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What Is Warehousing?
Let me explain warehousing to you directly: it's that middle phase in a collateralized debt obligation (CDO) deal where we buy up loans or bonds to use as collateral for the upcoming CDO. This warehousing usually runs for about three months, wrapping up when the deal closes and everything gets securitized and sold off as part of the CDO.
Key Takeaways
- Warehousing is the accumulation and custodianship of bonds or loans that will become securitized through a CDO transaction.
- A collateralized debt obligation (CDO) is a complex structured-finance product that is backed by a pool of loans and other interest-bearing assets.
- This intermediate step before the transaction is finalized typically lasts three months, during which time the underwriting bank is subject to the risks involved in holding those assets.
Understanding Warehousing
You need to know that a CDO is a structured financial product that gathers cash flow-generating assets and repackages them into distinct tranches for investors. These assets—think mortgages, bonds, and loans—act as debt obligations providing the collateral, which is why it's called a collateralized debt obligation. The tranches differ a lot in risk: senior ones are safer with priority on collateral if things go wrong, getting higher ratings but lower yields, while junior tranches have lower ratings and higher yields.
As an investment bank, I handle the warehousing by storing these assets in a warehouse account until we hit the target amount. Then, we transfer them to the corporation or trust set up for the CDO. During this time, the bank faces capital risk since the assets are on our books—you might hedge it or not, but the exposure is real.
CDOs Gone Wild!
Back in 2006 and 2007, firms like Goldman Sachs, Merrill Lynch, Citigroup, and UBS were heavily into warehousing subprime loans for CDO deals—the market couldn't get enough until it all fell apart. When demand dropped and the crisis hit, CDO holders lost hundreds of billions collectively.
A U.S. Senate subcommittee report, 'Wall Street and the Financial Crisis: Anatomy of a Financial Collapse,' detailed how Goldman was building assets for multiple CDOs, holding a big net long position in subprime stuff in their warehouse accounts. By early 2007, executives there were worried about the risks from these subprime assets.
How Goldman managed those assets and their CDO dealings afterward is a whole other story, but they got hit with fraud charges, paid massive fines, took a taxpayer bailout, and still handed out millions in bonuses to staff.
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