CDO Squareds: The Case of Subprime Mortgages

Abstract

Investment in residential subprime mortgages through structured products was at the heart of the financial crisis that began in 2007. Perhaps the most toxic such product was the CDO-squared. CDO-squareds are CDOs (collateralized debt obligations) with tranches of other CDOs serving as their collateral pool. CDO-squareds on mortgage-backed securities (ABS-CDOs) issued vast quantities of AAA rated securities that quickly fell to market values of a few cents on the dollar. This article examines ABS-CDOs with two primary purposes. First, it provides an intuitive explanation of ABS-CDOs, including their characteristics, risks, and models. Second, it performs a comprehensive sensitivity analysis of the AAA senior tranche width with respect to various parameters based on the Hull and White model of mortgage-backed securities. The authors find that ABSCDO senior tranche widths were unreasonable prior to the financial collapse that began in 2007, and they attribute the associated rating errors with the non-linearity, hyper-sensitivity, and complexity of the risks of the products with respect to their underlying parameters. Simply put, there is no reliable basis on which accurate measurements of risk can be made using existing data and theory.