In a nutshell, REITs would purchase mortgage debt or real estate related assets for investment, create a CDO, and then fill it with the mortgages or real estate assets they had purchased. In theory, the cost of the CDO debt was much lower than the yield on the mortgages, and REIT investors would benefit from the spread (arbitrage) income. It didn’t always work out so well, and for those of you that want to learn more about CDO structures, I have posted these excellent video tutorials. It would also be beneficial to re-read my post on FAS 159 (Muddled Mortgage REIT Book Values Create Opportunity) after you watch the videos. FAS 159 is closely connected to “legacy” Mortgage REIT CDOs and very important relative to the book value debate. In this market however, this is mainly an academic excercise. Don’t ever forget that operating cash flow is king, not GAAP income.
By way of introduction, Mortgage REITs issued synthetic, or arbitrage CDOs. They sold the debt to third party investors (in some cases, other CDOs), and held the equity. Since the debt was sold and the equity held, Mortgage REITs can never lose more than the amount of their equity investment:
Mortgage REITs also earned a yield on the equity investments they held. However, the concept of subordination meant that the equity yield would disappear if the senior lenders were put at risk. In order to get investment grade ratings on the senior tranches, any losses would first be applied to the junior tranches (the equity and mezzanine tranches). This was the result of tranching and overcollateralization, and this next video introduces those concepts:
In addition to tranching, the senior tranches were also (in theory) protected by “overcollateralization”, or that the investors would be holding assets that were greater in value than the total value of the securities they had purchased. This also relates to “over-collateralization tests”, that were designed to divert cash flows away from the equity and to the more senior tranches if and when a certain amount of defaults occurred in the reference portfolio:
Do read the REIT Wrecks summary of FAS 159, it may be easier to understand after watching these videos. It may also be helpful to read my other post on the mechanics of mark to market accounting. It is doubtful that the CDO market will ever come back in the same form for Mortgage REITs, but with so many legacy assets out there, and the opportunity for Mortgage REITs to repurchase their own high yielding CDO debt, understanding CDOs, FAS 159 and mark to market accounting is a critical foundation for conducting accurate research and due diligence on Mortgage REITs.