CDOs Explained: Tranches, the Gaussian Copula and Synthetic Side Bets

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A collateralized debt obligation is a special purpose vehicle that buys a pool of loans and sells the cash flows in tranches, from senior AAA slices that are paid first down to an equity tranche that absorbs the first losses. Its roots run to 1970, when Ginnie Mae created the first mortgage-backed security, and to 1977, when Lewis Ranieri and Larry Fink at Salomon Brothers began pooling private mortgages without a government guarantee. Drexel Burnham Lambert issued the first CDOs from a private bank in 1987, and through the 1990s they were multi-sector products mixing aircraft leases, manufactured housing, student loans and credit card debt. In the early 2000s about $70 trillion in global savings went hunting for yield, and in 2001 statistician David Li introduced the Gaussian copula model, which reduced the default correlation of thousands of loans to a single number.

By 2004 more than half of CDO collateral was mortgage-backed securities, much of it subprime. Banks bundled hard-to-sell BBB mezzanine slices into new CDOs, and rating agencies stamped 70 to 80 percent of them AAA on the assumption that regional housing markets would not fall together. Synthetic CDOs, built from credit default swaps rather than actual mortgages, let many bets reference the same pool and multiplied losses. Housing peaked in summer 2006, teaser rates reset, mass downgrades came in July 2007, two Bear Stearns hedge funds collapsed, and the chief executives of Merrill Lynch and Citigroup resigned. By late 2008, 91 percent of CDO securities had been downgraded, and CDOs accounted for over half of nearly $1 trillion in financial institution losses from 2007 to early 2009.

• Warren Buffett called these instruments financial weapons of mass destruction.
• A rating agency could earn up to $250,000 to rate a CDO pool versus about $50,000 for a municipal bond, and Moody's operating margins topped 50 percent.
• A Bakersfield strawberry picker earning $14,000 a year who spoke no English received a $724,000 home loan.
• Laws such as the Equal Credit Opportunity Act and Community Reinvestment Act formed part of the backdrop of 1970s mortgage securitization.
• A newer structure, the collateralized compute obligation, is backed by AI data center securities.