CHAPTER 1 Setting the Stage for Financial Meltdown
Bank of England, Financial Stability Report no. 22, October 2007, 32.
Collateralized debt obligations (CDOs) are securities created by pooling asset-backed securities (ABSs), mortgage-backed securities (MBSs) such as collateralized mortgage obligations (CMOs), loans, and corporate bonds, and dividing the pool’s promised income into tranches that are distinguished by risk and return. Collateralized loan obligations (CLOs) are CDOs predominantly backed by leveraged bank loans. Synthetic CDOs obtain the credit risk on an underlying portfolio of credit instruments using pools of credit default swaps, rather than owning the underlying cash assets.
The arranger purchases the assets to be placed in the pool, obtains the credit rating, structures the deals, files with the SEC, and underwrites the asset-backed securities to be issued by the SPV. Thus, the arranger must fund the loans over the period (typically three months or less) after origination and before the asset-backed securities are issued. Bank arrangers use their own funds to finance the loans over this period, but nonbank arrangers typically use third-party warehouse lenders. Indeed, an early step in the credit crisis of 2007 occurred in January 2007 when warehouse lenders pulled back and demanded more collateral to finance the loans of nonbank arrangers. (See the discussion in Chapter 2.)
The transformation of the securitization technology from pro rata pass-through ...