Essay on "CDO Market and Sub-Prime Crisis"

Essay 3 pages (1090 words) Sources: 5 Style: Harvard

[EXCERPT] . . . .

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… READ MORE

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