The ABC of CDOs and the sub-prime crisis

Co-authored by Rochak Agarwal, who is a 2nd year BMD student at XLRI

Vinod Kothari & Rochak Agarwal: The ABC of CDOs and the sub-prime crisis
Vinod Kothari & Rochak Agarwal / New Delhi August 13, 2007

Circa 2005, the US housing market was booming. As conveyed by the June 2005 Time magazine’s cover title “Home $weet Home,” the housing market was minting money for everyone. Amid this, every individual in the US was living the American dream to own a house. Housing prices were consistently rising and appreciation was the highest over the past 30 years. This, coupled with historically low interest rates, prompted most people to buy “investment properties”.

In the US mortgage market, by borrower quality, a mortgage is prime, sub-prime, or Alt-A. Prime borrowers are those who have good credit scores, a strong debt-to-income ratio, provide required documentation, tax history, residence records and so on. The mortgage is a first-lien mortgage. A sub-prime mortgage is to a borrower who does not qualify as per prime norms, or it is a second-lien mortgage. An Alt-A is to a borrower who is not necessarily poor quality, but does not qualify for prime lending due to documentation problems.

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