It was usual day for Mr Kamkazi , class was not much interactive, students took no interest in class. But at the end of class one student asked one Question, `sir please explain me CDO and use of it in our banking system”.
Mr Kamkazi knew this is one of the complex topic to explain, it need utmost care to use examples otherwise it may be misunderstood and the most important is to keep check on your emotion towards this particular instrument.
He explained `Few years back banks were operating at the limit of Basel Norms and were eager to tap into the lending business without diluting their equity capital. Part of the reason securitization picked up so rapidly was that it offered a way lender to do just this. The method was simple. Say a bank has 100 crore as the equity capital and is allowed by the Basel Norms to lend up to 1000 crore of home loans. If the NIM on such loan asset is 1%, the bank can lend the Rs 1000 crore and make Rs 10 crore of net income every year. Alternatively, if it securitizes Rs 800 crore out of Rs 1000 crore of loans, and sell them to other investors, this investment tool is called as Collateralized Debt Obligation(CDO). Now bank`s lending come down to Rs 200 crore. Within the limits of Basel Norms it can again relend Rs 800 crore more”.
`Now you may raise the question ,what is the benefit of it on the other part? And my answer is simple, while securitizing , it makes the fee out of the difference of interest rate paid by the home loan borrowers and that received by CDO investors. In doing so , on the Rs 100 crore of Equity capital, instead of earning Rs 10 crore in the single lending case, it can make Rs 20 crore or more.”
Now Mr Kamkazi take a look over all his students and satisfied.
