A primer on subprime (1 of 5): On CDOs, SPVs and CDSs

I prepared this in anticipation of a forum that ultimately did not materialise. It’s not so topical now, but better late than never ….

The roots of our current crisis are in the US housing and consumer-credit boom. This was fuelled by the Wall Street innovation called CDOs – Collateralised Debt Obligations.

The amount that any financial institution can lend is constrained by the capital it has. Historically, banks kept the mortgages on their balance sheets – these are their assets on which they earn interest income. Against these mortgages, they had to keep a certain level of capital aside to insulate against defaults.

Then, Wall Street invented special purpose vehicles (SPVs) just to buy and pool thousands and thousands of mortgages together. These SPVs raised the money to buy the mortgages by issuing their own securities – the CDOs. Banks were happy to sell their mortgages to the SPVs because it freed up their capital to make new loans.

Basic financial/statistical theory is that it is hard or impossible to predict if any single mortgage will default. But if you have a pool of, say 10,000 separate mortgages, you can be reasonably sure that, say, 98% will be fine and 2% will default. So the SPVs issued CDOs with varying risk levels. If you had a senior CDO, you got paid before everyone else. Of course you also received a lower interest rate than another investor buying a junior CDO, which would suffer first if the default rates were higher than expected, but that interest rate was still more compelling than other alternatives.

Wall Street and the SPVs managed to convince the credit ratings agencies (like Moody’s and Standard and Poors) that the more senior of these CDOs deserved AAA credit-ratings, suggesting they were very safe for pension funds and insurance companies to invest in. And on top of that, a new market in credit derivatives (CDS – credit default swaps) allowed buyers of CDOs to purchase insurance against default.

Markets were working like a dream. Banks rushed to give as many mortgages as possible. Millions of poor Americans who were hitherto considered poor credit risks (sub-prime) became new homeowners, millions of existing homeowners got to upgrade and others were able to “unlock home equity” ie take a mortgage on the rising value of their houses to spend as they wished.

Banks’ profits went up from the mortgages they generated. They didn’t care about the risks because these mortgages would quickly be sold to SPVs. The SPVs had no problems selling the CDOs to investors. Investors were happy because they got higher interest rates on the CDOs, at apparently little incremental risk. Even the junior CDOs did well. Everyone was happy. Investors made high returns and financial institutions and CEOs reaped billions in profits and millions in bonuses.

Then the gears jammed ….

Next (on Wed): Why governments had to bail out the banks