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Subprime residential mortgage defaults are generally viewed as being the genesis of the global financial crisis that began in 2007. Collateralized debt obligations (CDOs) facilitated the origination and leveraging of subprime mortgages. CDO structures were used to assemble mortgages into portfolios and to finance the mortgages by issuing tranches. Tranches are securities that represent claims on the assets of the CDO and in the case of mortgages are often termed RMBSs (residential mortgagebacked securities). Typically 70% to 75% of the mortgages held in the collateral pool of a CDO could be financed "with senior tranches that received AAA credit ratings. But perhaps 20% to 25% of the value of these CDO mortgage pools was financed by mezzanine tranches that received credit ratings somewhat lower than AAA (e.g., BBB or A) and were more difficult to place.
These mezzanine tranches were then often assembled into portfolios for an additional layer of structuring and securitization. This second level of CDOs is the primary subject of this article. These CDOs holding tranches of other CDOs are referred to in this article as ABS-CDOs (asset-backed security CDOs) but can also be termed "CDOsquareds." ABS-CDOs were able to be financed with substantial portions (widths) of tranches rated AAA. In this manner, mortgages in general and subprime mortgages in particular could be financed with over 90% of the funds directly or indirectly having a triple-A rating when both levels of securitization are included.
THE ECONOMICS OF SUBPRIME MORTGAGES
Prime mortgages are loans that are backed by real estate and are viewed as having high probabilities of repayment due primarily to the creditworthiness of the borrower. Subprime mortgages have borrowers with documentation that indicates lower creditworthiness. Subprime mortgages tend to have higher default rates and higher interest rates.
Mayer, Pence, and Sherlund [2009] provide a detailed review of the development of the subprime mortgage market leading up to the financial crisis. Exhibit 1 summarizes the growth in subprime mortgages from 2000 to 2006 in absolute terms and relative to prime mortgages.
Subprime mortgage are now known to have experienced high default and foreclosure rates during the recent financial crisis. Exhibit 2 indicates that the historical foreclosure rates on subprime mortgages were declining in the five years...