Collateralized Mortgage Obligation (CMO)

The world’s financial system was almost brought down in 2008 by the collapse of Lehman Brothers that was a major international investment bank at that time. The government sponsored these banks’ bailouts that were funded by tax money in order to restore the industry. Before the crisis, banks were lending irresponsible mortgages to subprime borrowers who had poor credit histories. These mortgages were purchased by banks and packaged into low-risk securities known as collateralized debt obligations (CDOs). CDOs were divided into tranches by its default risk. The ratings of those risks were determined by rating agencies such as Moody’s and Standard & Poor’s. However, those agencies were paid by banks and created an environment in which agencies were being generous to ratings since banks were their major clients.

In the 1980s, investments banks such as Goldman Sachs, Merrill Lynch, Bear Stearns, JP Morgan, and Morgan Stanley started selling mortgage bonds. Mortgage bonds were a collection of thousands of home mortgages, purchased from lenders, and their associated income streams (monthly payment). To address the fact that some homeowners often refinance their debt when interest rates are low which prematurely pays off the debt, mortgage bonds were stacked into layers called ‘tranches’. The lowest tranche represented mortgages to be paid off early, and the highest layer was the last mortgages to be paid off.

A ________ pays out cash flows from subprime mortgage-backed securities in different tranches, with the highest-rated tranch paying out first, while lower ones paid out less if there were losses on the mortgage-backed securities.

Capital Trust Mortgage Corp. is a mortgage brokerage firm that is located in Miami, Florida. Capital Trust Mortgage Corp. was established in 1995. Their loan programs include conventional, FHA, VA, jumbo, foreign national, and alternative and subprime loans. Capital Trust Mortgage Corp. is a proud member of the Florida Association of Mortgage Professionals, NAMB- The Association of Mortgage Professionals, and NMLS. This mortgage lending agency is an Equal Housing Lender.

Rating agencies would rate CDO’s (Collateralized Debt Obligations) on the basis of what tranches they were put into. The highest credit rating and safest is an AAA senior tranche, which has the lowest return because it’s considered “safe”. The middle tranches are rated AA and BB, these are considered riskier but have a higher rate of return. Eventually, when qualified people who would be considered to have an AAA mortgage ran dry. Lenders were quick to lend money out to lower-rated mortgages because they knew they would sell the to investors and pass on the risk to someone else. Even rating agencies were rating BB tranches and then labeling them AAA. While all of this was happening, big time investors thought they were buying safe investments

A CDO, as I understand it as it is an extremely complicated instrument, is a collection mortgage loans built by the financial industry, particularly the investment banks, to help package loans for credit agencies like Moody’s or Standard and Poor’s to more easily assign it the coveted “triple A rating”. The problem with these CDOs was that they housed hundreds and thousands of loans of varying credit ratings. By throwing in horribly rated B loans with a few triple A loans banks and insurance companies were able to insure and distribute mortgage loans to customers that were not able to normally receive a loan with a triple A credit rating. A triple A credit rating is essentially the rating agency saying “Yes this customer can pay off this loan and will not default or foreclose on their home.” The banks and insurance agencies didn’t have models to predict what would happen if multiple houses defaulted at the same time. All of their numbers and statistics were predicated on housing value going

If a borrower has collateral that he or she can use to secure a loan, the lender can feel more confident that the loan will be repaid. A mortgage is a type of secured loan; the home is the collateral, and if the borrower does not make payments, the lender can foreclose and sell the house to recoup all or most of the

After this, mortgage aggregators purchase the individual residential mortgages. These agencies group the mortgages to create a type of asset-backed security called Mortgage-Backed Security (MBS). The purpose to create a MBS is to sell them to investors and therefore can be traded on the securities markets. The securities owners receive principal and interest payments from homeowners either directly (mortgage-pass through) or by a financial company that change the way

Mortgage-backed securities (MBSs) are shares of a home loan sold to investors. They work like this: A bank lends a borrower the money to buy a house and collects payments on the loan. This loan and a number of others, perhaps thousands, are sold to a larger bank that compiles the loans together into a mortgage-backed security. The larger bank then issues shares of this security, called tranches (French for "slices"), to investors who buy them and ultimately collect the dividends in the form of the monthly mortgage payments. These tranches can be further repackaged and sold again as other securities, called collateralized debt obligations (CDOs). Home loans in 2008 were so divided and spread across the financial spectrum; it was possible a given

Collateralized debt obligations (CDOs) refers to a kind of innovative derivative securities product which simply bundling mortgage debt, bonds, loans and other assets together and then rearranging these assets into different tranches with different credit ratings, interest rate payments, risks, and priority of repayment to meet the needs of different investors. As borrowers began to default, investors in the inferior tranche of the CDOs took the first hit, so the owner of this tranche of CDOs may be riskier. In order to compensate for the higher risk, the subordinate tranche receives higher rate of return while the superior tranche receives lower rate but still nice return. To make the top even safer, the banks ensured it small fee called the credit default swap (CDS). The banks do all of the works so that creating rating agencies will stamp the top tranche since as a safe, triple A rated

In the new system, an investment banker buys the mortgage from the lender, borrowing millions of dollars to buy thousands of mortgages, and every month he gets payments from homeowners for each of the mortgages. The banker then consolidates all the mortgages and splits the final product into three sections: safe, okay, and risky mortgages, which make up a collateralized debt obligation (CDO). As homeowners pay their mortgages, money flows into each of the sections, with the safe filling first and the risky filling last, contributing to their respective names. Credit agencies stamp the top two safer mortgages with a triple A or triple B rating, which are then be sold to investors who want a safe mortgage, while the risky slice is sold to hedge funds who want a risky investment. The bankers make millions, pay back their loans, and investors also make a worthwhile investment. So pleased are the investors, however, that they want more. Unfortunately, back at the beginning of the cycle, the mortgage broker can no longer find qualified mortgagers

In the 1980s innovation was added to the traditional old bond. A bond was basically a promise (from government or corporation) to make interest payments on borrowed money, and, to eventually pay back the borrowed money. For generations, financial markets traded bonds in this way. Given that a bond was an income in a way based on borrowed money, Wall Street, in the late 1980s decided to create “bond-like” financial products from other debt-based income like credit cards, student loans, and most importantly in this case, home mortgages. The “mortgage bond” was created and became a financial product that was bought and sold by Wall Street investment banks. The mortgage bond would collect many home mortgages, purchased from lenders, and

In relation to the increase in house’s price, the rise of financial agreements such as mortgage-backed securities (MBS) and collateralized debt obligations (CDO) encouraged investors to invest in the U.S housing market (Krugman, 2009). When housing price declined in the U.S, many financial institutions that borrowed and invested in subprime mortgage reported losses. In addition, the fall of housing price resulted in default and foreclosure and that began to exhaust consumer’s wealth and

Collateralised Debt Obligations, short for CDOs, is an important part of asset securitisation. CDOs provided more liquidity in the economy which was a popular financial innovation. It is an innovative financial product that repackages different debts into a new portfolio. In CDOs, investment bank gathered a series of assets from the fixed-income market, such as mortgage-backed securities, credit-default swaps, and high-yield bonds. Once the CDO has created by the investment bank, it would distribute the cash flows from those mentioned assets to investors in the CDO. CDOs pool all the cash flows from its collection of assets together and divided into rated tranches or slices, in order to satisfy the needs of different risk preferences of investors. Suppose there are three basic tranches, safe, good enough and risky. When money comes in, the top one will be filled in first. It

After watching “the Big Short,” I understand some aspect of the mortgage crisis in 2007 from the movie. I learned a new concept: CDO and synthetic collateralized debt obligations (CDO). Poorly structured loans are packaged into CDO, and then it obtains good ratings (where in fact they deserve BB or even worse ratings). The movie explained synthetic CDO using the blackjack scene of Selena Gomez. Every person bet on the previous people’s bet as a side bet while Gomez is winning. However, once Gomez loses her hand, these large side bets set off the domino effect and create a giant loss in the system. This is an accurate metaphor