Subprime and Synthetic CDOs: Structure, Risk, and Valuation*

Article by Dr. Elaine Buckberg, Dr. Frederick C. Dunbar,1 Max Egan, Dr. Thomas Schopflocher, Dr. Arun Sen, and Carl Vogel

INTRODUCTION

Collateralized debt obligations (CDOs) and other structured financial products containing subprime mortgages have been a focal point of the credit crisis, giving rise to a growing amount of investigative journalism as well as credit crisis litigation. It is widely agreed that the leading edge of the credit crisis was the meltdown of the US subprime mortgage market that began in early 2007. Many of these mortgages were structured into asset-backed securities (ABS) that were then further structured into CDOs. Through these processes, exposures were propagated throughout the financial system, ultimately resulting in widespread losses. Concerns about the depth of these losses led to uncertainty about counterparty risk, causing the credit markets to freeze in August 2007. These fears were magnified in the financial market panic of September 2008 that followed the bankruptcy of Lehman Brothers. The government response had been massive, starting with bailouts and investigations by the Securities and Exchange Commission (SEC) and DOJ of potential wrongdoing, alongside an overhaul of financial regulation.

Given their prominent role, it is clear that disputes will continue to revolve around CDOs and other subprime-backed structured products for some time. Through the end of March 2010, the credit crisis had yielded at least 395 securities filings (excluding arbitrations). Of these, at least 41 are CDO-related, which includes suits by investors in CDOs; many others are suits by investors in various of their building blocks, such as ABS and credit default swaps (CDS).2

Though many market participants were conversant with these structures, it will usually be the case that a lay audience does not have such familiarity. The goal of this paper is to go behind the current headlines to describe in plain English the fundamental analytics of the ABS-backed CDOs and synthetic CDOs that were instrumental in the financial crises. We will also discuss the principles of their valuation, including the important issue of correlation. While no short paper can cover the full breadth and detail of the subprime mortgage market, structured finance, and credit derivatives, the fundamentals presented here should help those who desire to increase their understanding of these topics.

SUBPRIME, SECURITIZATION, AND THE FINANCIAL CRISIS

"[G]iven the fundamental factors in place that should support the demand for housing, we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system." -Federal Reserve Chairman Ben Bernanke, May 17, 2007

"[T]he economic outlook has been importantly affected by recent developments in financial markets, which have come under significant pressure in the past few months. The financial turmoil was triggered by investor concerns about the credit quality of mortgages, especially subprime mortgages with adjustable interest rates." -Federal Reserve Chairman Ben Bernanke, November 8, 2007

"The downturn in the housing market has been a key factor underlying both the strained condition of financial markets and the slowdown of the broader economy.... Despite the efforts of the Federal Reserve, the Treasury, and other agencies, global financial markets remain under extraordinary stress." -Federal Reserve Chairman Ben Bernanke, September 23, 2008

At the heart of the financial crisis are bank writedowns on CDOs, mortgage-backed securities (MBS), and ABS with mortgage collateral (called home equity ABS for reasons outlined in the next section). As the housing market declined and both subprime and prime mortgage delinquencies and defaults rose, these securities declined in value and became highly illiquid. Illiquidity and concern about the true value of CDOs and other structured products were the driving force behind TARP. The International Monetary Fund recently estimated that writedowns by US banks will total $885 billion between 2007 and 2010. Residential mortgage loans and securities account for over 40% of the estimated writedowns.3 Here, we briefly review how losses in the subprime mortgage market affected CDO values. As seen in Figure 1, delinquencies and foreclosures on subprime mortgages rose somewhat in 2006 and much more dramatically in 2007.

Losses, and fear of future losses, on subprime mortgage loans led to losses on home equity ABS containing those loans. The ABX indices, shown in Figure 2 (and described in detail below) track the value of a set of benchmark subprime-backed securities. The lower-rated BBB- index represents securities that are more sensitive to mortgage loan losses. While this index first began falling in response to problems in the subprime market, even the safest subprime-backed securities, tracked by the AAA index, began falling substantially in value as 2007 progressed.

In turn, losses, and fear of future losses on home equity ABS led to losses on CDOs containing those subprime ABS. By 2007 more than half of CDOs outstanding were what are called "structured finance CDOs"—the term for CDOs that contain structured finance securities including ABS, non-Agency MBS, and tranches of other CDOs.4 As we will discuss later in the paper, subprime-backed securities accounted for most of the collateral backing these CDOs.

The role of subprime in this turmoil is explained in large part by two factors. The first is that the design of subprime mortgages—many of which were originated with high loan-to-value (LTV) and debt-to-income (DTI) ratios—made them very sensitive to declines in housing prices (much more so than traditional mortgages). Defaults on large numbers of subprime loans followed slowdowns in the rate of change of housing prices. The second factor is that the risks underlying subprime mortgages were, through securitization and derivatives trading, distributed throughout the financial system. This reallocation and distribution of risks was believed to dissipate systemic risks. However, the large volume of home equity ABS and CDOs, and their purchase by a wide range of financial firms, caused the deterioration in subprime mortgages to affect balance sheets across the financial sector.5

In what follows, we will describe the vehicles through which subprime mortgage risk was securitized and traded. These vehicles are ABS, CDS, and CDOs, which we discuss in turn. In doing so, we will explain the economics of these vehicles, which will help address important topics such as how to determine their worth and what investors were actually buying and selling.

UNDERSTANDING HOME EQUITY ASSET-BACKED SECURITIES

Background: The Securitization of Mortgage Loans

Securitization is the process of pooling together assets that are not readily tradable, such as mortgages, corporate loans, or credit card loans, and issuing securities that entitle investors to payments based on cash flows that come from the pool.

Prior to the advent of securitization in the 1970s, depository institutions (commercial banks and thrifts) were the predominant originators of residential mortgages. These institutions funded mortgage originations with deposits or by issuing bonds. By the early 1990s, a different kind of financial firm—mortgage bankers—grew to be the predominant originators of residential mortgages. These institutions would fund their lending with short-term lines of credit and repay the loans either by selling the whole loans to a housing agency (e.g., Fannie Mae), or by selling the mortgages into the secondary market, i.e., securitization.6 Today, over half of the $15 trillion in residential US mortgage debt is securitized.7 Under this originate-to-distribute business model, the bank, savings and loan association, or mortgage bank originating a mortgage then sells the mortgage to a trust. The trust enlists an underwriter and issues bonds (MBS or ABS) backed by the future cash flows of these mortgages.8 The trust also enlists a rating agency to place a rating on the MBS and ABS that it issues. The bank (or other originator) typically still services the mortgage (although another firm may do so), collecting payments and forwarding them to the trust, as well as dealing with any delinquencies or defaults. The cash flows from the mortgages are passed through to the purchasers of the bonds, which may include pension funds, insurance companies, mutual funds, hedge funds, or CDOs.

Housing agencies Fannie Mae, Freddie Mac, and Ginnie Mae have historically been responsible for most of the MBS issuance.9 Agency MBS are thought to be very safe in terms of credit risk or default risk; the agencies guarantee full and timely payment, and those guarantees are perceived to be backed by the US government. (In fact, only Ginnie Mae MBS are explicitly backed by the full faith and credit of the US government.) The agencies, though, are restricted as to what mortgage loans they can purchase and securitize. These loans are called "conforming" and meet certain criteria correlated with low historical risk of default.

The many non-conforming mortgage loans are securitized by other private institutions, like banks and mortgage lending companies; these include jumbo, Alt-A, and subprime. Jumbos are securitized pools of high credit quality mortgages whose loan sizes exceed the conforming limit. The mortgages that underlie Alt-A and home equity ABS, on the other hand, usually meet the conforming loan size limit. However, Alt-A mortgages are usually missing documentation, have minor credit problems, or both, while subprime mortgages generally suffer from substantial credit deficiencies.

Subprime mortgages are made to borrowers with a high DTI ratio, an impaired or minimal credit history, or other characteristics correlated with a higher...