Understanding CDOs

Question

I watched every documentary on the financial crisis and CDOs, tried to understand Wikipedia etc.. but still not getting the full picture as examples seem to be limited (or complicated).

Say Local-Bank-A starts providing mortgages to US subprime, big marketing campaign and sweet offer 100% mortgage, offer start 1 Jun and finish 31 August, so a 3 month marketing window. The sales and marketing guys believe they are going to close 10,000 mortgages with an average loan of US$100,000.

Where they do they get the money from first to finance 10,000 mortgages. Do they borrow US$ 1 billion and from where? When they borrow from other banks what collateral do they accept?

Okay 1st September comes round and Local-Bank-A has sold all expected 10,000 mortgages, exhausted the 1 billion and now wants to sell it on to Goldman Sachs etc.. What do they charge to sell it? How much money is in selling US$1billion of 100% mortgages to the wall street investment banks?

So they sell, they get the US$1billion back plus whatever profit and settle their original loan of 1 billion. They make some money out of this and start the process again?

Goldman Sach now has 1 billion of mortgages on their books and works quickly to CDO this and shift it on. How much were they making on this as obviously they had shell out at least 1 billion for them (as Local-Bank-A wouldnt be selling for a loss)?

When the bank sell these mortgages on who is responsible for collecting the monthly payments and handling redemptions etc..? Do US mortgages have a separate handling fee to a 3rd party entity like $10 a month? Who answers the phone when changing repayment amounts etc..

I talk in the current sense but obviously I mean 2006/2007.

Answer 1

When the bank sell these mortgages on who is responsible for collecting the monthly payments and handling redemptions etc..? Do US mortgages have a separate handling fee to a 3rd party entity like $10 a month? Who answers the phone when changing repayment amounts etc..

This would be the "servicer", which is often the bank/lending institution that wrote the loan in the first place. The servicer collects the monthly payment, subtracts its fee, and passes the payment on to the next guy.

It might be helpful to look at how GNMA/FNM/FRE handle the situation and turn the results into a "mortgage-backed security" (MBS):

1. The lender (usually a bank) writes the original loan by lending money it already has.
2. If the loan meets the underwriting standards, then GNMA/FNM/FRE will purchase the loan from the lender.
3. They will then bundle the loans into large pools so that the risk of an individual foreclosure/default won't adversely sink any individual bond. Sample list of GNMA pools and bonds from April 2011.
4. They'll carve the huge bundle of loans into individual bonds (usually denominated in $5k chunks).

Each pool is an MBS and will have its own unique CUSIP.

Where they do they get the money from first to finance 10,000 mortgages.

The lenders themselves don't need to "have enough to finance 10k mortgages", because they sell them as they get them.

Okay 1st September comes round and Local-Bank-A has sold all expected 10,000 mortgages, exhausted the 1 billion and now wants to sell it on to...

They will sell the notes within a day or two after the closing.

I know this isn't going to come close to answering all your questions, as some of them ("How much were they making on this?") cannot be answered.

Answer 2

Where they do they get the money from first to finance 10,000 mortgages. Do they borrow US$ 1 billion and from where? When they borrow from other banks what collateral do they accept?

It sounds like you're missing a basic understanding of how banking works here. In the fractional reserve system, a bank doesn't need to have 1 billion on its books to issue 1 billion in loans, it only needs to maintain the minimal capital ratio specified by the government. Say this ratio is 10%, they would need to have 100 million to lend out 1 billion.

Answer 3

I wanted to post it as comment to @codebolt's answer, but I'm not sure I would fit with the length limit.

I'm not sure I agree with the current wording of your response.

I think we mean the same, but I'd rather say they (the bank) need 1 billion in the first place (or exactly said 1,(1) billion) for example coming from deposits. They leave 10% of this 1,(1) billion as reserves, so they now have 1 billion left for lending.

Let's say they use the whole billion for lending. Now all this money will come back somehow to the financial system. If you borrow money, you have to keep it somewhere (let's assume it's not in your wallet). Even if you use it to pay somebody, he will have the same "problem".

So this way most of this 1 billion of initial lending will come back to our bank (or some other banks) as new deposits.

Rinse and repeat till no money comes back or you can't find new clients to lend money to.