Collateralized debt obligations and the global financial crisis

CDOs

Collateralized debt obligations were one of the most significant contributing factors to the global economic downturn. In particular, they played a role in spreading the crisis so widely, and in being a root cause of the credit crunch that precipitated the worst of the recession. This paper will outline what CDOs are, how they are created, and how the nature of this product ultimately allowed it to do the opposite of what it was intended, and damage the entire global economy.

Definition of CDO

A collateralized debt obligation is a security that is comprised of claims of varying exposure to cash flows from debt instruments. This means that the content of a CDO will be the cash flows from multiple bonds. They are contrasted with singular debt instruments in that there are many instruments involved -- or more specifically the cash flows from many instruments. They are different from bond funds in that they are not actively managed. A CDO will typically contain a number of different tranches as well. Each tranche will have its own unique makeup and risk profile. In many cases, the high-grade tranches were sold alongside the low-grade tranches. The fact that CDOs typically involve a combination of a number of cash flows of different credit grade makes them difficult to value (Scheicher, 2009).

The underlying theory behind the creation of CDOs is that diversification reduces overall risk. The risk of any one cash flow not materializing (credit risk) may be high, but with dozens or even hundreds of said flows in any one CDO, there is minimal risk to the security itself. Moreover, diversification occurs at the macro level as well. Any given financial institution can underwrite loans with little regard to the firm's total risk level, because the risk is packaged with lower-risk securities, sometimes from other institutions, into the CDO. The theory behind this is that it enables more debt to enter the economy, but spreads the risk of that debt around the entire economy. Ultimately, this should not result in a significant increase in the risk for the economy as a whole, especially since CDOs were also sold to overseas financial institutions, taking American risk global.

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 accurately assessed the risk levels associated with CDOs.

The second recommendation is to regulate this industry more heavily. 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