Do CDOs place the housing market at risk?

From Joseph R. Madison and Joshua Rosner, as presented at the Hudson Institute:

How Resilient Are Mortgage Backed Securities to Collateralized Debt Obligation Market Disruptions? (PDF)

A summary, provided by reader/commenter abamitphd:

Some highlights:

1. Since the last cycle, servicers are more likely to renegotiate a problem loan than put it into foreclosure. They amortize the late interest into a new loan, and start all over again. This makes the foreclosure numbers look much worse than they actually are. I am trying to track down some measures of work-outs.

2. A significant fraction of mortgages originated are securitized, and sold to bankruptcy-remote structures created by investment banks, which in turn sell the credit risk to investors through RMBS (residential mortgage-backed securities).

3. Most mortgages are placed in a structure called a master-trust. These trusts have to sell junior tranches (BBB) before they can sell the senior tranches (AAA), which means investors in the mezz tranches are crucial to the ability of these structures (and of course investment banks) to buy new mortgages.

4. There is a no-arbitrage relationship between the junior RMBS tranches and the mezz tranche of the ABX. This means if the spreads on ABX tranches stay high, hedge funds could make easy money with a trade against the RMBS mezz tranches. This will push the spreads on the RMBS mezz tranches up, and make the securitization of mortgage credit uneconomical at current mortgage rates.

5. The biggest investor of these mezz RMBS tranches are something called a CDO. A CDO is like a mutual fund, but it only invests in about 100-125 instruments, and tranches the risk. The authors say that about 40 percent of the securities in CDOs are RMBS, and of this, 70 percent are sub-prime and home equity loans. The authors document that CDOs purchased more RMBS than was actually originated in 2005 (they bought some old stuff).

6. Demand for CDOs is typically driven by the ability of investment banks to find investors for its mezz and equity tranches.

7. The deterioration in sub-prime will hit the mezz tranches of these CDOs hard. Investors in mezz tranches of new CDOs will demand higher spreads to cover the risk, but this makes the CDO uneconomical. You lose a natural investor for both sub-prime and prime RMBS

8. With the CDO falling apart as an investor in RMBS, investment banks won’t be able to securitize mortgage pools. This means both prime and sub-prime, although the market might be other ways to sell the prime. This means big increases in sub-prime spreads, moderate increases in prime spreads.

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