The CDO market and subprime 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.

The Problem with CDOs

One of the major problems with CDOs is that they are difficult to value, and it is also difficult to evaluate the risk associated with these products. The value of any given debt instrument is related to the debtor-specific risk. The diversification within the CDO is intended to eliminate this risk. Thus, the price associated with a CDO derives from the correlations of movements in the risk levels of the underlying assets. This sometimes involves hundreds of correlations for a given CDO. Barnett-Hart (2009) argues that the methods used by bond rating agencies to evaluate risk -- the basis of price -- are not sophisticated enough to calculate these correlations. As such, the rating agencies did not have a full understanding of the risk associated with CDOs. Naturally, this lack of understanding was reflected in both the bond rating and the price of the CDO. CDOs were not priced appropriately, and were purchased by many investors both retail and institutional as a means of lowering the risk of their portfolios.

Unfortunately, the housing market in the U.S. collapsed. It had been riding a speculative bubble fueled by low interest rates and creative financing. 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 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.