Discussion in 'General Investing Discussion' started by Ema24, 14th Jun, 2013.
What is the Key Difference between a Subprime Mortgage and a CDO?
A good first question needing a slightly more complicated response.
Sub prime mortgage is the name given to US mortgages which were given to people whose credit history did not enable them to get more conventional mortgages. Sometimes given to people with no credit history or at the very least impaired history and often withour evidence of the ability to repay the loan.
CDO's are a tool that allowed banks to repackage individual loans (of all types, sub prime, conventional mortgages, car loans, credit card debt, commercial debt, etc) into a bundle to become a product that could then be sold onto investors on the secondary market. The promised repayment of these loans as collateral that gave them value.
The link between the two is that for some CDO's, subprime mortgages were a part of the mix of what made up the CDO. They became difficult to price, the asset backing fell and they became toxic and it snowballed across the whole product range of CDO's.
Hope this helps, plenty of information on a Google search.
Thank you for your response, I had searched Google - information overload that clouded my brain and ability to take in information.
Your response helped me understand.
So, what I got from that is:
The key difference between a subprime mortgage and a CDO is that a subprime is a mortgage product, and a CDO is an investment option made up of a bundle of mortgage products (including a sub-prime mortgage) that investors can invest in.
Therefore, sub-crime = mortgage (lending product), CDO = Bundled Loans made into an Investment Option.
And what really messed up the system is that other financial institutions started selling insurance on CDOs, so if the CDO went belly-up, the insurance would pay out. This enabled players to "bet against" CDOs, which flowed back and encouraged CDO originators to package up the smelliest load of old fish they could find (the smellier the better for the people buying the insurance and waiting for the CDO to fail).
Where that really came unstuck was the insurance was priced according to the ratings agencies opinion of the CDO quality. It was relatively straightforward for the CDO originators to package up different types of old fish such that the combination looked to the ratings agencies like AAA.
The originators needed an ongoing supply of old fish, and that's why they encouraged the mortgage suppliers to lend to people who couldn't afford it.
Betting against the loan only works if you can be sure the loan is going to fail.
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