CDOs

The REcapitulator was asked by an acquantance the other day how the CDO market is effected by the MBS markets, and I found my response was far too complicated for a layman.  This deficiency cannot stand uncorrected, and thus I write today to simplify how these two derivatives interact.

An MBS, or mortguage-backed security, is a derivative that provides cash-flow rights from a group of mortgages to a buyer of the security.  
Lenders to homes like to securitize liabilities like mortguages because it frees
up capital for other purposes in addition to being a profitable business itself.

However, when the MBS is backed by "sub-prime" borrowers, it is difficult to find bidders for the securities (one of the reasons investors like MBS's is because they exhibit a property called negative convexity, and a post on this will be forthcoming).

I-banks cater to needs of disparate investors, some of whom like very safe investments, some willing to hold more risk, and some willing to hold a great deal of risk, of course hoping to reap a more handsome reward.

So I-banks divide the MBS securities into several different "levels" (spatially speaking, not geographically speaking) of risk and return.  The levels are typically described, proceeding from lowest risk level to highest risk level, as "Investment Grade", 
"Mezzanine", and "Equity".  These categories as also known as "tranches" and are now grown up to become "CDO"s, or Collaterlized Debt Obligations - securities that depend on the values of the MBS groups so divided.

And so we follow the money.  Cash flows from the mortguage payments now flow first to capitalize the safe, from a probablistic standpoint, investment grade bonds.  Any remaining cash flows go to the mezzanine level, and then any remaining cash flow finally makes its way to the (by now somewhat nervous) "Equity" level CDO holders.

When there are mortguage defaults and slowing cash flows, firms like Bear Stearns, which opened a coupld of hedge funds for the specific purpose of investing in the "Equity" level of CDOs, get in trouble very quickly.  Since the securities depend on the cash flows from the underlying mortguages, no money flowing to the Equity level means that these securities, which are not often traded, must be valued at far, far less than when the housing market was booming.