CDO’s – Collateralized Debt Obligations
In 2007 and 2008, the combination of falling home prices, lax credit in the mortgage markets, disruptions in the credit markets, and gross misconduct by financial institutions led to tremendous losses in mortgage-backed securities, collateralized debt obligations and related securities. While sub-prime mortgage losses fueled problems initially, these problems soon engulfed virtually the entire mortgage securities market.
Sub-Prime Mortgage Losses Put Mortgage Securities at Risk
Sub-prime mortgages were offered to individuals with modest income and poor credit so they could become homebuyers. Such mortgage loans often had below market teaser rates that rose to above market levels after the introductory period. The mortgages became extremely difficult to refinance. Often, homeowners could no longer afford the mortgage payment once the interest rate increased to market rates or if the homeowner lost his or her job. Consequently, such mortgages had high rates of default.
Mortgage-Backed Securities Created From Mortgage Loans
Investors started to face problems when these mortgages were sold to Wall Street investment banks that securitized the mortgages by pooling the income stream from many mortgages into bonds known as:
- Collateralized mortgage obligations (CMO)
- Mortgage-backed securities (MBS)
- Asset-backed securities (ABS).
This practice began in late 1990s, as investment banks began creating mortgage-backed securities out of mortgage loans by pooling loans and slicing them into various classes having different benefits and risks. Pooling the loans purportedly created a cushion against default by diversifying risk, and the higher interest rates gave such bonds the high yield that investors favored. Many of these classes were sold as “AAA” or “AA” rated.
Different Kinds of Debt Bundled in the Form of CDO Bonds
The investment banks then created collateralized debt obligations (CDOs), a type of securities investment. The CDO entities bought and bundled different kinds of debt, often ranging from mortgage-backed securities to corporate bonds to debt backed by credit card payments. The CDOs were then cut into different slices and sold to investors in the form of bonds.
While these slices contained the same debt, they differed in terms of preference, interest payments, and risk. Slices that paid the least interest were the safest if there were defaults in the debts pooled in the CDO. Slices that paid the most interest were the first to go bust in the event of defaults. Many of the riskier slices were also highly rated. Because of the CDO structure and the diversification gained by bundling different debts, underwriters tried to package these high-risk debt instruments in a manner to receive investment grade ratings.
CDOs Were Often Not Properly Valued
The CDOs often used borrowed money or leverage to increase returns. The CDOs were sold to investors, including:
- Hedge funds
- Pension plans
- Mutual funds.
Because they were illiquid and did not trade regularly, it was difficult to value the CDOs accurately. As the defaults increased, it became clear that these instruments were not properly valued.
During the process, many investment banks became enamored with the profits generated by these mortgage backed securities. They began ignoring the standards that had been previously established. They failed to conduct adequate due diligence. In certain cases, some investment banks bet on the failure of the mortgage investments they created and recommended to investor
Contact Illinois Securities Law Attorney John C. Barlow
If you believe an investment bank failed to advise you about the potential risks of a CDO sold to you, contact my Chicago law firm for a free initial consultation. I am John C. Barlow, a securities lawyer with more than 33 years of experience. I have a strong background helping investors nationwide take a stance against all forms of stockbroker misconduct and fraud. Most of my cases are handled on a contingency basis. This means you would owe me nothing, unless I am able to recover compensation for you.