What you should know sub-prime mortgages and CDO’s
Sub-Prime Mortgages
These mortgages are typically
- highly leveraged - mortgagees have little or no equity in their homes
- shorter loan seasoning - recently written as opposed to mature loans with strong repayment history
- weak documentation - little or no proof of savings & employment
- honeymoon rates - reliance on lower short term rates vs 30 year rates common in US market
The combination of mortgagees experiencing low rates to borrow and investors receiving higher potential returns has resulted in strong demand for these securities. This demand has negated the risk return trade-off and investors were no longer paid a premium for these risky assets.
No better evidence of this is illustrated by the historically small differential between these assets and treasury bonds.
Collateralised Debt Obligations
Where a bank segments a pool of loans (collateral) and restructures them using a technique called ‘credit tranching’. This technique groups classes of debt together and repackaged into a range of securities.
There are a number of classes of debt ranked from highest to lowest. The classes are designated as senior debt (highest quality), subordinate debt, mezzanine debt and equity.
The credit risk is amplified to equity and lower rates bond holders as any default losses from the pool of loans is first applied in reverse order to the securities lowest in the structure.
Impact of recent headlines
With increasing numbers of sub-prime mortgage providers declaring bankruptcy or exiting this business, widespread credit rating downgrades by credit rating agencies (Moody’s and Standard & Poors) has resulted in a broad re-pricing of credit risk.
This re-pricing has affected more highly rated prime mortgaged backed securities as well as non-investment grade, high yield corporate debt and emerging markets debt. This general re-assessment of risk has flowed on to equity markets and the cost of refinancing less certain thereby potentially reducing the level of M&A activity.
Furthermore some investors including hedge funds have leveraged their exposures to seek increased returns as the cost of borrowings was less than the yield on the securities. As cash rates globally increased funds and liquidity pulled from the markets leveraged investors were forced to begin de-levering. As highly rated debt assets dwindle as sold first to meet obligations, the funds were forced to liquidate lower quality structures at reduced prices.
In Australia hedge fund manager Basis Capital has suspended redemptions and may face large losses in some of its funds. To meet borrowing commitments, their prime broker who extended credit to the structure simply sold the funds assets.
This action highlights how quickly leveraged structures that invest in illiquid assets can unwind. Not surprising given the lender is anxious to preserve the value of their claim on the borrower.
In summary the collateral for borrowing in a leveraged product is the assets of the fund to which the leverage is applied.