Sign Up Now
Get instant access to over 1 million+ study documents
OR
Already registered? click here to login
By creating your account, you agree to our terms of service, privacy policy and student honor code.
Lending to "subprime" borrowers was encouraged, in part by the liquid secondary market for subprime mortgages that was created by the popularization of CDOs. The widespread defaults in the U.S. mortgage market created a situation where CDOs were subject to considerable default risk. While individual-specific risk had been eliminated, market risk had not. When the market tanked, the value of the CDOs did as well. That many viewed them as investment grade products only complicated the issue -- now these investors needed to sell their CDOs because their risk profile was skewed. A European study of banks that held CDOs and banks that did not found that the banks with CDOs were riskier in the long-run than those that did not have CDOs (Hansel & Krahnen, 2007). Fender and Kiff (2004) determined that there are multiple different rating methodologies and the choice of methodology can have a significant impact in the assessment of risk. This calls into question the appropriateness of the methodologies used by ratings agencies and the banks that invested heavily in CDOs.
Recommendations and Conclusions
The first recommendation is that bond rating agencies -- and financial institutions interested in purchasing CDOs -- develop a better formula for pricing the risk associated with these types of instruments prior to issuing a rating. Essentially, investor confidence in the product was buoyed by the liquid secondary market and the investment-grade credit ratings. This lead to a proliferation of CDOs that introduced substantial risk to financial markets (Deng, 2008). The market would not have been so big -- CDOs would not have introduced the amount of risk into the economy that they did -- had the ratings agencies more...
The system collapsed because the system had taken on too much risk. This occurred because firms were able to package off that risk and sell it -- thus they were given motivation to take on more risk. If firms were compelled to carry their own risk, the catastrophe would have been centered on those firms, perhaps driven a few subprime lenders out of business. However, the damage would largely have been contained, to the benefit of all.
Works Cited:
Barnett-Hart, a. (2009). The story of the CDO market meltdown: An empirical analysis. Harvard College. Retrieved May 3, 2011 from http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
Deng, Y.; Gabriel, S. & Sanders, a. (2008). CDO Market implosion and the pricing of CMBS and sub-prime ABS. Real Estate Research Institute. Retrieved May 3, 2011 from http://www.reri.org/research/article_pdf/wp150.pdf
Fender, I. & Kiff, J. (2004). CDO rating methodology: Some thoughts on model risk and its implications. BIS Working Papers No. 163. Retrieved May 4, 2011 from http://www.bis.org/publ/work163.pdf
Hansel, D. & Krahnen, J. (2007). Does credit securitization reduce bank risk? Evidence from the European CDO market. Gothe University Frankfurt. Retrieved May 4, 2011 from http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID967430_code120211.pdf?abstractid=967430
Scheicher, M. (2009). How has CDO market pricing changed during the turmoil? European Central Bank Working Paper Series No. 910. Retrieved May 3, 2011 from http://www.ecb.int/pub/pdf/scpwps/ecbwp910.pdf
Works Cited:
Barnett-Hart, a. (2009). The story of the CDO market meltdown: An empirical analysis. Harvard College. Retrieved May 3, 2011 from http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf
Deng, Y.; Gabriel, S. & Sanders, a. (2008). CDO Market implosion and the pricing of CMBS and sub-prime ABS. Real Estate Research Institute. Retrieved May 3, 2011 from http://www.reri.org/research/article_pdf/wp150.pdf
Fender, I. & Kiff, J. (2004). CDO rating methodology: Some thoughts on model risk and its implications. BIS Working Papers No. 163. Retrieved May 4, 2011 from http://www.bis.org/publ/work163.pdf
Hansel, D. & Krahnen, J. (2007). Does credit securitization reduce bank risk? Evidence from the European CDO market. Gothe University Frankfurt. Retrieved May 4, 2011 from http://papers.ssrn.com/sol3/Delivery.cfm/SSRN_ID967430_code120211.pdf?abstractid=967430
Scheicher, M. (2009). How has CDO market pricing changed during the turmoil? European Central Bank Working Paper Series No. 910. Retrieved May 3, 2011 from http://www.ecb.int/pub/pdf/scpwps/ecbwp910.pdf
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
The credit risk is transferred through true sale of assets; the practice is applicable in the case of cash-flow CDOs which is based upon the traditional securitization mechanisms. The tranches of CDO are issued in different proportions in synthetic securitization structures, these structures are entirely funded, partially funded or unfunded, and 'the main considerations in the design of these funding structures are the cost and management of counterparty risk' (Schmidt,
To be able to do that is to possess the sociological imagination" (1959). In order for one to fully understand the current recession and his/her position within society he or she needs to do two things. The first is be self-conscious of the intimate and personal decisions one has made that has led him/her down his/her current path, the second thing is to understand the structural factors that ultimately
The philosophy behind Frank-Dodd is to minimize the risk to the taxpayer of trade in these instruments, but this is to be balanced against the needs of the industry. Arguably, however, there is no particular need for synthetic CDOs, so tight regulation that restricts their manufacture and use should be sufficient. The Frank-Dodd Act imposes significant regulatory burden on synthetic CDOs and the use of credit default swaps to create
The article that was written by Conley (2011) discusses the impact that collateralized debt obligations (CDO's) would have upon the subprime loans. These were created in 1987, by the Wall Street firm Drexel Burnham. In this product, the investment bankers would take a number of different articles and combine them together as one investment. The various assets that were used included: junk bonds, mortgages and other high yielding investments from
2010, September 18 Corporate Finance Corporate Finance The CDO market was largely attributed as being central to the sub-prime crisis. By first describing what CODs are and how they operate, identify and assess the failings in risk management practices used to manage the risks posed by these products by the banks involved. Risk assessment failure has been shown to be the primary causes of the sub-prime crisis in addition to a lack of