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This is actually fine. While CDOs were involved in the last financial crisis, they weren't the fundamental culprit. That honor would belong to ill-coordinated b
by ThrustVectoring 7y ago
This is actually fine. While CDOs were involved in the last financial crisis, they weren't the fundamental culprit. That honor would belong to ill-coordinated banking regulations between the US and Europe.
In order to provide a public backstop without encouraging moral hazard, banking regulators impose risk-taking limitations on banks. In the US, this took the form of encouraging asset sales into capital markets, under the assumption that this would make any risk the banks take dissipate away harmlessly. In the EU, this took the form of leverage limits based off the credit rating of the asset, with the highest rated asset commanding the largest leverage limits.
These regulations combined in a very unfortunate way in the transatlantic CDO trade. The CDO part isn't the important innovation, though; as long as the above structure persisted, something would be found to take advantage of it. Anyhow, the short of the crisis is that American banks would sell their risky assets into concentrated positions of systematically important banks, particularly ones outside of the narrow American regulatory purview. On the other side of the Atlantic, they accidentally applied a massive incentive to figure out a way to slap an AAA rating on stuff, and the market delivered that in spades.
The cherry on top of this entire system is that when American banks make loans, this cash gets transferred and winds up sitting in some money market fund somewhere. These funds are searching for short-term dollar-denominated yields, and the best way to get that is to lend money to European banks secured by AAA-rated assets. After all, with the generous leverage limits bestowed on them, they can borrow a hell of a lot of money.
- coliveira 7y agoThese are all incidental issues. The real problem with CDOs and related financial products is that they deal with tremendous leverage without proper transparency. In a leveraged environment, you need to have a framework to understand who owns what and if the counterpart can pay for that leverage. Good examples of such a well regulated market are the options and futures markets. On the contrary, CDOs, swaps, and other exotic instruments give institutions the ability to leverage themselves, but nobody is regulating where the money is to pay counterparts when bets are wrong (and they eventually will be). The result are frozen markets! The only solution the financial world has at this point is to create money to bring liquidity to the markets again. This can only work up to a point, and in fact can exacerbate the results of a financial catastrophe.
- JumpCrisscross 7y ago> they deal with tremendous leverage without proper transparency At least immediately post crisis, these products were super transparent. You have all the underlying loans and their docs in the closing package. Everyone knows who the ultimate borrower is, and how a dollar traces from them to their point in the chain. As long as these assets are held outside the payments system, the contagion risk is contained. The problem happens when the public doubts the solvency of a payment processor.
- lifeisstillgood 7y agoSo, my take has been that these products were (de facto, of not de jure) insurance products that were incorrectly priced premiums. If that is right, and as you say they were very transparent, what was it that made this mid-priced? was it simply impossible to insure?
- vijayr02 7y agoAgain, only true for regular (non synthetic) CDOs - this is where the issuer is a dumb (or managed) vehicle that buys loans and tranches them up. The best example today would be Mortgage Backed Security (MBS) tranches / Asset Backed Security (ABS) tranches. AS you say, if the intermediary is suspect the structure can become suspect - but this can be fixed by appropriate structuring and security. In a synthetic CDO the cash raised from CDO issuance is invested in collateral (more often than not, chosen for highest return rather than real safety), and the investment return is generated by selling protection on CDS - the terms of this CDS may not always be very clear. If you have sold protection to Lehman for example and they go bust, your structure is in limbo, without a single underlying having defaulted.
- ThrustVectoring 7y agoCollateralized Debt Obligations themselves aren't a leveraged product. The originating bank issues loans and then sells on the assets. The various tranches are sold for cash and receive varying priority of cash-flow from the original loans. All the leverage is outside of the CDO itself - either European banks buying a dollar's worth of "AAA" assets with 98 cents of borrowed money, or some company writing a credit-default swap on it and backing it with cash worth a fraction of the value at risk.
- vijayr02 7y agoIf that is the case why were so many US entities victims of the collapse? 1. AIG 2. WamMu 3. Merrill 4. All the monoline insurers (MBIA etc.) In my view, your comment is just one part of the (v complex) set of conditions leading to the financial crisis. There were also: 1. Substantial savings from mercantilist economies (China / Germany) driving a glut of malinvestment 2. A regulatory view that financial complexity always reduced systemic risk 3. A central bank seen as overly accomodative of speculators (the Greenspan put) “The world has enough for everyone's need, but not enough for everyone's greed.” - Mahatma Gandhi