The story is familiar- Bear Stearns and many others.... here is a perfect example of CDOs mess....
IKB Deutsche Industriebank AG, a German bank, was bailed-out for €3.5 billion. This is because IKB’s subsidiary- Rhineland Funding Capital is in a financial crisis. The reason is that Rhineland was holding €14 billion debts, most of them are Collateralized debt obligation (CDO).
CDO is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also..... these CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept teh ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!
Coming back...... Rhineland issued commercial papers to get the required money to buy CDO's. Since commercial papers have lower interest rate than CDO, Rhineland earns the differences and became a very profitable vehicle of IKB.
So this is how the cash flows: US investors bought commercial papers from Rhineland, which had very good credits. And Rhineland is paying them at a rate of LIBOR. Rhineland then used the money to buy CDO’s from other US issuers. These debts have higher risk and pay higher interest rate to Rhineland and many are back by MBS’s. So, Rhineland earns profits.
Last few years, the US banks provided more mortgage to homeowners with weak credits (e.g. some even allow the homeowners to have zero down payment) during low interest rates years of 2006. These are called sub-prime mortgages. However, the abilities of these homeowners to pay the mortgage are generally weak. As a result, when there is a slight economic downturn or increase in interest rate, these homeowners have to give up their houses to the bank. But since the housing price has been dropping, even banks are not able to get back the entire mortgage through house auctions. So, banks won’t be able to pay the MBS they have issued! And since some CDO’s have MBS as backing, these CDO’s will be default too.
As a results, CDO’s market price drops. Rhineland also has to pay back the money to their commercial paper holders as it is of shorter terms. But Rhineland cannot do so because the price of the CDO’s it’s holding is dropping. And they cannot issue more commercial paper neither because now everyone believe that Rhineland is holding risky CDO’s backed by sub-prime mortgage. So, Rhineland is in financial crisis.
Since parent has to back its subsidiary, IKB is in financial crisis too. Similarly, many other hedge funds and investment banks in the world have engaged in the CDO’s or MBS’s involving sub-prime mortgages. And similar was Bear Stearns story - fallout of Bear's hedge funds that actively traded CDOs!!!
CDO is backed by a pool of other debt obligations (business loans, asset-backed securities etc. and can even another CDO). Some of these CDO’s are backed by Mortgage Backed Security (MSB) also..... these CDO's are traded between institutions, usually further bundled in other CDO basket, making it impossible to understand the true underlying.... the interesting thing here is that credit rating agencies like Moodys & Fitch still graded those CDO basket as investible securities with A & A+ etc... probably some good credit or corporate loans bundled in those baskets kept teh ratings high even if the basket had lot of MBS (subprime housing loans) that were about to start defaulting!!!
Coming back...... Rhineland issued commercial papers to get the required money to buy CDO's. Since commercial papers have lower interest rate than CDO, Rhineland earns the differences and became a very profitable vehicle of IKB.
So this is how the cash flows: US investors bought commercial papers from Rhineland, which had very good credits. And Rhineland is paying them at a rate of LIBOR. Rhineland then used the money to buy CDO’s from other US issuers. These debts have higher risk and pay higher interest rate to Rhineland and many are back by MBS’s. So, Rhineland earns profits.
Last few years, the US banks provided more mortgage to homeowners with weak credits (e.g. some even allow the homeowners to have zero down payment) during low interest rates years of 2006. These are called sub-prime mortgages. However, the abilities of these homeowners to pay the mortgage are generally weak. As a result, when there is a slight economic downturn or increase in interest rate, these homeowners have to give up their houses to the bank. But since the housing price has been dropping, even banks are not able to get back the entire mortgage through house auctions. So, banks won’t be able to pay the MBS they have issued! And since some CDO’s have MBS as backing, these CDO’s will be default too.
As a results, CDO’s market price drops. Rhineland also has to pay back the money to their commercial paper holders as it is of shorter terms. But Rhineland cannot do so because the price of the CDO’s it’s holding is dropping. And they cannot issue more commercial paper neither because now everyone believe that Rhineland is holding risky CDO’s backed by sub-prime mortgage. So, Rhineland is in financial crisis.
Since parent has to back its subsidiary, IKB is in financial crisis too. Similarly, many other hedge funds and investment banks in the world have engaged in the CDO’s or MBS’s involving sub-prime mortgages. And similar was Bear Stearns story - fallout of Bear's hedge funds that actively traded CDOs!!!
Today, the world is blaming complex CDO products for the financial woes of the 2007 credit crunch. Credit rating agencies failed to value these products using their risk and recovery models. Some institutions buying CDOs even lacked the understanding to monitor credit performance and estimate its expected cash flows. As many CDO products are held on a mark to market basis, the steep fall in the credit markets and declining liquidity in CDOs led to substantial write-downs in 2007-08.
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