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The alchemy at the center of the subprime-loan crisis

CDOs are complicated - and important.

See Yeng Quek, executive vice president and managing director of fixed income at Center City's Delaware Investments, which manages $6 billion in collateralized debt obligations, or CDOs.
See Yeng Quek, executive vice president and managing director of fixed income at Center City's Delaware Investments, which manages $6 billion in collateralized debt obligations, or CDOs.Read moreRON TARVER / Inquirer Staff Photographer

At the heart of today's subprime-mortgage crisis are complicated investments that Vanguard Group founder and financial curmudgeon John C. Bogle called a "modern version of alchemy," the medieval pursuit of turning lead into gold.

The investments are called collateralized debt obligations, or CDOs. To understand how subprime lending got so out of hand - enabling a housing bubble whose deflation threatens to topple the U.S. economy into recession - requires a grasp of how they work.

Today, the Federal Reserve is widely expected to lower its benchmark interest rate to help steady the economy.

Bogle said the lead in this case was "B"-rated mortgages "miraculously turned into the gold . . . of a $100 million CDO with 75 percent of its bonds rated 'AAA.' "

Like other products of financial boom times, such as junk bonds in the 1980s or dot-com stocks in the 1990s, the market for subprime CDOs was predicated on the powerful feeling that the good times would never end.

But they always do. And crushing losses, which usually wipe out some firms, follow. UBS AG's $10 billion write-down yesterday brought this fall's losses at big financial institutions to more than $50 billion.

How does a pool of thousands of mortgages to borrowers with poor credit or no down payment garner top credit ratings?

That kind of magic requires a special kind of division. Investment banks pool borrowers' monthly mortgage payments and divide them among different classes of investors. Those with the highest-rated slices - and lowest returns - have first dibs on the cash. Those with lower-rated slices get their cash afterward, and are rewarded with a higher interest rate - provided borrowers continue to pay off their mortgages.

That structure enabled the creation of ever more high-yield - and ostensibly high-quality - securities that pension funds and other large investors were clamoring for during a period of low interest rates on traditional bonds.

The resulting flood of $2 trillion in subprime loans - most with adjustable interest rates after two years - into the housing market from 2003 through 2006 caused home prices to soar and swept up people such as Regina Taylor, of Philadelphia's Mount Airy section.

Taylor borrowed $78,000 from Countrywide Financial Corp. in an early 2005 refinancing to pay for home repairs and her grandmother's nursing-home expenses. She fell behind after losing her job last year. Now she is working, but the monthly payments on her adjustable-rate mortgage have soared from $515 to $899, which she cannot afford.

Taylor and millions of others drove the U.S. delinquency rate to 5.59 percent in the third quarter, the highest level since the second quarter of 1986, according to the Mortgage Bankers Association. The portion of the nation's 45 million mortgage loans in foreclosure was estimated at 1.69 percent, or 760,500 - the highest ever, the lenders' group said.

Despite the industry rescue plan announced last week by the Bush administration, conditions are expected to worsen next year, with roughly 150,000 subprime mortgages per month scheduled to undergo their first interest-rate adjustment.

That means losses at banks and other financial institutions are likely to continue - a prospect that has the Federal Reserve under pressure to lower its benchmark interest rate at a meeting today for the third time since September.

"Right now the extent of the damage is unknown," said See Yeng Quek, executive vice president and managing director of fixed income at Center City's Delaware Investments, which manages $6 billion in CDOs as a small part of its $160 billion investment-management business.

CDOs belong to the field of structured finance. What that means is that the money generated by an underlying pool of debt is divided into tranches - French for slices - for different groups of owners.

Structured finance - or asset-backed securities - started out innocently enough in the 1970s as a way to make pools of mortgages more attractive to institutional investors who did not like the uncertainty of when they would get their money back.

That's because homeowners tend to refinance if interest rates go down - leaving the investor to find a new investment at a lower rate - and to hold on to their mortgages if rates go up, forcing the investor to forego higher returns in the market.

Investment banks solved the problem of prepayment risk by dividing the principal and interest payments from the mortgages into distinct slices for different classes of bondholders. That meant that some would get paid off sooner than others.

Such financial structure can be applied to any debt that generates a stream of cash and is used mainly to create bonds with high ratings from relatively low-quality assets.

For example, the investment bank Lehman Bros. Holdings Inc. issued a prospectus this year for an $816.13 million pool of 5,652 mortgages with an average credit score of 619, which is considered risky.

Out of that weak mortgage pool, Lehman planned to create 15 tranches, including six with a principal amount of $692.33 million that had "AAA" ratings.

The likely fate of the lower tranches with "BBB" ratings - which are designed to take the first losses - is a sale to a CDO, a "special-purpose entity" set up expressly to buy many kinds debt securities, not just subprime mortgages.

The subprime CDO sets up the same kind of tranches, creating yet another set of "AAA"-rated securities based on what are essentially junk bonds based on junk mortgages.

As long as home prices kept going up, troubled borrowers could refinance and the losses could be pushed forward. That was true until early this year, when lenders were deluged by borrowers who had failed to make the first few payments on loans.

Among the casualties, for now, are CDOs, which exploded from $87 billion in 2003 to $533 billion last year. Delaware Investments and a partner completed a subprime CDO in July, not long before the window slammed shut on subprime securitizations in August.

"We expect to have some losses there," Quek said, but he is comfortable with the CDO's prospects because Delaware invested only in fixed-rate subprime asset-backed securities.

Quek, whose experience with mortgage-related securities dates to the 1980s, said Delaware Investments had been cautious about CDOs because it also managed the general account for its insurance-company parent, Lincoln National Corp.

"Whenever something is growing that rapidly, it's a sign that something is wrong," Quek said.

Go to for previous coverage of the subprime meltdown, including an interactive map of the region. EndText