![]() During the 1990s the collateral of CDOs was generally corporate and emerging market bonds and bank loans. for the also now-defunct Imperial Savings Association. The first CDOs to be issued by a private bank were seen in 1987 by the bankers at the now-defunct Drexel Burnham Lambert Inc. Many of these tranches were in turn bundled together, earning them the name CDO (Collateralized debt obligation). Subsequently, Lewis Ranieri ( Salomon) and Larry Fink ( First Boston) invented the idea of securitization different mortgages were pooled together and this pool was then sliced into tranches, each of which was then sold separately to different investors. In 1977, the investment bank Salomon Brothers created a "private label" MBS (mortgage backed security)-one that did not involve government-sponsored enterprise (GSE) mortgages. ![]() ![]() The Act encouraged commercial banks and savings associations (Savings and loan banks) to meet the needs of borrowers in all segments of their communities, including low- and moderate-income neighborhoods (who might earlier have been thought of as too risky for home loans). In 1977, the Community Reinvestment Act was enacted to address historical discrimination in lending, such as ' redlining'. In 1974, the Equal Credit Opportunity Act in the United States imposed heavy sanctions for financial institutions found guilty of discrimination on the basis of race, color, religion, national origin, sex, marital status, or age This led to a more open policy of giving loans (sometimes subprime) by banks, guaranteed in most cases by Fannie Mae and Freddie Mac. All through the 1970s, private companies began mortgage asset securitization by creating private mortgage pools. This was the first mortgage-backed security made of ordinary mortgages. In 1971, Freddie Mac issued its first Mortgage Participation Certificate. This would be the precursor to CDOs that would be created two decades later. In 1970, the US government-backed mortgage guarantor Ginnie Mae created the first MBS ( mortgage-backed security), based on FHA and VA mortgages. These CDOs have been called "the engine that powered the mortgage supply chain" for subprime mortgages, and are credited with giving lenders greater incentive to make subprime loans, leading to the 2007-2009 subprime mortgage crisis. CDO collateral became dominated by high risk ( BBB or A) tranches recycled from other asset-backed securities, whose assets were usually subprime mortgages. In the early 2000s, the debt underpinning CDOs was generally diversified, but by 2006–2007-when the CDO market grew to hundreds of billions of dollars-this had changed. As CDOs developed, some sponsors repackaged tranches into yet another iteration, known as " CDO-Squared", "CDOs of CDOs" or " synthetic CDOs". Separate special purpose entities-rather than the parent investment bank-issue the CDOs and pay interest to investors. As an example, a CDO might issue the following tranches in order of safeness: Senior AAA (sometimes known as "super senior") Junior AAA AA A BBB Residual. ![]() Consequently, coupon payments (and interest rates) vary by tranche with the safest/most senior tranches receiving the lowest rates and the lowest tranches receiving the highest rates to compensate for higher default risk. The last to lose payment from default are the safest, most senior tranches. If some loans default and the cash collected by the CDO is insufficient to pay all of its investors, those in the lowest, most "junior" tranches suffer losses first. The CDO is "sliced" into sections known as "tranches", which "catch" the cash flow of interest and principal payments in sequence based on seniority. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets. Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). A collateralized debt obligation ( CDO) is a type of structured asset-backed security (ABS).
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