What Is Warehousing?
Warehousing is a pivotal phase in a collateralized debt obligation (CDO) transaction involving the procurement of loans or bonds intended to serve as collateral. This warehousing period typically spans around three months, ceasing upon the culmination of the transaction when the assets are finally securitized and sold as part of the CDO.
Key Insights
- Warehousing constitutes the assembly and safeguarding of bonds or loans that will be securitized through a CDO transaction.
- A collateralized debt obligation (CDO) is an intricate structured-finance product backed by a collection of loans and other interest-bearing assets.
- This interim step generally covers a three-month period, wherein the underwriting bank faces the inherent risks related to holding those assets.
Grasping the Essence of Warehousing
A CDO is a structured financial product designed to pool together cash flow-generating assets and tirelessly reorganize this asset pool into distinct tranches for investors. The pooled assets, which include mortgages, bonds, and loans, function as debt obligations serving as the collateral, thus earning the term collateralized debt obligation. Each tranche of a CDO carries differing risk profiles. Senior tranches are relatively secure due to having priority in terms of collateral if a default occurs. These senior tranches carry higher credit ratings but offer lower yields, whereas junior tranches, although riskier due to their lower credit ratings, provide higher yields in compensation.
An investment bank plays a crucial role in executing the warehousing of these assets as it gears up to launch a CDO into the marketplace. The assets are held in a dedicated warehouse account until the predetermined target amount is accumulated, subsequently transferring the assets to the corporate entity or trust formulated for the CDO. This warehousing phase exposes the bank to capital risk, given that the assets linger on its balance sheets - a risk the bank may or may not choose to hedge.
The Roller Coaster of CDOs
During 2006 and 2007, institutions like Goldman Sachs, Merrill Lynch, Citigroup, UBS and others were deeply engrossed in warehousing subprime loans for CDO deals, which were highly demanded by the market – until the market’s sentiment shifted. Emerging issues dampened demand for CDOs, leading from a slowdown to an eventual collapse, resulting in collective losses amounting to hundreds of billions of dollars.
A detailed report from a U.S. Senate subcommittee titled, “Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,” highlighted that Goldman was handling assets for multiple CDOs simultaneously, often having a substantial net long position in subprime assets within its CDO warehouse accounts. In early 2007, internal concerns grew among Goldman executives regarding the risks carried by subprime mortgage-related assets in these warehouse accounts.
Subsequent actions by Goldman in managing these risks and dealing in CDOs led to charges of fraud and record fines, despite accepting taxpayer bailouts and continuing to issue substantial bonuses to employees, igniting broader debate and scrutiny.
Related Terms: Tranche, Securitization, Collateral, Capital Risk, Subprime Loans.
