Role of Subprime Mortgages and CDOs in GFC
We will cover following topics
Introduction
In the lead-up to the 2007-2009 financial crisis, certain financial products and practices played a significant role in exacerbating the crisis. Subprime mortgages and collateralized debt obligations (CDOs) were at the heart of the turmoil. This chapter dives into the mechanics and impact of these instruments, shedding light on how they contributed to the crisis.
Subprime Mortgages
Subprime mortgages were home loans extended to borrowers with poor credit histories. These loans carried higher interest rates to compensate for the increased risk. Lenders packaged these subprime mortgages into securities and sold them to investors. The attractiveness of these securities was driven by their promised higher returns.
Role of Collateralized Debt Obligations (CDOs)
Collateralized debt obligations (CDOs) were complex financial products that bundled various types of debt, including subprime mortgages, into different tranches based on risk and return. The tranches were then sold to investors. The CDO structure aimed to spread risk and offer investors a range of risk profiles. The most senior tranches were considered less risky due to their priority in receiving payments from underlying assets.
CDO Example
Consider a CDO backed by subprime mortgages. The CDO might have several tranches: senior, mezzanine, and equity. The senior tranche, being the least risky, would receive payments first, followed by the mezzanine tranche and then the equity tranche. Investors seeking lower risk invested in the senior tranche, while those aiming for higher returns took on the equity tranche, which carried higher risk.
Chain Reaction
The trouble arose when the housing market declined and subprime borrowers started defaulting on their mortgages. This caused the value of the subprime mortgage-backed securities to plummet. Since many CDOs held these securities as assets, the value of CDOs also dropped. This triggered a domino effect throughout the financial system, affecting banks, investors, and institutions holding these assets.
Conclusion
The involvement of subprime mortgages and collateralized debt obligations in the financial crisis highlighted the vulnerability of financial products that were intricately tied to the housing market’s health. The crisis underscored the importance of understanding the risks associated with complex financial instruments and the need for transparent risk assessment and management.