CDO Market the Recent Recession

CDO Market

The recent recession had a multitude of different contributing factors. Among those factors was the allegedly aggressive marketing of collateralized debt obligations that had a high percentage of defaults on the underlying assets. As the value of these CDOs collapsed, the balance sheets of financial institutions that held a substantial portion of CDOs began to suffer, leading to a credit crunch that is widely believed to have been the tipping point at which the economy entered recession. This paper will discuss the nature of CDOs and their contribution to the financial crisis and ensuing recession.

CDOs

Scheicher (2009) explains the nature of CDOs. Collateralized debt obligations are "a set of claims of varying exposure to the cash flows from a portfolio of credit instruments." A CDO can have a number of tranches, reflecting different underlying assets and therefore different levels of risk. CDOs grew to prominence following the iTraxx credit index in the summer of 2004. "Firm-specific risk can be traded through credit default swaps and the correlation of credit risk within the underlying credit portfolio can be traded through credit index tranches." As Scheicher points out, CDO valuation is complex in part because of the complex nature of the product, the low liquidity of CDOs on the secondary market.

The complexity of CDO pricing is one of the weaknesses in the product that contributed to the financial crisis. While CDOs were sold to investment banks, hedge funds and other institutional investors, they were often treated as safe investments. The idea behind CDOs is to spread risk further around the economy by pooling diverse assets together in the CDO package. Therein lies the problem with the CDOs in the crisis. Barnett-Hart (2009) asserts that CDOs became heavily exposed to the U.S. residential housing market in 2006 and 2007, a time when mortgage quality had begun to deteriorate with a rapid increase in subprime lending. When the residential housing market collapsed, mortgage defaults increased dramatically. Neither the firms that held the CDOs nor the bond ratings agencies fully understood how to value CDOs, and as a consequence were caught off guard by the high percentage of poor quality assets in many of these securities.

The difficult with pricing CDOs, as Scheicher (2009) notes, is that their value relies on correlations. Thus, if a CDO has 100 underlying loans, valuing the CDO would require estimating comovement of 100 different companies. Most investment firms relied heavily on ratings agencies to attest to the security of CDOs, but for their part the ratings agencies relied on computer models for valuation that were inadequate to the task of measuring the risk in these securities (Barnett-Hart, 2009). As a result, the risk of CDOs was poorly understood.

One result of this poor understanding was that firms heavily invested in CDOs had little sense of how much risk they faced. Lehman Brothers, the investment bank that ultimately went bankrupt as a result of its CDO holdings, had been heavily involved in the CDO market, underwriting new issues on average every six weeks. It is questionable whether Lehman truly understood the risks, however, and it was largely assumed within the industry that the high degree of diversification would all but eliminate loan-specific risk (Lannin 2011). The housing market collapse, however, was broad-based and this meant that large portions of the CDOs, particularly in the lower tranches, were highly correlated, providing no diversification benefit.

Despite the complexity of CDO pricing, banks should have understood the risks posed by CDOs. Lannin (2011) notes that legal action taken against Lehman in Australia relating to its sales of CDOs alleges that the company was aware of the risks inherent in the products and simply ignored these risks in its marketing of the products. Hansel & Krahnen (2007) conducted a study that noted the equity beta of banks engaged in the marketing of CDOs increased relative to banks that did not market CDOs. This again highlights the risk associated with CDOs, especially given that the impact on the firm's beta was more pronounced in smaller, less well-capitalized banks.

While CDOs introduced more risk into the banking system, they also encourage more risk in the credit markets. CDOs accomplished this by providing a secondary market for credit assets. There was only a limited secondary market for low-grade corporate debt and for subprime mortgages prior to the rise of CDOs (Deng, Gabriel & Sanders, 2008). The increase in the amount of subprime loans granted in the U.S. correlates with an increase in the availability of a secondary market for such debt in the form of CDOs. In turn, this encourage the adding of more subprime debt to CDOs, as occurred in 2006 and 2007.

Thus, there were two major failings in the risk management systems at the banks that marketed CDOs. The first failing was the inability to accurately gauge the risk or to price CDOs. Too many banks appear to have relied on the ratings agencies, and their methods of evaluating these products were flawed. The second major failing was the failure to manage the level of subprime debt in CDOs. As this level increased, the level of risk of these products increased as well. Banks earn significant interest income on subprime debt so they have an incentive to market this type of debt, if the bank feels that it can sell the risk associated with that debt. This act of spreading the risk around the economy as a whole was intended to better insulate banks, but instead it seems to have simply encouraged them to take on more risky debt and repackage that for public consumption. The result is that the crisis in the U.S. housing market and subsequently the CDO market spread throughout the economy as a whole, making a significant contribution to the economic downturn.

It is recommended that ratings agencies and banks devise better formulae with which to evaluate the risks presented by collateralized debt obligations. Valuing these complex is a complex task, but must be done accurately in order to ensure the health of the financial system. In addition, there needs to be increased financial regulation in order to reduce the adverse selection that occurs when banks can offload the risk associated with subprime loans and other risky forms of credit. Having a ready secondary market encourages banks to write these kinds of loans, so it is important that there be means built into the financial system to avoid this, in order to avoid similar crises from emerging in the future.