Page 157 - untitled


 F FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT

Collateralized Debt Obligations

Collateralized debt obligations (CDOs) are structured 3. CDO tranches
financial instruments that purchase and pool
Similar to
financial assets such as the riskier tranches of various mortgage-backed
mortgage-backed securities. securities, the CDO
issues securities in
tranches that vary
based on their place in
the cash flow waterfall.
1. Purchase
Low risk, low yield
The CDO manager and securities
firm select and purchase assets,
such as some of the lower-rated
tranches of mortgage-backed
securities.
First claim to cash flow from
principal & interest payments…

New pool AAA
of RMBS
and other
securities
next
AAA claim…
2. Pool

The CDO manager
and securities firm
AA
pool various assets next…
in an attempt to etc. A
get diversification BBB
AA BB
benefits. EQUITY
A
BBB High risk, high yield
BB

Figure .

The securities firms argued—and the rating agencies agreed—that if they pooled
many BBB-rated mortgage-backed securities, they would create additional diversifi-
cation benefits. The rating agencies believed that those diversification benefits were
significant—that if one security went bad, the second had only a very small chance of
going bad at the same time. And as long as losses were limited, only those investors at
the bottom would lose money. They would absorb the blow, and the other investors
would continue to get paid.
Relying on that logic, the CDO machine gobbled up the BBB and other lower-rated