I’ve always struggled a bit with wrapping my head around these types of instruments. Can someone provide a simple walkthrough of pros/cons of the various instruments?
If you plug the following search string into Google, it’ll bring back some useful papers: “risk cdo gaussian copula valuation filetype:pdf”
I’ll start from ABS (Asset Backed Security). An ABS is simply a pool of financial products that have an associated cash flow i.e. mortgages, auto loans, credit cards, student loans, accounts receivable, etc… These financial products are securitized by Wall Street ibanks and sold to investors in the form of Asset Backed Securities/Bonds. A MBS (Mortgage Back Security which can be CMBS or RMBS) is simply a subset of ABS. Thousands of mortgages are pooled together to form a single MBS. The principal and interest payments from the homeowners flow into the MBS and are then paid out to investors. L2 dives pretty deep into MBS. A CDO (Collateralized Debt Obligation) is a SIV (Structured Investment Vehicle) and is a portfolio of ABS. CDOs are the financial products of doom we have been hearing so much about over the last 2 years with regard to the financial crisis. CDOs have seniority structures (tranches) that dictate which groups of investors are paid first, second, etc…last. CDOs have come under fire because the ratings agencies like S&P, Moody, etc… would rate a particular CDO AAA while its entire portfolio of ABS was no higher than BBB. Their thinking was that MBS had relatively low default correlations and would never go bad all at the same time. Not to blow your mind but Wall Street also invented the CDO^2, no joke, which is a CDO made up of CDOs made up of ABS. CDS (Credit Default Swap). Simply put a CDS is an insurance policy against the default of a particular debt. I would google this one if you want more info. http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf Read that paper if you want to learn more about CDOs and CDS.
Ok, all this reading sparked another question. CMO vs MBS. Seems like the same thing. This is all very helpful though, there is like an alphabet soup of structured finance now.
Major difference between the two is: In MBS, all holders of securities from that pool, have same risks for prepayments and defaults. Whereas in a CMO, pool is structured into various tranches, each having different risk profile.