Home Debt Investments

Debt Investments

CMO: A Brief Guide

Guide to Subprime Mortgages

Guide to Subprime Mortgages

What is a Subprime Mortgage?


• A subprime mortgage, in finance, refers to the product of subprime lending. This process involves the delivery of loans to individuals who have difficulty maintaining their mortgage repayment schedule or other significant debts. As a result, these loans are categorized, to offset the implied risk associated, by higher interest rates and less favorable terms. 
• Those in favor of subprime mortgages and subprime lending state that the practice offers credit to people who would otherwise be rejected from obtaining a mortgage. Those who obtain subprime mortgages typically possess a low credit rating and more specifically: limited debt experience, no possession of property assets that can be used as collateral, excessive debts, a history of late or missed payments and the possible presence of legal judgments, such as bankruptcy filings or “orders to pay.”
• A lender of a subprime mortgage will determine risk and the size of the proposed loan. When constructing the subprime loan the lender will also structure the repayment obligation. The following structures (repayment plans) may be attached to a subprime loan: an Endowment mortgage interest only loan, a standard repayment loan, a credit card limit or an amortized loan. 
Subprime Lending in the United States:
• Although there is no standard definition in the United States, subprime lending is typically classified as those loans offered to individuals with a FICO score below 640. The term, subprime lending, was made popular by the media during the Subprime mortgage crisis and credit crunch of 2007-2008.
• The primary difference between a subprime mortgage or loan and regular loans is the borrower’s credit history. Those borrowers with outstanding records of payment (both in regards to on time and in full) will get what is referred to as an A-graded paper loan. Borrowers with less than perfect credit scores will be given lower-graded paper loans; these extensions of credit will be attached with higher interest rates and unfavorable terms. 
The Subprime Mortgage Crisis:
• The United States subprime mortgage crisis occurred in 2007 and 2008 and was characterized by a rise in the number of subprime defaults, foreclosures and the subsequent decline of securities backing mortgages. 
• During this time, nearly 80% of mortgages issued in the United States were given to subprime lenders in the form of adjustable-rate mortgages. When real estate prices peaked in the middle of the decade, refinancing was difficult to achieve. When the adjustable-rate mortgages reset at higher interest rates, the number of defaults soared. Those securities backed with mortgages, including subprime mortgage bundles (typically held by financial institutions) became worthless. This led to a domino effect of cataclysmic events, including an unwillingness of global investors to purchase mortgage-backed debt and other asset-backed securities. 
• The subprime mortgage crisis was triggered, in general, for two reasons: the bursting of the housing bubble which peaked in 2005 and 2006 and the deregulation of the real estate market—mortgages were lent, at absurd rates, to individuals who were living beyond their means. 

CDO: Everything to Know

CDO: Everything to Know

What is a CDO?


• A CDO, or collateralized debt obligation, is a type of structured asset-backed security that possesses multiple Tranches, are issued by special purpose organizations and packaged with debt obligations including loans and bonds. 
• CDOs will vary in formation and the underlying assets that make up the product; however, the basic principle will remain the same—a CDO is an asset-backed security created by a corporate entity to hold assets as collateral or to sell packages of debt and cash flows to investors. 
• Each tranche of a CDO offers a varying level of risk and return to meet fluctuating investor demands. The value of a CDO is derived from the portfolio of underlying fixed-income assets; the tranches are divided into different classes based on a risk assessment, whereby “senior” tranches are regarded as the safest securities. This division is necessary because interest and principal payments are delivered in order of seniority. As a result, a junior tranche, due to the increased risk, will offer higher coupon payments or lower prices to entice investors and offset the increased exposure to default risk. 
CDO Example:
• A CDO is a fairly complex and unique investment product. To simplify the explanation, think of a CDO as a promise to distribute cash flows to investors in a predetermined sequence, based on how much money the CDO collects from its pool of fixed income assets. If the cash collected by the CDO is not enough to pay to all of its investors, those in the lower tranches will suffer losses first. 
How is a CDO Created?
• A CDO is structured when a special purpose organization acquires a portfolio of assets, such as commercial real estate bonds, mortgage-backed securities and corporate loans. The SPE, once packaged, will the issue bonds to investors in exchange for cash. 
• The cash is then used to purchase the portfolio of investments or debt. The bonds, when issued, are organized by different risk factors (tranches). As stated before, senior tranches are paid from the cash flows of the underlying securities before junior and equity securities. If the CDO loses money, losses are first assumed by the equity securities, then by the junior tranches and lastly by the senior tranches. 
• The return and associated risk of the CDO depends on how the tranches are formulated and the performance of the underlying assets. A CDO enables the creator of the bundle to pass credit risk to other investors (institutions or individuals); as a result of this basic premise, it is crucial to understand how the particular CDO is calculated.  
• A CDO is typically created by an investment bank; the investment security requires the presence of an underwriter and an asset manager before the bundle can be sold to other institutions or individual investors.