a conventional loan. Some borrowers with income which is difficult to document may find it necessary to pursue one of these loans, even if their credit is good.
Next, a brief overview of collateralized debt obligation would be helpful. Collateralized debt obligations (CDOs) were first issued in the 1980's, and became a growing sector of the securities market. These investments are put together in a wide variety of ways and are made up of different assets, but the principles behind a CDO remain essentially the same. Assets (such as mortgage-backed securities, high yield business loans, etc.) are held as collateral in a special purpose vehicle (SPV) and the cash flow from the investment is distributed to the investor. The SPV issues different classes of bonds and equity. There are several tiers(tranches) of investors, ranging from senior tiers which are designed to have little risk, to the lower rungs, which have a far greater potential of loss. The returns on the investment are designed to correspond to the level of risk; lower tiers receive higher rates of return to compensate for the risk involved. The senior tranche receives less return, yet is paid first from the cash flow.
The collateralized debt obligation is different from a regular mortgage or mortgage-backed security because investment is actually made in this cash flow rather than in the asset itself. There are different levels of risk and reward, yet the same portfolio of securities generates the cash flow. In a sense, then, the investor is relying on (or investing in) their belief in the system or mathematical model which is behind the construction of the various tranches. One factor in the growth of CDOs was the development of the Gaussian copula model by banker David Li in 2000. He came up with a computerized model to determine whether a given group of companies would default on bond debt one after the other. Interestingly, the model is based on a concept known as the 'broken heart'. Actuaries noticed that at times there is a correlation between a death of a spouse and his/her partner, where a person is more likely to die soon after the death of a beloved spouse. Mr. Li saw default as the 'death' of a company, and used these principles to come up with a model which made pricing collaterallized debt obligations faster and easier. Li's model used copulas, particularly one named after Carl F. Gauss, a 19th century German statistician. Copulas are mathematical models which predict the likelihood of events occurring when these events are interrelated.
Using this Gaussian copula model, investors can estimate risk and return, and devise strategies accordingly. If there is a high default correlation (high likelihood that all the companies in a particular sector will have losses at once), the difference between returns for risky vs. conservative investments might be small. However, if the pool of bonds had a low risk of default (low risk of the companies suffering losses all at once) the spread could be wider. Huge amounts of money are invested using this model or its variations. Even though this system has resulted in market growth, it is not foolproof. Investors who use such models without fully understanding them may think that they have taken sufficient precautions against loss when actually the system guarantees nothing. Not only are such investors suffering loss, but also there may be collateral damage to other markets which can trigger a loss avalanche.
How does this all relate to sub prime mortgage loans? Well, such sub prime mortgage debt is often a significant part of the investments bundled together in a collateralized debt obligation. Some large investment firms had great fortunes tied up in securites based on sub prime mortgage loans. In fact, one well known firm's recent collapse (even after assistance was given by the Federal Reserve) seemed due to the sub prime mortgage loan crisis which devalued its assets. Some believe that the government should not be involved at all in giving assistance in such matters, while others want the government to purchase foreclosed properties in order to stop falling housing prices. Others warn of upcoming waves of foreclosures and look for interest rate cuts. The government points to the many people already assisted by current programs and awaits the impact of billions of tax rebates due in upcoming months upon the economy. The uncertainty of future events provides a bleak background against which the light of God's Word in I Timothy 6:17 shines even more brightly: Charge them that are rich in this world, that they be not highminded, nor trust in uncertain riches, but in the living God, who giveth us richly all things to enjoy... That is a model which will never fail.
Collateralized Debt Obligation
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