“Collateralized Debt Obligations (CDOs) are structured fixed-income and equity securities backed by a variety of assets including corporate loans, bonds, residential and commercial mortgages and other asset-backed securities.
CDOs are securitized products issued out of a special purpose vehicle or trust structure, with a variety of tranches issued that vary in seniority, coupon rate and credit quality. It is estimated that approximately $1 trillion in face value of CDO securities remain outstanding. Largely intended to be buy-and-hold securities, CDOs were issued on a 144A or Reg S basis, with limited information available for a buyer to accurately determine pricing in the secondary market1(secondmarket.com).”
Can we get that simply?
A CDO is a security issued by a trust. A trust is a legal entity set up to own and manages property for someone else. Those two things together mean that if you buy a CDO, you own assets in the trust, but you don’t have any rights to the assets the trust owns.
If the trust is created with a Triple-A credit rating, then the CDOs issued by that trust will have a Triple-A credit rating. This sounds OK so far.
The trust can own all sorts of assets. Real estate, corporate stock, corporate bonds, mortgages, commercial loans, and even US Treasury notes can be owned by the trust. Still nothing new or surprising here.
Then the trusts split their assets into a variety of tranches and resold them by the tranch.
What’s a tranch?
Tranches are interesting stuff. Before I go on a little diversion is necessary here. If you buy common stock in a chapter C corporation, you own a piece of each of the assets of that corporation. If you buy preferred stock in a chapter C corporation, you also own a piece of each of the assets in the corporation. Before the First Depression, you could also buy asset backed stock, which gave you a piece of an individual asset in the corporation. For example, you could own $100 worth of a steam locomotive, along with 10,000 other investors. If the corporation defaulted an asset backed stock is made good by selling the specific asset and splitting the proceeds among the owners.
A tranch is like an asset backed stock. The word means slice. So to buy a tranch is to buy a slice of something. For instance, if a mortgage was written for $250,000, tranches could slice it into 5 bonds at $50,000 each. This is the way that Fannie Mae used to work.
What if you split the mortgage according to its payout dates? Someone could buy a 90 day slice and get everything the mortgage holder paid in 90 days. Someone could buy a 1 year slice and get everything paid over a year, and then a 5 year slice, a 10 year slice, and so on.
This method converts a 30 fixed asset into a series of fast cash turnarounds.Another way to slice an asset is to put pieces of one mortgage into multiple tranches. You can build 4 $100,000 tranches from 4 $40,000 mortgages if you put $10,000 from each into the mortgage.A lot of people considered this second method as a way to diversify your investment and spread the risk of a single investment across multiple tranches.
Think of what selling one of these nightmares is like.
Each CDO created by reselling these tranches has a real value based upon the tranches that form the CDO. But no one except the original trust knows the real value of the CDO and so it virtually cannot be sold.That’s why it’s called illiquid.Now consider selling a billion of them.
Splitting tranches across time divisions (90 day, 1 year, 5 year, etc) ought to be illegal. Splitting multiple assets into multiple resalable items (such as CDOs) ought to be illegal. Any organization which holds assets and sells investments based upon those assets ought to be required to be a chapter C corporation and those investments required to be common stock.
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