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These are all incidental issues. The real problem with CDOs and related financial products is that they deal with tremendous leverage without proper transparenc

These 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 ago
  So, 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 ago
  Again, 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 ago
Collateralized 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 ago
  This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on demand (unlike a regular CDO, where the full capital structure has to be placed), banks can create bespoke standalone tranches which are then hedged based on a correlation model. Thus there is much lesser market feedback to put a brake on unbridled issuance. A (very) loose analogy would be insuring your house (i.e. needing to own the loan under the CDO) and betting that your neighbour's house will burn down (where you have no skin in the actual asset). You can clearly do much larger sizes of the latter contract, for the first one, you need to buy a house each time you want to put the trade on. 2. The CDO invests in collateral to back the protection sold. One of the issues during the crisis was that this collateral itself was other CDO tranches (either synthetic or physical). When the market melted down, these assets became unpriceable given the opacity of the collateral. Result = even higher illiquidity Of course the issued size is nowhere near becoming a systemic problem similar to 2007, but it does seem that those who do not learn from history are condemned to repeat their errors. In this context Raghuram Rajan's speech at the 2005 Jackson Hole symposium is especially prescient: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp082705 https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp0827... Edit: misread JumpCrissCross's reference to payment processors as protection buyers, deleted this part.
  - coliveira 7y ago

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 ago
So, 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 ago
Again, 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 ago

Collateralized 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 ago
This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on demand (unlike a regular CDO, where the full capital structure has to be placed), banks can create bespoke standalone tranches which are then hedged based on a correlation model. Thus there is much lesser market feedback to put a brake on unbridled issuance. A (very) loose analogy would be insuring your house (i.e. needing to own the loan under the CDO) and betting that your neighbour's house will burn down (where you have no skin in the actual asset). You can clearly do much larger sizes of the latter contract, for the first one, you need to buy a house each time you want to put the trade on. 2. The CDO invests in collateral to back the protection sold. One of the issues during the crisis was that this collateral itself was other CDO tranches (either synthetic or physical). When the market melted down, these assets became unpriceable given the opacity of the collateral. Result = even higher illiquidity Of course the issued size is nowhere near becoming a systemic problem similar to 2007, but it does seem that those who do not learn from history are condemned to repeat their errors. In this context Raghuram Rajan's speech at the 2005 Jackson Hole symposium is especially prescient: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp082705 https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp0827... Edit: misread JumpCrissCross's reference to payment processors as protection buyers, deleted this part.
- coliveira 7y ago