Commercial Real Estate Collateralized Debt Obligations (CRE CDOs)
Hi! I am hoping to gain some clarity on the following paragraph:
"CDOs were the vehicle used to securitize a lot of the subprime mortgages on residential real estate that were made to home owners who had poor credit ratings and got into trouble as home prices began to fall in the late 2000s and interest rates began to rise triggering resets on the adjustable interest rate mortgages. Many of these securities had high credit ratings under the theory that they were diversified with lots of residential mortgages backing them but the drop in home prices and rise in interest rates affected virtually all the mortgages. It remains to be seen if the CDO market will recover as investors have become skeptical of these types of securities whether they are backed by residential or commercial mortgages."
Questions:
Can someone please help explain
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Why did the drop in home prices and rise in interest rates affect all the mortgages?
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Why was it bad for the rising interest rates to trigger resets on the adjustable interest rate mortgages?
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Why was there trouble when CDOs were the vehicle used to securitize a lot of subprime mortgages
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Why were CDOs in the past thought to have higher returns compared to CMBS?
Would be really grateful for the help, thank you!!
The key difference between CDOs and CMBS loans is the risk free rate that they use. CDOs are underwritten with a spread over LIBOR whereas CMBS loans are underwritten with a spread over the 10 year treasury bond. This means that CDOs have a higher interest rate exposure than CMBS loans because LIBOR has larger fluctuations. Second, the amoritization on those CDOs were set to have a very low rate for the first few years that would then increase in later years because they were designed to give out loans to homeowners who could not afford mortgage payments at the moment, but would hypothetically be able to have a higher income in the future and make those payments. The combination of this thesis not playing out and a rise in interest rates meant that millions of home loans were not able to be paid off, which also meant that the CDOs that were securitized against those home loans became worthless. This was a problem because of the amount of companies that had substantial amounts of their portfolios in CDOs and they had to then sell off other assets to cover their losses on their CDOs. Combine this with a credit crunch since the same banks that made those subprime mortgages were also in a liquidity crisis and not lending out then the entire economy collapsed.
Margot Robbie has a much better explanation of this in a bathtub than I do.
Not sure why CDOs have a higher return than CMBS loans in the past since I wasn't in real estate in that era.
CMBS is spread over swaps, not treasuries.
So, it may be true they use different benchmark rates (but I'm not sure tbh), this is far from the "key difference". CMBS securitize portfolios of whole commercial loans then sell bonds (organized by payment priority "tranches" generally) against those whole loans which as collateral and source of interest/repayment. CDOs, are broadly just a structured credit product that can buy up damn near whatever the manager/sponsor wanted to (assuming they could sell the interests to investors, they also may use similar tranching scheme like CMBS). In practice, CDOs buy whole loans, b-pieces, trances of CMBS/RMBS, and even mezz loans from the CRE space. They can also include "debt assets/obligations" not real estate related like auto loans, credit card loans, whatever.
The whole point of the extra risk is that this re-extended the credit and potential leverage of the underlying loans/assets (i.e. the CDO interests where purchased with leverage by investors often, or the CDO used leverage directly to buy more assets and earn the spread). And yes, CDO purchased a lot of bonds and other instruments backed by sub-prime back before 08; so they def helped fuel the subprime bubble by providing it secondary liquidity.
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