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Financial markets

Bond market Fixed income Corporate bond Government bond Municipal bond Bond valuation High-yield debt Image File history File links Broom_icon. ... This article does not cite any references or sources. ... Download high resolution version (480x640, 110 KB)Blockade in front of NYSE. Picture taken in April 2004. ... The bond market, also known as the debit, credit, or fixed income market, is a financial market where participants buy and sell debt securities usually in the form of bonds. ... This article does not cite any references or sources. ... A corporate bond is a bond issued by a corporation. ... A government bond is a bond issued by a national government denominated in the countrys own currency. ... In the United States, a municipal bond or muni is a bond issued by a state, city or other local government, or their agencies. ... Bond valuation is the process of determining the fair price of a bond. ... In finance, a high yield bond (non-investment grade bond, speculative grade bond or junk bond) is a bond that is rated below investment grade at the time of purchase. ...

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Derivatives market Credit derivative Hybrid security Options Futures Forwards Swaps The derivatives markets are the financial markets for derivatives. ... // A credit derivative is a financial instrument or derivative (finance) whose price and value derives from the creditworthiness of the obligations of a third party, which is isolated and traded. ... Definition A hybrid security, as the name implies, is a security that combines two or more different financial instruments. ... This article is about options traded in financial markets. ... In finance, a futures contract is a standardized contract, traded on a futures exchange, to buy or sell a certain underlying instrument at a certain date in the future, at a specified price. ... A forward contract is an agreement between two parties to buy or sell an asset (which can be of any kind) at a pre-agreed future point in time. ... For the Thoroughbred horse racing champion, see: Swaps (horse). ...

Other Markets Commodity market OTC market Real estate market Spot market Chicago Board of Trade Futures market Commodity markets are markets where raw or primary products are exchanged. ... Over-the-counter (OTC) trading is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. ... Real estate is a legal term that encompasses land along with anything permanently affixed to the land, such as buildings. ... Template:The Spot Market The Spot Market or Cash Marketis a commodities or securities market in which goods are sold for cash and delivered immediately. ...

Finance series Financial market Financial market participants Corporate finance Personal finance Public finance Banks and Banking Financial regulation Finance studies and addresses the ways in which individuals, businesses, and organizations raise, allocate, and use monetary resources over time, taking into account the risks entailed in their projects. ... This article does not cite any references or sources. ... There are two basic financial market participant catagories, Investor vs. ... Domestic credit to private sector in 2005 Corporate finance is an area of finance dealing with the financial decisions corporations make and the tools and analysis used to make these decisions. ... Personal finance is the application of the principles of finance to the monetary decisions of an individual or family unit. ... This article does not cite any references or sources. ... For other uses, see Bank (disambiguation). ... Financial supervision is government supervision of financial institutions by regulators. ...

v • d • e

For other subjects with the same abbreviation, see CDO. CDO may refer to: Collateralized debt obligation, a structured finance product Central dense overcast, in a tropical storm Cysteine dioxygenase, an enzyme Collaboration Data Objects, a Microsoft application programming interface for data access The ISO-639 code for Min Dong Chief Data Officer, an information systems title Chief Dental Officer...

In financial markets, collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets. This article does not cite any references or sources. ... An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ... Structured finance describes any non-standard way of raising money. ... The word tranche is French for slice. ... A credit rating assesses the credit worthiness of an individual, corporation, or even a country. ... In finance, coupons are attached to bonds, either physically, as with old bonds (with a stapler), or electronically. ...

Some news and media commentary blame the financial woes of the 2007 credit crunch on complexity of CDO products, and the failure of risk and recovery models used by credit rating agencies to value these products. Some institutions buying CDOs lacked the competency to monitor credit performance and/or estimate expected cash flows. As many CDO products are held on a mark to market basis, the paralysis in the credit markets and the collapse of liquidity in these products led to substantial write-downs in 2007. Major loss of confidence in the validity of process used by ratings agencies to assign credit ratings to CDO tranches occurred and persists into 2008. The subprime mortgage financial crisis, is an ongoing financial crisis that has caused a sharp rise in home foreclosures. ... This article does not cite any references or sources. ...

Market history and growth

First issued in the late 1980s, CDOs emerged a decade later as the fastest growing sector of the asset-backed synthetic securities market. This growth may reflect the increasing appeal of CDOs for a growing number of asset managers and investors, which now include insurance companies, mutual fund companies, unit trusts, investment trusts, commercial banks, investment banks, pension fund managers, private banking organizations, other CDOs and structured investment vehicles. It may also reflect the greater profit margins that CDOs provide their manufacturers. Insurance is a system to alleviate financial losses by transferring risk of loss from one entity to another. ... This article deals with U.S. mutual funds. ... A unit trust is a form of collective investment constituted under a trust deed. ... This article does not cite any references or sources. ... A commercial bank is a type of financial intermediary and a type of bank. ... Investment banks assist corporations in raising funds in the public markets (both equity and debt), as well as provide strategic advisory services for mergers, acquisitions and other types of transactions. ... A pension (also known as superannuation) is a retirement plan intended to provide a person with a secure income for life. ... Private banking is done by major institutional banks known as private banks, which offer financial services to private individuals. ...

A major factor in the growth of CDOs was the 2001 introduction by David X. Li of Gaussian copula models, which allowed for the rapid pricing of CDOs.

According to the Securities Industry and Financial Markets Association, aggregate global CDO issuance totaled USD $157 billion in 2004, USD $249 billion in 2005, and USD $489 billion in 2006. Research firm Celent estimates the size of the CDO global market to close to $2 trillion by the end of 2006.^[1] The Securities Industry and Financial Markets Association (SIFMA) is an industry trade group representing securities firms, banks and asset management companies in the U.S., Europe and Asia. ...

Concept

CDOs vary in structure and underlying assets, but the basic principle is the same. Essentially a CDO is a corporate entity constructed to hold assets as collateral and to sell packages of cash flows to investors. A CDO is constructed as follows:

• A Special Purpose Vehicle (SPV) acquires a portfolio of credits. Common assets held include mortgage-backed securities, CRE debt, and high-yield corporate loans.

• The SPV issues different classes of bonds and equity and the proceeds are used to purchase the portfolio of credits. The bonds and equity are entitled to the cash flows from the portfolio of credits, in accordance with the Priority of Payments set forth in the transaction documents. The senior notes are paid from the cash flows before the junior notes and equity notes. In this way, losses are first borne by the equity notes, next by the junior notes, and finally by the senior notes. In this way, the senior notes, junior notes, and equity notes offer distinctly different combinations of risk and return, while each reference the same portfolio of debt securities.

A CDO investor takes a position in an entity that has defined risk and reward, not directly in the underlying assets. Therefore, the investment is dependent on the quality of the metrics and assumptions used for defining the risk and reward of the tranches.

The issuer of the CDO, typically an Investment Bank, earns a commission at time of issue and earns management fees during the life of the CDO. An investment in a CDO is therefore an investment in the cash flows of the assets, and the promises and mathematical models of this intermediary, rather than a direct investment in the underlying collateral. This differentiates a CDO from a mortgage or a mortgage backed security (MBS).

The loss of an investor's principal is applied in reverse order of seniority (i.e., highest credit risk tranches to lowest). The senior tranche is protected by the subordinated security structure; thus, it is the most highly rated tranche. The equity tranche (also known as the first-loss tranche or "toxic waste") is most vulnerable, and has to offer higher coupons to compensate for the higher risk.

Structures

C D O is a broad term that can refer to several different types of products. They can be categorized in several ways. The primary classifications are as follows:

Source of funds -- cash flow vs. market value

• Cash flow CDOs pay interest and principal to tranche holders using the cash flows produced by the CDO's assets. Cash flow CDOs focus primarily on managing the credit quality of the underlying portfolio.
• Market value CDOs attempt to enhance investor returns through the more frequent trading and profitable sale of collateral assets. The CDO asset manager seeks to realize capital gains on the assets in the CDO's portfolio. There is greater focus on the changes in market value of the CDO's assets. Market value CDOs are longer-established, but less common than cash flow CDOs.

Motivation -- arbitrage vs. balance sheet

• Arbitrage transactions (cash flow and market value) attempt to capture for equity investors the spread between the relatively high yielding assets and the lower yielding liabilities represented by the rated bonds. The majority, 86%, of CDOs are arbitrage-motivated^[2].
• Balance sheet transactions, by contrast, are primarily motivated by the issuing institutions’ desire to remove loans and other assets from their balance sheets, to reduce their regulatory capital requirements and improve their return on risk capital. A bank may wish to offload the credit risk in order to reduce its balance sheet's credit risk.

Funding -- cash vs. synthetic

• Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
• Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums.

A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDO's reference portfolio. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below LIBOR. The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterpaty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDO's tranches can be precisely structured.

• Hybrid CDOs are an intermediate instrument between cash CDOs and synthetic CDOs. The portfolio of a hybrid CDO includes both cash assets as well as swaps that give the CDO credit exposure to additional assets. A portion of the proceeds from the funded tranches is invested in cash assets and the remainder is held in reserve to cover payments that may be required under the credit default swaps. The CDO receives payments from three sources: the return from the cash assets, the GIC or reserve account investments, and the CDS premiums.

Single-tranche CDOs

The flexibility of credit default swaps is used to construct Single Tranche CDOs (bespoke CDOs) where the entire CDO is structured specifically for a single or small group of investors, and the remaining tranches are never sold but held by the dealer based on valuations from internal models. Residual risk is delta-hedged by the dealer.

Variants

Unlike CDOs, which are terminating structures that typically wind-down or refinance at the end of their financing term, Structured Operating Companies are permanently capitalized variants of CDOs, with an active management team and infrastructure. They often issue term notes, commercial paper, and/or auction rate securities, depending upon the structural and portfolio characteristics of the company. Credit Derivative Products Companies (CDPC) and Structured Investment Vehicles (SIV) are examples, with CDPC taking risk synthetically and SIV with predominantly 'cash' exposure.

Banks and depository institutions are regulated by governments to disclose and handle their capital in a certain way. ... An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ... In finance, a mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. ... A credit default swap (CDS) is a bilateral contract under which two counterparties agree to isolate and separately trade the credit risk of at least one third-party reference entity. ... Commercial paper is a money market security issued by large banks and corporations. ...

Types of CDOs

The two main types of CDOs are:

• Collateralized loan obligations (CLOs) -- CDOs backed primarily by leveraged bank loans.

• Structured finance CDOs (SFCDOs) -- CDOs backed primarily by asset-backed securities and mortgage-backed securities (In 2006, 54% of CDOs were backed by structured finance and 35% were backed by leverage loans^[3])

Other types of CDOs include: An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ...

• Commercial Real Estate CDOs (CRE CDOs) -- backed primarily by commercial real estate assets

• Collateralized bond obligations (CBOs) -- CDOs backed primarily by corporate bonds

• Collateralized Insurance Obligations (CIOs) -- backed by insurance or, more usually, reinsurance contracts

• CDO-Squared -- CDOs backed primarily by the tranches issued by other CDOs.

• CDO^n -- Generic term for CDO^3 (CDO cubed) and higher, where the CDO is backed by other CDOs/CDO^2/CDO^3. These are particularly difficult vehicles to model due to the possible repetition of exposures in the underlying CDO.

This article belongs in one or more categories. ...

Types of Collateral

The collateral for cash CDOs include:

• Structured finance securities (mortgage-backed securities, home equity asset-backed securities, commercial mortgage-backed securities)

• Leveraged loans

• Corporate bonds

• Real estate investment trust (REIT) debt

• Commercial real estate mortgage debt (including whole loans, B notes, and Mezzanine debt)

• Emerging-market sovereign debt

• Project finance debt

• Trust Preferred securities

Structured finance describes any non-standard way of raising money. ... In finance, a mortgage-backed security (MBS) is an asset-backed security whose cash flows are backed by the principal and interest payments of a set of mortgage loans. ... An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ... A corporate bond is a bond issued by a corporation. ... // A Real Estate Investment Trust or REIT (rēt, rhymes with treat) is a tax designation for a corporation investing in real estate that reduces or eliminates corporate income taxes. ...

Transaction Participants

Participants in a CDO transaction include investors, the underwriter, the asset manager, the trustee and collateral administrator, accountants and attorneys.

Investors

Investors have different motivations for purchasing CDO securities depending on which tranche they select. At the more senior levels of debt, investors are able to obtain better yields than those that are available on more traditional securities (e.g. corporate bonds) of a similar rating. In some cases, investors utilize leverage and hope to profit from the excess of the spread offered by the senior tranche and their cost of borrowing. This is because senior tranches pay a spread above LIBOR despite their AAA-ratings. Investors also benefit from the diversification of the CDO portfolio, the expertise of the asset manager, and the credit support built into the transaction. Investors include banks and insurance companies as well as investment funds.

Junior tranche investors achieve a leveraged, non-recourse investment in the underlying diversified collateral portfolio. Mezzanine notes and equity notes offer yields that are not available in most other fixed income securities. Investors include hedge funds, banks, and wealthy individuals.

Underwriter

The underwriter, typically an investment bank, acts as the structurer and arranger of the CDO. Working with the asset management firm that selects the CDO's portfolio, the underwriter structures debt and equity tranches. This includes selecting the debt-to-equity ratio, sizing each tranche, establishing coverage and collateral quality tests, and working with the credit rating agencies to gain the desired ratings for each debt tranche. Underwriting refers to the process that a large financial service provider (bank, insurer, investment house) uses to assess the eligibility of a customer to receive their products like equity capital, insurance or credit to a customer. ...

The key economic consideration for an underwriter that is considering bringing a new deal to market is whether the transaction can offer a sufficient return to the equity noteholders. Such a determination requires estimating the after-default return offered by the portfolio of debt securities and comparing it to the cost of funding the CDO's rated notes. The excess spread must be large enough to offer the potential of attractive IRRs to the equityholders.

Other underwriter responsibilities include working with a law firm and creating the special purpose legal vehicle (typically a trust incorporated in the Cayman Islands) that will purchase the assets and issue the CDO's tranches. In addition, the underwriter will work with the asset manager to determine the post-closing trading restrictions that will be included in the CDO's transaction documents.

The final step is to price the CDO (e.g. set the coupons for each debt tranche) and place the tranches with investors. The priority in placement is finding investors for the risky equity tranche and junior debt tranches of the CDO. It is common for the asset manager to retain a piece of the equity tranche. In addition, the underwriter was generally expected to provide some type of secondary market liquidity for the CDO, especially its more senior tranches.

According to Thomson Financial, the top underwriters are Bear Stearns, Merrill Lynch, Wachovia, Citigroup, Deutsche Bank, and Bank of America Securities. CDOs are more profitable for underwriters than conventional bond underwriting due to the complexity involved. The underwriter is paid a fee when the CDO is issued. The Bear Stearns Companies, Inc. ... Merrill Lynch & Co. ... For Moravian settlements in North Carolina, see Wachovia, North Carolina. ... Citigroup Inc. ... Deutsche Bank AG (IPA: [1]) (ISIN: DE0005140008, NYSE: DB) (English: ) is a bank operating worldwide and employing more than 75,000 people (June, 2007). ... Bank of America (NYSE: BAC TYO: 8648) is the largest commercial bank in the United States in terms of deposits, and the largest company of its kind in the world. ...

The Asset Manager

The asset manager plays a key role in each CDO transaction, even after the CDO is issued. An experienced manager is critical in both the construction and maintenance of the CDO's portfolio. The manager can maintain the credit quality of a CDO's portfolio through trades as well as maximize recovery rates when defaults on CDO assets occur.

The asset manager's role begins before the CDO is issued. Months before a CDO is issued, a bank will usually provide financing to enable the manager to purchase some of the collateral assets that may be used in the forthcoming CDO in a process called warehousing.

Even by the issuance date, the asset manager often will not have completed the construction of the CDO's portfolio. A "ramp-up" period following issuance during which the remaining assets are purchased can extend for several months after the CDO is issued. For this reason, some senior CDO notes are structured as delayed drawdown notes, allowing the asset manager to drawdown cash from investors as collateral purchases are made. When a transaction is fully ramped, its initial portfolio of credits has been selected by the asset manager.

However, the asset manager's role continues even after the ramp-up period ends, albeit in a less active role. During the CDO's "reinvestment period", which usually extends several years past the issuance date of the CDO, the asset manager is authorized to reinvest principal proceeds by purchasing additional debt securities. Within the confines of the trading restrictions specified in the CDO's transaction documents, the asset manager can also make trades to maintain the credit quality of the CDO's portfolio. The manager also has a role in the redemption of a CDO's notes by auction call.

The manager's prominent role throughout the life of a CDO underscores the importance of the manager and his or her staff.

There are approximately 300 asset managers in the marketplace. Some collateral managers are active whilst some are nothing more than placebos where the investor will be at risk to the underlying portfolio. Asset Managers make money by virtue of the senior fee (which is paid before any of the CDO investors are paid) and subordinated fee as well as any equity investment the manager has in the CDO, making CDOs a lucrative business for asset managers. These fees, together with underwriting fees, administration{approx 1.5 - 2%} by virtue of capital structure are provided by the equity investment, by virtue of reduced cashflow.

See also: List of CDO Managers

Aladdin Capital Management Alcentra Capital Ares Management Avoca Capital AXA Investment Managers Babson Capital Management Baker Street Asset Management Cairn Capital Cambridge Place Investment Management Cheyne Capital Management Churchill Pacific Asset Management Cohen & Company Eiger Capital Faxtor Securities GSC Group Harbourmaster Capital ICP Asset Management Intermediate Capital Group Magnetar Capital...

The Trustee and Collateral Administrator

The trustee holds title to the assets of the CDO for the benefit of the noteholders. In the CDO market, the trustee also typically serves as collateral administrator. In this role, the collateral administrator produces and distributes noteholder reports, performs various compliance tests regarding the composition and liquidity of the asset portfolios in addition to constructing and executing the priority of payment waterfall models. Two notable exceptions to this are Virtus Partners and Wilmington Trust Conduit Services, a subsidiary of Wilmington Trust, which offer collateral administration services, but are not trustee banks. In contrast to the asset manager, there are relatively few trustees in the marketplace. The following institutions currently offer trustee services in the CDO marketplace:

• Bank of New York Mellon (note: the Bank of New York Mellon recently also acquired the corporate trust unit of JP Morgan which is the market share leader)
• HSBC
• LaSalle Bank (Recently acquired by Bank of America)
• Wells Fargo
• Deutsche Bank
• US Bank (note: US Bank recently also acquired the corporate trust unit of Wachovia)
• Fortis Intertrust (note: was formerly known as MeesPierson Intertrust)
• BNP Paribas Securities Services (note: currently serves the European market only)
• Wilmington Trust Company
• Sanne Trust
• State Street Corporation
• Virtus Partners (four partners split off from the former JPMorgan Trust shop to create a start up)

The Bank of New York Mellon Corporation (NYSE: BK), is a global financial services company formed on 2 July 2007 as result of the merger of The Bank of New York and Mellon Financial Corporation. ... John Pierpont Morgan John Pierpont Morgan I (April 17, 1837 – March 31, 1913) was an American financier and banker, who at the turn of the century (1901), was one of the wealthiest men in America. ... For other uses, see HSBC (disambiguation). ... LaSalle Bank Corporation is the holding company for LaSalle Bank N.A. and LaSalle Bank Midwest N.A. With $116 billion in assets, it is headquartered at 135 South LaSalle Street in Chicago, Illinois. ... Bank of America (NYSE: BAC TYO: 8648) is the largest commercial bank in the United States in terms of deposits, and the largest company of its kind in the world. ... An older Wells Fargo branch, located in Berkeley, California Wells Fargos corporate headquarters and main branch Wells Fargo & Co. ... Deutsche Bank AG (IPA: [1]) (ISIN: DE0005140008, NYSE: DB) (English: ) is a bank operating worldwide and employing more than 75,000 people (June, 2007). ... U.S. Bancorp (NYSE: USB) is a financial services holding company, headquartered in Minneapolis, Minnesota. ... For Moravian settlements in North Carolina, see Wachovia, North Carolina. ... BNP Paribas (Euronext: BNP, TYO: 8665 ) is one of the main banks in Europe and France. ... State Street Corporation (NYSE: STT) is a financial services company based in Boston, Massachusetts. ...

Accountants

The underwriter typically will hire an accounting firm to perform due diligence on the CDO's portfolio of debt securities. This entails verifying certain attributes, such as credit rating and coupon/spread, of each collateral security. Source documents or public sources will typically be used to tie-out the collateral pool information. In addition, the accountants typically calculate certain collateral tests and determine whether the portfolio is in compliance with such tests.

The firm may also perform a cash flow tie-out in which the transaction's waterfall is modeled per the priority of payments set forth in the transaction documents. The yield and weighted average life of the bonds or equity notes being issued is then calculated based on the modeling assumptions provided by the underwriter. On each payment date, an accounting firm may work with the trustee to verify the distributions that are scheduled to be made to the noteholders.

Attorneys

Attorneys ensure compliance with applicable securities law and negotiate and draft the transaction documents. Attorneys will also draft an offering document or prospectus the purpose of which is to satisfy statutory requirements to disclose certain information to investors. This will be circulated to investors. It is common for multiple counsels to be involved in a single deal due to the number of parties to a single CDO from asset management firms to underwriters.

Subprime mortgage crisis

This article or section may contain inappropriate or misinterpreted citations that do not verify the text. Please help improve this article by checking for inaccuracies. (July 2007) (help, talk, get involved!)

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Main article: Subprime mortgage crisis

See also: Subprime lending and Bear Stearns subprime mortgage hedge fund crisis

From 2003 to 2006, new issues of CDOs backed by asset-backed and mortgage-backed securities had increasing exposure to subprime mortgage bonds. In 2006, $200 billion in mezzanine ABS CDOs (mezzanine ABS CDOs are mainly backed by the BBB or lower-rated tranches of mortgage bonds) were issued with an average exposure to subprime bonds of 70%.^{[citation needed]} As delinquencies and defaults on subprime mortgages continue to rise to record levels, CDOs backed by significant mezzanine subprime collateral are expected to experience severe rating downgrades and possibly losses in the coming months and years. Image File history File links This is a lossless scalable vector image. ... Image File history File links Broom_icon. ... Prose is writing distinguished from poetry by its greater variety of rhythm and its closer resemblance to everyday speech. ... The subprime mortgage crisis is an ongoing problem manifesting itself through liquidity issues in the banking system which have become more prevalent due to foreclosures which accelerated in the United States in late 2006 and triggered a global financial crisis during 2007 and 2008. ... Subprime lending, also called B-paper, near-prime, or second chance lending, is the practice of making loans to borrowers who do not qualify for the best market interest rates because of their deficient credit history. ... The Bear Stearns Companies, Inc. ...

As the mortgages underlying the CDO's collateral decline in value, banks and investment funds holding CDOs face difficulty in assigning a precise price to their CDO holdings. Many are recording their CDO assets at par due to the difficulty in pricing CDOs.^{[citation needed]} The pricing challenge arises because CDOs do not actively trade and mortgage defaults take time to lead to CDO losses.

In June 2007, two hedge funds managed by Bear Stearns Asset Management Inc., an asset management company affiliated with a top U.S. investment bank, faced cash or collateral calls from lenders that had accepted CDOs backed by subprime loans as loan collateral. More losses are expected in the coming months.^{[citation needed]}

The now defunct Bear Stearns, but at that time the fifth-largest U.S. securities firm, said July 18, 2007 that investors in its two failed hedge funds will get little if any money back after "unprecedented declines" in the value of securities used to bet on subprime mortgages.^[4]

The extent of the declines in assets such as those at Basis Capital, an Australian securities firm, and Bear Stearns is being masked by the reluctance of investors to buy or sell the illiquid securities.^{[citation needed]}

Investors have criticized S&P, Fitch Ratings and Moody's Investors Service, saying their ratings on bonds backed by U.S. mortgages to people with limited credit didn't reflect the gaining default rate. They often gave top ratings to the securities. Some bonds have lost more than 50 cents on the dollar this year while their credit ratings haven't changed.

The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities is expected to slow significantly in the second-half of 2007 due to weakness in subprime collateral and the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds. This in turn could limit the availability of mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly $1 trillion in mortgage bonds in 2006 alone. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners are trying to refinance out of mortgage experiencing payment shock (e.g. adjustable-rate mortgages with rising interest rates).^[5] An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ... A mortgage-backed security (MBS) is a bond whose cash flows are backed by homeowners mortgage payements. ...

On 24th October 2007, Merrill Lynch reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations.^[6] Merrill Lynch & Co. ...

On 30th October 2007, Stan O'Neal, Merrill Lynch's CEO resigned from his position reportedly due to his involvement in the collateralized debt obligation crash this year.^[7]

On 4th November 2007, Charles (Chuck) Prince, Chairman and CEO of Citigroup resigned and cited the following reasons : "...as you have seen publicly reported, the rating agencies have recently downgraded significantly certain CDOs and the mortgage securities contained in CDOs. As a result of these downgrades, valuations for these instruments have dropped sharply. This will have a significant impact on our fourth quarter financial results. I am responsible for the conduct of our businesses. It is my judgment that the size of these charges makes stepping down the only honorable course for me to take as Chief Executive Officer. This is what I advised the Board."^[8]

See also

• Asset-backed security
• Collateralized mortgage obligation

An asset-backed security is a type of bond or note that is based on pools of assets, or collateralized by the cash flows from a specified pool of underlying assets. ... A Collateralized Mortgage Obligation (CMO) is a type of Mortgage Backed Security, which has been divided up into tranches. ...

References

External links

• Popular article - "Investment Landfill"
• Portfolio.com explains what CDO's are in an easy-to-understand multimedia graphic
• FinancialMathematics.com is a more technical source of information on CDO pricing
• The Making of a Mortgage CDO multimedia graphic from The Wall Street Journal

• JPRI Occasional Paper No. 37, October 2007 Risk vs Uncertainty: The Cause of the Current Financial Crisis By Marshall Auerback

explains how CDO's are essential to understanding the current financial crisis.