Monday, September 29, 2008

MBS, CDO's and CDS's In Layman's Terms......

You've probably been hearing a lot about securities that you've never heard of before. I bet you never thought it would be important to know what an MBS or CDO or CDS you may be wondering. I'll try to give you a brief synopsis of each.

MBS - Mortgage Backed Security

This is in its simplest form a bond. The bond is backed by a pool of mortgages that are being paid by homeowners across the United States. Each month a homeowner makes a payment, that payment basically sent to the holder of this bond. If one were to buy a Mortgage Backed Security (MBS) they would receive an interest payment and a partial repayment of their principal (since some of a homeowners payment is interest and principal). These securities are issued by Fannie Mae, Freddie Mac and Ginnie Mae - but can also be issued by other institutions. When an investor buys a Fannie Mae bond, they are essentially buying the cash flow from different homeowners as they make their monthly mortgage payments. If a homeowner defaults on their mortgage or misses a payment, the MBS holder suffers....of course this is where Fannie, Freddie and Ginnie step in and make them whole. With so many people in foreclosure and not making can see why Fannie and Freddie had to be bailed out.

O.K. - as if MBS was not hard enough - Collateralized Debt Obligations or CDO's.

These are tough to understand and I won't bore you with the internals, but think of this as a Mortgage Backed Security on steroids. Instead of one investor owning the cash flow of a mortgage - multiple investors could own it. Here is an example of how a CDO might work:

Pretend that you have a mortgage (okay, most of us aren't pretending) and you make principal and interest payments each month - these payments are made to your loan servicer and then split up as follows:

Investor A - Gets all of the interest payments from years 1 - 4
Investor B - Gets all of the principal payments from years 1 - 4
Investor C - Gets all of the interest payments from year 5
Investor D - Gets all of the principal payments from year 5
Investor E - Gets the interest and principal payments from years 6 - 10
Investor F - Gets interest payments from years 11- 24
Investor G - Gets principal payments from years 11 - 24
Investor H - Gets the remainder of principal and interest payments, if made from years 25 - 30

Imagine you are the borrower - your payments don't just go to your local bank anymore - they get split up depending on the year you are making a payment and how much is principal and interest. All of these investors who are in line to receive these payments have bought into a trust - called a CDO. The trustee of the trust has a fiduciary responsibility to each of these investors. Now you know why when someone who is having problems paying their mortgage and is on the brink of foreclosure is having such problems trying to get their loan modified - if the trustee changes the interest payments, one of multiple investors may get hurt at the expense of another, same goes for principal changes. The trustee is in an impossible situation and thus does nothing........the house forecloses even though a workout was entirely possible.

CDO's were purchased by investors who were told by "creditable" ratings agencies that these securities were "investment grade". Some of these investors obviously didn't believe the credit agencies and decided to seek insurance in the case that their CDO defaulted. They went out and bought.........Credit Default Swaps or CDS.

There is nothing wrong with a Credit Default Swap - it is basically an insurance policy against the failure of a specific asset. The reason these have been in the news is because some companies - like AIG, Lehman and Fortis (and many others) found these insurance policies to be very lucrative business. AIG in particular issued Credit Default Swaps on CDO's so that institutions that held CDO's would be made whole if the CDO defaulted. The problem is that AIG didn't foresee that ANY of these would default - they thought this was a risk free operation. AIG took in a ton of money to insure the CDO's through Credit Default Swaps - but never reserved for losses. As we all know now, AIG made a huge mistake as there were and is risk with CDO's. Credit Default Swaps are basically just insurance policies for securities.

Consider this a 101 class on mortgage derivatives.....its probably boring to you, but it might help to explain a little of what is going on right now.

If you're an expert in these derivates please don't e-mail me telling me how I botched these explanations.....they are correct enough to ensure normal people understand the basics of what is going on!

Scott Dauenhauer CFP, MSFP, AIF