SAN FRANCISCO (MarketWatch) -- After a mortgage is sold, it's usually packaged up with other home loans into a mortgage-backed security, or MBS.
But who buys the riskier parts of these derivatives -- the bits backed by subprime mortgages offered to poorer borrowers with lower credit scores? The answer may be collateralized debt obligations, or CDOs.
They could now do the reverse, according to a recent study by Joseph Mason, an associate finance professor at Drexel University's business school, and Joshua Rosner, a managing director at research firm Graham Fisher & Co.
By exiting in search of more attractive assets, CDOs could limit the supply of money to the mortgage market, making home loans more expensive and reducing the availability of subprime loans, Mason said in an interview this week.
"We started out a few months ago trying to find out who is investing in the riskiest portions of these MBSs," Mason said. "We found the answer to the big question: the CDO sector."
"CDOs are providing the primary liquidity at this level, but they're hot money that will jump in and out of sectors," he added.
CDOs have become an important part of the mortgage market because they buy the riskier parts of MBS that others don't want. The higher-rated portions, or tranches, of MBS are sold to pension funds and insurers. But if the riskier tranches aren't sold too, the whole deal is off, Mason explained.
"You may remember the phrase 'banking system,'" Grant wrote on March 9. "Today, in residential mortgage finance, there is a CDO system."
Stagnant home prices and rising delinquencies on subprime mortgages have sparked concern that some riskier MBS tranches could suffer losses. That, in turn, could hit CDOs.
"Even investment grade rated CDOs will experience significant losses if home prices depreciate," Mason and Rosner said in their study.
If CDOs take some of the hit, they could exit the residential mortgage market, Mason warned.
Something similar happened several years ago. During the late 1990s, CDOs invested a lot in asset-backed securities backed by manufactured housing loans and aircraft leases. After suffering losses, CDOs got out of those sectors, Mason said.
Even today, the manufactured housing and aircraft leasing industries still feel the effects of that shakeout when trying to borrow money via the asset-backed securities market, Mason said.
The implications of CDOs withdrawing from the residential MBS market could be far-reaching, Mason said.
"If they lose their appetite, that would mean lower tranches of residential MBS can't be placed and upper tranches won't be sold either," Mason warned. "Mortgage lenders may then find it harder to sell on the loans they originated."
That, in turn, could lift interest rates, even for home buyers with good credit scores, and cut the availability of home loans for subprime borrowers, he explained.
"These markets are all intertwined and if we care we need to monitor this," Mason concluded. "This all comes back to mortgage borrowers and whether they'll be able to get loans."
