Short Read

CDOs: The genius idea that destroyed the World Economy

What are they?

Collateralized debt obligations (CDO), initially created by the Drexel Burnham Lambert bank, are instruments which are formed by pooling together cash-generating assets such as mortgages, loans and other forms of debt. They are made up of various ‘tranches’ based on their respective level of credit risk. Supposedly, one diversifies their risk when buying a CDO as they have portions of high, medium and low risk loans.

What have they got to do with the Global Financial Crisis in 2008?

In a CDO, the underlying asset acts as collateral if the debtor defaults on their loan. For mortgages, when the loan is defaulted on, the home is therefore taken as collateral. These became extremely popular in the early to mid 2000s as the mortgage industry was thought to be as safe and solid as any other investment – perhaps more so. There was a boom in the housing market with many people in the US buying homes and taking out mortgages. This meant even more opportunity for these loans to be packaged up and sold in a CDO. A particularly popular mortgage was one called a ‘sub-prime mortgage’. These were essentially mortgages with a higher chance of default and they started to gain more and more value in CDOs.

How did it all go wrong?

At first, the investor could buy a CDO and understand the risks he is taking due to the various tranches being rated on their risk. However, this could only be sustainable if the ratings were accurate. What began to happen was that the ratings agencies were rating CDOs, which were comprised of high-risk mortgages, as low risk. Since those buying and selling these CDOs were making so much money, they were very happy to continue to do so. Along with the fact that there were so many types of debt making up a CDO and therefore so much paperwork, it was very hard for the average investor to examine a CDO for its true underlying value and risk. Therefore, they trusted the ratings agencies highly. There was a bubble in the US housing market and when this burst (home owners defaulted on their mortgages), it destroyed the value of CDOs (which were reliant upon people making their mortgage payments).

The vast amounts of money which banks were making led to them buying too much of these CDOs and taking on too much risk. In 2003, $30 billion worth of CDOs were sold. In 2006, over $225 billion were sold! They were effectively buying an instrument which had a much lower intrinsic value than what they were paying (and carried much more risk than was being factored in). This was all well and good until the sub-prime mortgage bubble burst and the CDOs became virtually worthless.

This burst of the sub-prime mortgage bubble led to millions of people losing their homes and the big banks losing billions of dollars and ultimately requiring a governmental bail-out.

What about Synthetic CDOs?

A synthetic CDO in simple terms is effectively a way for investors to bet on the performance of a CDO. In order to have a synthetic CDO, there needs to be two parties betting on the CDO’s outcome with one going long and the other going short. Generally, one side will pay premiums if the value of the CDO is opposite to their bet whilst the other side will pay a large sum if specific losses occur: similar to how insurance payments work.

During the financial crisis, synthetic CDOs astronomically expanded the initial CDO market. According to Dealogic (a financial data company), at least $108 billion worth of synthetic CDOs were sold between 2005 and 2007. However, Journalist Gregory Zuckerman said that according to estimates, up to $5 trillion worth of investments were made based on sub-prime loans. This is due to the fact that these trades were highly unregulated and underreported.

So, what has been done about it?

In reality, not a lot. Initially after the crash, CDOs had such poor publicity that they almost disappeared. However now, as stated at the end of ‘The Big Short’, there is a new instrument. Effectively, the CDO has been renamed as a ‘Bespoke Tranche Opportunity’ (BTO). This is where an investor can buy a specific tranche of the CDO knowing exactly how risky that specific tranche is. The value of Bespoke Tranche Opportunities sold in 2018 was already at least $80B and is growing.

Will this cause another bubble and crash?

Of course it is impossible to say with certainty whether the same will all happen again but there are certain points we can highlight. Firstly, the 2008 crisis was based upon the fact that there was a bubble in the underlying housing market. Therefore, when that bubble burst, CDOs went with it. It is fairly unlikely that this will happen again.

Another reason it is tricky to tell is that it is very hard to find specific data on the amount of CDOs or BTOs being sold. Since they go under various different titles nowadays due to their poor publicity one suspects that the actual value of CDOs being sold nowadays is higher than publicly stated.

At the same time, nations have put regulations in place to stem the tide of contagion if such a banking failure were to occur again. Thus, it is highly unlikely these instruments would cause such a great recession once again, but the banks trading them should proceed with caution.

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