Collateralized Debt Obligation - Subprime Mortgage Crisis

Subprime Mortgage Crisis

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

The CDO played a pivotal role in financing the housing bubble that peaked in the U.S. during 2006. The CDO provided a key link between the global pool of fixed income investor capital and the U.S. housing market. In a Peabody Award winning program, CPM correspondents argued that a "Giant Pool of Money" (represented by $70 trillion in worldwide fixed income investments) sought higher yields than those offered by U.S. Treasury bonds early in the decade.

Further, this pool of money had roughly doubled in size from 2000 to 2007, yet the supply of relatively safe, income generating investments had not grown as fast. Investment banks on Wall Street answered this demand with financial innovation such as the mortgage-backed security (MBS) and collateralized debt obligation (CDO), which were assigned safe ratings by the credit rating agencies.

In effect, Wall Street connected this pool of money to the mortgage market in the U.S., with enormous fees accruing to those throughout the mortgage supply chain, from the mortgage broker selling the loans, to small banks that funded the brokers, to the giant investment banks behind them. By approximately 2003, the supply of mortgages originated at traditional lending standards had been exhausted. However, continued strong demand for MBS and CDO began to drive down lending standards, as long as mortgages could still be sold along the supply chain.

A sample of 735 CDO deals originated between 1999 and 2007 showed that subprime and other less-than-prime mortgages represented an increasing percentage of CDO assets, rising from 5% in 2000 to 36% in 2007; yet these CDOs were still rated the same, and their ratings did not get lower until many mortgage holders began to default. The main problem was that their risk was not diluted by combining large pools of low quality mortgages, and instead was spread more widely because the risks were highly correlated, and when one mortgage defaulted, many did, affected by the same financial events.

An early indicator of the crisis was the failure of two Bear Stearns hedge funds in July 2007. The assets held by these hedge funds had declined in value, in large part because of increasing defaults on subprime mortgages. Investors demanded their money back under contractual arrangements referred to as margin calls. The now defunct Bear Stearns, 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, despite investment-grade ratings from rating agencies.

On 24 October 2007, Merrill Lynch reported third quarter earnings that contained $7.9 billion of losses on collateralized debt obligations. A week later Stan O'Neal, Merrill Lynch's CEO, resigned from his position, reportedly as a result. On 4 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."

The new issue pipeline for CDOs backed by asset-backed and mortgage-backed securities slowed significantly in the second-half of 2007 and the first quarter of 2008 because of weakness in subprime collateral, the resulting reevaluation by the market of pricing of CDOs backed by mortgage bonds, and a general downturn in the global credit markets. Global CDO issuance in the fourth quarter of 2007 was USD 47.5 billion, a nearly 74 percent decline from the USD 180 billion issued in the fourth quarter of 2006. First quarter 2008 issuance of USD 11.7 billion was nearly 94 percent lower than the USD 186 billion issued in the first quarter of 2007. Moreover, virtually all first quarter 2008 CDO issuance was in the form of collateralized loan obligations backed by middle-market or leveraged bank loans, not by home mortgage ABS.

This trend has limited the mortgage credit that is available to homeowners. CDOs purchased much of the riskier portions of mortgage bonds, helping to support issuance of nearly USD 1 trillion in mortgage bonds in 2006 alone. Rating agencies were strongly criticized by regulators and other experts, including economist Joseph Stiglitz, for their role in enabling the origination of enormous amounts of low-quality debt packaged in CDOs with erroneous, high-quality credit ratings. In the first quarter of 2008 alone, rating agencies announced 4,485 downgrades of CDOs. Declining ABS CDO issuance could affect the broader secondary mortgage market, making credit less available to homeowners who are trying to refinance out of mortgages that are experiencing payment shock (e.g., adjustable-rate mortgages with rising interest rates).