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Mbs And Cdo's - How Do They Work Exactly?


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Can any of the city/finance types on here please explain the following to a humble engineer:

Ok I understand that a lot of lenders - especially sub-prime - have been selling on the debt packaged up as CDO's or MBS's - are these the same thing by the way? But how does ths actually work in practice? Say I have a mortgage with Northern Rock, they sell my debt on, it gets sliced/diced/re-sold/leveraged etc, etc. But as far I am concerned I still pay my monthly payments of capital plus interest (or just interest if IO) to NR. Do they (NR) somehow pass this money on to the current holder of the debt? Or maybe it's holders if the debt has been subdivided? This would requre someone to be tracking who is currently holding the debt in some sort of central register, which would be hugely complex and costly, so I guess this does not happen in practice, so how does this selling on of debt work?

Confused bear.

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Can any of the city/finance types on here please explain the following to a humble engineer:

Ok I understand that a lot of lenders - especially sub-prime - have been selling on the debt packaged up as CDO's or MBS's - are these the same thing by the way? But how does ths actually work in practice? Say I have a mortgage with Northern Rock, they sell my debt on, it gets sliced/diced/re-sold/leveraged etc, etc. But as far I am concerned I still pay my monthly payments of capital plus interest (or just interest if IO) to NR. Do they (NR) somehow pass this money on to the current holder of the debt? Or maybe it's holders if the debt has been subdivided? This would requre someone to be tracking who is currently holding the debt in some sort of central register, which would be hugely complex and costly, so I guess this does not happen in practice, so how does this selling on of debt work?

Confused bear.

Bob,

I guess there are no banker types about today.

I started trying to answer your question, but it's a long and silly story. I suggest you take a look at this excerpt from the New York Times which does a better job than I could. NY Times I hope it helps

JR

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Can any of the city/finance types on here please explain the following to a humble engineer:

Ok I understand that a lot of lenders - especially sub-prime - have been selling on the debt packaged up as CDO's or MBS's - are these the same thing by the way? But how does ths actually work in practice? Say I have a mortgage with Northern Rock, they sell my debt on, it gets sliced/diced/re-sold/leveraged etc, etc. But as far I am concerned I still pay my monthly payments of capital plus interest (or just interest if IO) to NR. Do they (NR) somehow pass this money on to the current holder of the debt? Or maybe it's holders if the debt has been subdivided? This would requre someone to be tracking who is currently holding the debt in some sort of central register, which would be hugely complex and costly, so I guess this does not happen in practice, so how does this selling on of debt work?

Confused bear.

Confused Bear - first up CDOs and MBSs are different. MBSs or Mortgage Backed Securities (includes RMBS and CMBS [r = residential, c = commercial], are exactly what they say on the tin - securities that are backed by mortgages. Typically many thousands of mortgages are grouped together to create a cashflow structure that pays off a bond. This way the risk can be moved to whoever wants to hold it.

CDOs or Collateralised Debt Obligations are structures that are backed by any bonds/credit deault swaps (credit default swaps = protection on a 'name' or firm, or mortgage broker or whatever going bankrupt or having a 'Credit Event' i.e. usually where they are unable to make the re-payments as originally sepcified).

CDOs group a whole load of these 'credit derivatives' (essentially securities based on loans), in a super strcuture. Say there are a 100 such securities, the first 5% of the 100 can't make repayments, then this will first effect the first group of investors in the 'equity tranche' only. This 'tranche' will pay a commensurate interest payment to reflect the risk. If 4% of the underlying debt obligations don't pay up, then 4/5ths of the first tranche will not get their money back that they've invested.

So if 5 go bust, the next 'tranche' up won't be affected. Say 8 go bust, now the second tranche is affected and they might lose some or all of their originally invested money and so on and so forth till you get to the top rated tranche which needs 45 or so firms to go bust before its investors are affected.

There are a few types of CDOs - centring around whether the CDO depends on the actual cash flows from the underlying debt coming through, or is simply made to reflect the original debt 'synthetically.' Synthetic CDOs allow for far greater gearing and leverage - originating investment banks might buy one share in the underlying firm to make sure they know if they default to make sure they track the underlying debt for their synthetically produced CDO.

CDOs are not inherently evil or misleading or toxic. It all depends on how honest you are with the risk, interesst or 'coupon,' rating and info to and from rating agencies and crucially - what kind of debt they are backed by. If they are backed by the debt obligations of FTSE 100 companies, then it's less likely to go belly up than dodgy sub prime mortgages you might have bought up. You can put pretty much anything into a CDO... student loans, car loans, sovereign debt, mortgages, commercial mortgages, government debt, shares, bonds, loans, whatever. A structure concentrating wholly on loans would be a Collateralised Loan Obligation and so on.

The underlying loans are not tracked on a one-to-one basis. Investment banks don't give a flying koala whether mr and mrs robnison are missing their payments. The originating mortgage provider aggregates his mortgage incomings and passes them along on pre-agreed payment dates. If he has less money coming in then he will only pass that amount on, having got 'protection' on such losses as part of his deal to sell the loan on.

Hope this helps,

Kingmaker

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Can any of the city/finance types on here please explain the following to a humble engineer:

Ok I understand that a lot of lenders - especially sub-prime - have been selling on the debt packaged up as CDO's or MBS's - are these the same thing by the way? But how does ths actually work in practice? Say I have a mortgage with Northern Rock, they sell my debt on, it gets sliced/diced/re-sold/leveraged etc, etc. But as far I am concerned I still pay my monthly payments of capital plus interest (or just interest if IO) to NR. Do they (NR) somehow pass this money on to the current holder of the debt? Or maybe it's holders if the debt has been subdivided? This would requre someone to be tracking who is currently holding the debt in some sort of central register, which would be hugely complex and costly, so I guess this does not happen in practice, so how does this selling on of debt work?

Confused bear.

http://www.marketoracle.co.uk/Article1858.html

explains it all.

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Confused Bear - first up CDOs and MBSs are different. MBSs or Mortgage Backed Securities (includes RMBS and CMBS [r = residential, c = commercial], are exactly what they say on the tin - securities that are backed by mortgages. Typically many thousands of mortgages are grouped together to create a cashflow structure that pays off a bond. This way the risk can be moved to whoever wants to hold it.

CDOs or Collateralised Debt Obligations are structures that are backed by any bonds/credit deault swaps (credit default swaps = protection on a 'name' or firm, or mortgage broker or whatever going bankrupt or having a 'Credit Event' i.e. usually where they are unable to make the re-payments as originally sepcified).

CDOs group a whole load of these 'credit derivatives' (essentially securities based on loans), in a super strcuture. Say there are a 100 such securities, the first 5% of the 100 can't make repayments, then this will first effect the first group of investors in the 'equity tranche' only. This 'tranche' will pay a commensurate interest payment to reflect the risk. If 4% of the underlying debt obligations don't pay up, then 4/5ths of the first tranche will not get their money back that they've invested.

So if 5 go bust, the next 'tranche' up won't be affected. Say 8 go bust, now the second tranche is affected and they might lose some or all of their originally invested money and so on and so forth till you get to the top rated tranche which needs 45 or so firms to go bust before its investors are affected.

There are a few types of CDOs - centring around whether the CDO depends on the actual cash flows from the underlying debt coming through, or is simply made to reflect the original debt 'synthetically.' Synthetic CDOs allow for far greater gearing and leverage - originating investment banks might buy one share in the underlying firm to make sure they know if they default to make sure they track the underlying debt for their synthetically produced CDO.

CDOs are not inherently evil or misleading or toxic. It all depends on how honest you are with the risk, interesst or 'coupon,' rating and info to and from rating agencies and crucially - what kind of debt they are backed by. If they are backed by the debt obligations of FTSE 100 companies, then it's less likely to go belly up than dodgy sub prime mortgages you might have bought up. You can put pretty much anything into a CDO... student loans, car loans, sovereign debt, mortgages, commercial mortgages, government debt, shares, bonds, loans, whatever. A structure concentrating wholly on loans would be a Collateralised Loan Obligation and so on.

The underlying loans are not tracked on a one-to-one basis. Investment banks don't give a flying koala whether mr and mrs robnison are missing their payments. The originating mortgage provider aggregates his mortgage incomings and passes them along on pre-agreed payment dates. If he has less money coming in then he will only pass that amount on, having got 'protection' on such losses as part of his deal to sell the loan on.

Hope this helps,

Kingmaker

Thanks Kingmaker, nice, very nice! ;):rolleyes:

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Thanks very much Kingmaker for your very detailed answers, and to the other posters for the links - which I'm working my way through, kind of open mouthed as I read.......

My gut feeling has always been that the root cause of HPI is simply too much easy credit, but now I understand the source; money conjured from thin air by very clever, but irresponsible city boys.

As a simple engineer I had only an inkling of the sort of tricks these "masters of the universe" types on Wall St and the City have been up to. Regulation? there doesn't appear to be any. I've always thought that these people were spivs and wideboys (as my father would have called them) now I know they are. It beggars belief that these people are allowed to to put the entire world financial system at risk with their complex games and greed. This is what happens when economies lose sight of creating real wealth based on making things, and sensibly valued assets, and instead become obsessed with making money from money by gambling without any regard to any real underlying creation of real wealth or assets - all very scary.

I STR last month, but I'm now beginning to wonder if my house fund is actually safe anywhere!! I've already moved it all out of Northern Rock as a result of some of the comments on here about there funding and cash flow. However, as others on here have said in other threads, at least you can live in a house. If things get really, really, really bad, there could come a point where so many are re-possessed, that most houses will simply not sell, and there will be nowhere for the homeless to go, defaulters will just be allowed to stay in their homes and pay what they can, as there would be no point in the lenders kicking them out. Maybe I should buy a more expensive house with the biggest mortgage I can get and then not bother paying the mortgage......

Seriously though, by STR we have swapped our 4-bed cardboard box on an estate; that was getting to the stage where a lot of things were wearing out, for a a fantastic newly renovated 15thC cottage with grounds, gardener, sweeping gravel drive, and no neighbours within sight or earshot. Bliss. And all for the price of our after tax interest on our STR fund, plus the money we were paying for our mortgage, plus about £200pm on top. This is the sort of place we could never afford to buy, but it'll be a bit like an extended holiday let for the next year or two until we can see through the smoke - hopefully. The fact that we can do this shows (yet again) how distorted the house market in the UK has become over the last few years though.

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  • 441 Brexit, House prices and Summer 2020

    1. 1. Including the effects Brexit, where do you think average UK house prices will be relative to now in June 2020?


      • down 5% +
      • down 2.5%
      • Even
      • up 2.5%
      • up 5%



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