Collateralized debt obligations and credit default swaps

Find this piece with prettier formatting published here.

The CDO, the CDS, and the Subprime Mortgage Crisis

How these two financial instruments helped cause the financial crisis

What exactly are collateralized debt obligations (CDOs) and credit default swaps (CDSs)? This post draws from The Big Short by Michael Lewis and a study on CDOs by A.K. Barnett-Hart to summarize how these two financial instruments are structured and why they’re in part responsible for the financial crisis.

They have a well-deserved reputation for being very technical, but at their core they are simple concepts. A CDO is just a fancy bond, while a CDS is basically an insurance policy. Bear with me and I’ll try to explain them in the clearest terms I can. This is not so much about the actions of individual banks or hedge funds; instead, it’s about how these two instruments are structured.

First we get into the CDO, then the CDS, then how they relate to each other, and finally their role in the subprime mortgage crisis.

Mortgage-backed Securities

CDOs are made up of sections of mortgage bonds, or mortgage-backed securities (MBS). So to understand the CDO you have to first understand the mortgage bond. What is a mortgage bond?

If you’re buying a house you’re probably taking out a mortgage. That means that you’re getting a loan from a bank or a lending agency and then making a payment back every month with some interest.

Interest rates on mortgages are fairly high. A 30-year U.S. Treasury Bond may yield about 3 to 6%, while a homeowner pays between 5 to 10% on her monthly mortgage payment.  Mortgages offer much higher returns, and so investors are more attracted to them.

But for various reasons, it’s hard to invest in individual mortgages. They’re easier to invest when thousands of individual mortgages are bundled together to form a mortgage bond. The mortgage bonds were packaged by agencies like Fannie Mae and Freddie Mac, who bundled the mortgages from banks like Wells Fargo or lending agencies like the New Century Financial Corporation.

A mortgage bond isn’t like a corporate bond or a government bond. Instead, it’s a claim on payments from its thousands of mortgages. But just as a corporate bond can default, a mortgage bond can fail too: When enough individual mortgages failed, the entire bond won’t be able to generate its promised returns.

What happens when thousands of bonds get pooled together? Then the law of large numbers kicks in: Maybe a few mortgages will fail, but it’s unlikely that all of them will fail. The failure of a few are unlikely to sink the whole bond. So they’re pooled together to reduce the idiosyncratic risk of letting any single failure get in the way.

Continue reading