Opinion ID: 2820087
Heading Depth: 2
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Heading: The Structure of a CDO1

Text: The construction of a CDO begins, at least conceptually, with asset-backed loans, such as mortgages or car loans. These loans are, of course, contracts in which the lender trades capital up front for the borrower’s promise, secured by the borrower’s asset, to make monthly payments. Banks frequently sell their secured rights to the monthly payments to the makers of financial products known as “asset-backed securities,” the most prominent of which are mortgage-backed securities (“MBSs”). An MBS is created when a financial institution bundles a large number of mortgage loans into a special-purpose entity. The resulting entity owns the rights to a large pool of borrowers’ monthly payments. The institution simultaneously sells notes backed by the MBS, i.e., by the bundle of loans, and may also sell equity interests in the MBS. When the maker of an MBS does this—when it sells the rights to the cash flow generated by the mortgages in its bundle—it may do so by creating different classes, or “tranches,” of notes. “Tranching” allows the bank to create notes with different risk- 1 Our description draws from and supplements the helpful accounts already given by other courts, including panels of our Court as well as district courts in this Circuit. See, e.g., Fin. Guar. Ins. Co. v. Putnam Advisory Co., LLC, 783 F.3d 395, 398 (2d Cir. 2015); Gearren v. McGraw‐Hill Cos., Inc., 690 F. Supp. 2d 254, 258 n.2 (S.D.N.Y. 2010); In re Am. Int’l Grp., Inc. 2008 Sec. Litig., 741 F. Supp. 2d 511, 520 (S.D.N.Y. 2010). For a more comprehensive introduction to CDOs, see generally Douglas J. Lucas, Laurie S. Goodman & Frank J. Fabozzi, Collateralized Debt Obligations: Structures and Analysis (2d ed. 2006). 4 13‐1476‐cv Loreley Financing (Jersey) No. 3 v. Wells Fargo Securities, LLC and-return profiles and thereby to attract a variety of buyers, from the most risk-averse to the least. Such tranches are often classified by letter, with first priority in receiving payment given to the holders of tranche “A” notes, second priority to “B,” and so on. The riskier, lower-priority notes will receive higher interest rates. (Although lettering conventions differ across MBSs, the mechanics are roughly the same, regardless of how the various tranches are denominated.) At the bottom of the hierarchy is a small class of investors who have purchased equity interests in the MBS. The payment scheme for the different tranches is typically known as a “waterfall.” As mortgage payments come into the MBS entity, they cascade, “watering” tranche A noteholders first, then B, and so on down to the equity. No part of the borrowers’ payments will go to the holders of equity in the MBS unless those payments exceed what the MBS must pay to its noteholders. The brunt of any borrower’s default on one of the underlying mortgages is therefore borne first by the equity interest, then by the most junior notes, intermediate notes, and so on. It takes a large number of defaults to impair the cash flow to holders of tranche A notes—which is what makes those notes the least risky. If, however, the MBS performs well, receiving full payment, the holders of the riskier tranches (and especially the equity) will receive higher returns. By bundling large numbers of mortgages together into tranched MBS notes, a bank can achieve a number of goals. For one, it can create securities that enable nonlending institutions to invest in the housing market. In addition, it can create relatively safe investment opportunities through the senior tranches, because it takes widespread mortgage defaults to impair the cash flow to those tranches. Needless to say, the word 5 13‐1476‐cv Loreley Financing (Jersey) No. 3 v. Wells Fargo Securities, LLC “relatively” bears emphasizing in light of the real estate market collapse that lies behind this case and the many other cases like it. In the same way that an MBS comprises a bundle of mortgage notes, a CDO comprises a bundle of MBS (or other asset-backed security) notes. Thus, where an MBS is a financial product backed by mortgages, a CDO is, in a sense, simply a second-order MBS, backed by those first-order financial products. A CDO is likewise built by creating a special-purpose entity that takes possession of a large group of notes—say, tranche B notes of various MBSs. The CDO will then sell to investors tranches of notes with diminishing priority, paying out the funds collected on the securities held by the CDO to noteholders in the order of the tranches’ relative priority. A related type of derivative security available to investors in the mortgage market is a “credit default swap” (“CDS”). A CDS is known as a “derivative” because it transfers the risk associated with owning a particular security without necessarily transferring ownership of that security. In general, derivatives are purely financial contracts that call for payment by one contracting party to the other based on a specific event, such as fluctuation in the value of a selected security, interest rate, market index, or the like. Investment in a mortgage-based CDS is the opposite of investment in mortgage notes, in that it benefits the investor only if the borrowers do not make their mortgage payments. More precisely, the purchaser of the CDS promises to make regular monthly payments to the issuer in exchange for the issuer's promise to pay the purchaser in the event—and roughly to the extent—that borrowers default in making 6 13‐1476‐cv Loreley Financing (Jersey) No. 3 v. Wells Fargo Securities, LLC payments on the selected category of mortgage notes. Unless such defaults occur, the CDS buyer gets nothing in return for her regular payments. Investment in mortgage-based CDSs can serve two purposes. First, it may function as a speculative bet against the mortgage market. In other words, an investor who believed the housing market to be unrealistically inflated could purchase a CDS in anticipation of borrowers’ defaults. Such an investor is essentially shorting the mortgage market, while the issuer of the CDS is taking a “long” position in that market.2 Indeed, an investor eager to capitalize on an expected downturn in the market could increase its short position by purchasing multiple CDSs, thereby placing what amounts to a very large bet on impending defaults by borrowers. A second use for a CDS is as a hedge, or insurance against such defaults. Thus, investors in MBSs or CDOs, whose cash flow and value depend on borrowers’ making their payments, can lessen the consequences of defaults by purchasing CDSs keyed to a similar class of mortgages. As pertinent here, some CDOs contain—in addition to asset-backed securities like MBSs—derivative securities like CDSs. A CDO might contain, for instance, not only specific tranches of MBS notes but also the long side of CDS contracts related to those tranches. In that case, the cash flow into the CDO would come from the regular 2 The buyer of a CDS is sometimes referred to as holding the long position. See, e.g., Anouk G. P. Claes & Mark J. K. De Ceuster, Single Name Credit Default Swap Valuation: A Review, in Credit Risk: Models, Derivatives and Management (Niklas Wagner ed., 2008). While we understand the motivation for that usage, we think that, at least in the securities litigation context, it makes more sense to use “long” to refer to the position taken by the party who stands to benefit from the success of the reference security—here, the CDS seller. See Lucas et al., supra, at 221 (“The protection seller under a CDS is said to be the seller of the CDS, but he is also long the CDS and long the underlying credit. The logic behind selling protection and being long the CDS is that the protection seller is in the same credit position as someone who owns, or is long, a bond.”). 7 13‐1476‐cv Loreley Financing (Jersey) No. 3 v. Wells Fargo Securities, LLC payments by the CDS buyers—the short investors—as well as payments on the underlying mortgages. The CDO would also bear the corresponding risk both of defaults by borrowers and of the payouts to CDS buyers triggered by such defaults. Given that CDOs consist of a portfolio of assets, a crucial matter for the makers of a CDO is deciding who will pick the assets, e.g., the MBSs and CDSs that will be bundled together to form the CDO’s collateral. Generally, this job is performed by a “collateral manager,” an entity or person who has discretion to select assets that further the goals, and fulfill the requirements, of the CDO. Such requirements may concern various characteristics of the collateral securities, including their ratings by credit ratings agencies, their contractual structure, and their performance to date. With that basic structure in mind, we turn to the particulars of this case.