Cdos and the Sub-Prime Crisis
FINC2012 – Essay
CDOs and the sub-prime crisis
Yuzhou Fang
SID: 310303885
Semester 2
2010
The protagonist of sub-prime crisis: CDOs
Synopsis
The most exciting developments in financial market in recent decades have been in credit derivatives market. This essay will focus on one prevalent credit derivatives: CDOs. By describing what CDO’s are and how they operate, the author try to reveal the charisma of CDOs and show why banks and financial institutions are enchanted by them, then readers will see how the overdeveloped CDOs led to the sub-prime crisis in the summer of 2007.
1. Introduction to CDOs
CDOs or collateralized debt obligations are a type of security back by a diversified pool of debt instruments. CDOs are split based on the different underlying credit risk of different components of the asset. (Jones and Peat, 2008) In itself it is a particularly popular kind of asset-backed securities that expanded tremendously in recent years before the sub-prime crisis. In 2006 global CDO issuance reached the peak, up to over 520 billion USD (Securities Industry and Financial Markets Association, 2010).
2. Participants of CDOs market and how it works
The creators of CDO, include banks and other financial institutions, found a special purpose vehicle or SPV to hold collateral and issue securities. The SPV attains packaged mortgages (MBSs) from a mortgage originator. SPV holds the mortgages, the only asset of it, on trust for bondholders. The credit risk of the underlying asset is split into several levels and then sold to bondholders in these different tranches. (Jones and Peat, 2008)
Income generated by bonds is passed to bondholders of tranches by the SPV. The most senior tranche will first receive the promised return, then turn to the second most senior tranche, then to third most senior and so on. Senior and mezzanine tranches of the CDO are rated by major credit rating agencies such as Standard and Poor’s and
CDOs and the sub-prime crisis
Yuzhou Fang
SID: 310303885
Semester 2
2010
The protagonist of sub-prime crisis: CDOs
Synopsis
The most exciting developments in financial market in recent decades have been in credit derivatives market. This essay will focus on one prevalent credit derivatives: CDOs. By describing what CDO’s are and how they operate, the author try to reveal the charisma of CDOs and show why banks and financial institutions are enchanted by them, then readers will see how the overdeveloped CDOs led to the sub-prime crisis in the summer of 2007.
1. Introduction to CDOs
CDOs or collateralized debt obligations are a type of security back by a diversified pool of debt instruments. CDOs are split based on the different underlying credit risk of different components of the asset. (Jones and Peat, 2008) In itself it is a particularly popular kind of asset-backed securities that expanded tremendously in recent years before the sub-prime crisis. In 2006 global CDO issuance reached the peak, up to over 520 billion USD (Securities Industry and Financial Markets Association, 2010).
2. Participants of CDOs market and how it works
The creators of CDO, include banks and other financial institutions, found a special purpose vehicle or SPV to hold collateral and issue securities. The SPV attains packaged mortgages (MBSs) from a mortgage originator. SPV holds the mortgages, the only asset of it, on trust for bondholders. The credit risk of the underlying asset is split into several levels and then sold to bondholders in these different tranches. (Jones and Peat, 2008)
Income generated by bonds is passed to bondholders of tranches by the SPV. The most senior tranche will first receive the promised return, then turn to the second most senior tranche, then to third most senior and so on. Senior and mezzanine tranches of the CDO are rated by major credit rating agencies such as Standard and Poor’s and