0

I was reading a comparative description in between CDO's and CMO's on Investopedia.com and I cant seem to understand the following statement:

When the mortgages underlying a CMO are of poor credit quality, such as subprime loans, overcollateralization will occur

from what I understand overcollateralization occurs when the lender receives more collateral then what the loan was worth, so would it not be true that if the underlying mortgage debts have a high risk of default then they are worth less then the loan was worth

In other words the bonds would actually be undercollateralized

I would appreciate if someone could provide a clear explanation

there is the original link that the text refers to :

http://www.investopedia.com/ask/answers/07/cmo-cbo.asp

3 Answers 3

4

I think the definition of overcollateralization on investopedia will answer this question for you. Namely this part:

For example, in the case of a mortgage backed security, the principal amount of an issue may be $100 million while the principal value of the mortgages underlying the issue may be equal to $120 million.

The bond is packed with more mortgages than the face value indicates. It's effectively sold at a discount to underlying value.

4
  • so what you are saying is that there are more mortgages in the bond , but they are of lesser quality? Commented Sep 13, 2016 at 22:22
  • Yes they are of lesser quality in that they are more likely to default. That is why they are sold at a discount.
    – paulzag
    Commented Sep 13, 2016 at 22:28
  • ok so to compensate for the risk of default the issuer must put more mortgages in the bond, to "diversify it" Commented Sep 13, 2016 at 22:51
  • 3
    It's not to diversify it. It's just to provide more collateral. You're over-thinking this - if you needed $100m of good mortgages of collateral then you might need $120m of poorer quality mortgages. Commented Sep 14, 2016 at 9:32
1

Say there are 5 people took loan of $100000 each. Those 5 people work in different jobs and have different capacity to payoff loan. Someone earning $40000 a year has higher risk to default on their payment then someone making $250000 a year.

  • Say investment bank creates one CDO out of it by putting all those loans in one basket with underlying asset worth $500000.
  • You can think of CDO as a single loan worth $500000.
  • CDO units are then sold to investors.
  • CDO contains loans of various risk factor but overall risk is average of all risks of underlying assets.
  • Bank gets payment from mortgage holder and it pays CDO holder.

As Bank wants to sell this CDO to investor but how would investor know what the risk factor for this CDO is. This is where rating agency comes in picture. They apparently look at the underlying asset and assign rating to this CDO say AAA, B, AA etc which give investor idea of underlying risk.

Problem here is rating agency gets paid by Bank to rate their CDO. So if a rating agency starts rating their CDO to higher risk Bank will go to next agency round the corner to get better rating and agency will lose commission. You can see the problem here.

Now if people start struggling to pay loan, bank will not get money and it cannot pay CDO holders. If house that was worth $100000 when CDO was created is devalued to say $50000 today the underlying asset is not worth as much when CDO was sold. That is what happened when market crashed in 2008 and GFC hit.

0

Actually, you're missing the key feature of CDOs. Most CDOs use (much to our economic misery, ultimately) a system call tranching. To simplify this idea, I'll make a two tranch example. Suppose I buy mortgages covering a face value of $120,000,000. Because they are subprime, if I just put them in a pool and finance them with bonds, the rating will be lousy and most investors will shun them (at least investors who are safety oriented). What I do is divide them into two tranches. One bond issue is for $100,000,000 and another for $20,000,000. The idea is that any defaulting mortgage comes out of the latter bond issue. I'll probably keep these bonds (the lower tranch). Thus buyers of the first issue are safe unless defaults exceed $20,000,000. Then the rating agencies rate the first issue AAA and it gets snapped up by investors. In a strict sense it is overcollateralized, basically the entire $120,000,000 backs up the first bond issue.

In reality, many CDOs had multiple tranches, with the lowest tranch being retained by the underwriters and the other tranches sold as bonds of various ratings.

You must log in to answer this question.

Not the answer you're looking for? Browse other questions tagged .