Collateralized debt obligations (CDOs) are financial tools used to repackage individual loans into securities that are then sold to investors on the secondary market. They are also infamous for their role in the financial crisis of 2008.
The way these financial derivatives were traded – packaged with subprime mortgages, rated as safer than they truly were, and offloaded to investors while the very banks peddling them took out short positions at the same time – led to a massive bubble in the housing market. The rest is history; what followed was the greatest economic downturn in the U.S. since the Great Depression.
Now, CDOs are making a comeback. While the market is still a fraction of what it once was – today it stands at roughly $70 billion compared to more than $200 billion pre-crisis – major institutions like Citigroup and Deutsche Bank have skin in the CDO game once again. What does the re-emergence of this financial instrument mean for the economy as a whole? Are the same risks inherent in the trading of CDOs? What has changed that might mitigate future disaster?
CDOs and the financial crisis
When various debts, like corporate bonds or mortgage-backed securities, are pooled together, it creates a new security: a CDO. The CDO is then separated into various "tranches," or levels of risk, and then each tranche is sold to investors.
"What actually happens … is you have a pool of corporate credits. They don't all have to be good credits, some can be junk bonds," said Ed Grebeck, CEO of Tempus Advisors.
The creation of tranches, said Grabek, is done largely with respect to mathematical models, rather than corporate credits. As a result, there is little understanding of the actual risk to a CDO based on the credits it contained. Instead, it's a numbers game detached from the true security.
There were a few reasons CDOs became attractive pre-crisis. For banks, they helped offload risk onto investors and free up more capital to make new investments or issue new loans. For investors, they purportedly offered a way to realize higher yields with the expectation that the riskier aspects of the CDO were supported by the less risky assets. Unfortunately, speculation and unwarranted optimism in the housing market undercut those expectations.
"They were rating these things based on the probability of the loss of the pool of assets, rather than the creditworthiness of each individual borrower," Grebeck said. "That's where they got into trouble and lost a bunch of money. There were big losses on CDOs, and rating agencies came under fire for that as well."
The typical buyers of CDOs were insurance companies, banks, pension funds and hedge funds, rather than individuals. These were the institutions left holding the bag when the financial crisis hit, and the losses precipitated down to the rest of the country just as the value of homes – often individual Americans' largest source of equity – were crashing.
The immediate aftermath of the crash
After the crash, the market for CDOs virtually disappeared. In 2006 and 2007, about $386 billion worth of CDOs were issued, according to ProPublica. By the end of 2007 and through 2008, those numbers plummeted and the market evaporated almost entirely. The news was out: CDOs were toxic.
Most institutions involved in the CDO game took major losses when the crisis hit. In the third quarter of 2007, Merrill Lynch posted $2.2 billion in losses. Citigroup, which has returned to investing in CDOs in recent years, reported $6.5 billion in losses. Goldman Sachs, one of the most prominent CDO peddlers in the pre-crisis years, realized its tenuous position before disaster struck and took out more than $13 billion in short positions on the real estate market, even as they continued offloading the CDOs on their own balance sheet. As a result, Goldman Sachs turned a $2.9 billion profit in the same quarter other companies were taking massive hits.
These losses threatened to destabilize the entire economy. If the largest institutions collapsed, the theory went, it was likely a domino effect would follow and exacerbate the entire crisis. As a result, Congress approved a $700 billion bailout program known as the Troubled Asset Relief Program (TARP), which targeted financial institutions struggling as a result of subprime loan defaults. Essentially, the government used taxpayer money to acquire the bad loans from troubled lenders to stabilize the credit market.
The return of CDOs and economic outlook
Today, CDOs have returned, although the playing field is a bit different, said Adham Sbeih, CEO of Sacramento-based real estate lending and investment firm Socotra Capital.
"Today, hedge funds are securitizing and selling the CDOs," Sbeih said. "They need higher returns, so in order to juice their yields, they are holding the first tranche on the CDOs they sell. In turn, to cover these loss reserves, the hedge funds are borrowing from banks. So, in essence, the banks are ultimately once again holding the bag."
Despite this arrangement, Sbeih still believes the risks are lower than they were in the run up to the housing crisis. Loans tend to be higher quality now, he said, and Americans now have more equity in their property on average.
"If there are high defaults, there is equity that should help stop losses," he said.
In addition to these changes, regulatory shifts meant to address the causes of the financial crisis have demanded more stringent capital requirements. Banks are required to have more cash on hand in reserve in case of a downturn, making them more likely to weather the storm without public assistance. The Dodd-Frank Wall Street Reform Act of 2010, the flagship post-crisis legislation, includes a provision known as the Volcker Rule, which forbids banks from owning any proprietary trading operations, hedge funds or private equity funds. The rule alsoprevents the use of FDIC funds for hedge funds or private equity funds. This measure is intended to limit the sort of exposure that threatened to collapse the largest banks during the crisis.
However, Grebeck says the "stress tests" imposed by the legislation are largely still based on those mathematical models. As a result, he said, the new CDO market is not without its risks, despite moves by regulatory bodies and education amongst investors that have reduced exposure from pre-crisis levels.
"I think there are real threats associated with CDOs simply because … the product is flawed," Grebeck told Business News Daily. "With the models, things will happen largely at the point that a credit goes bad from the perspective of the model, rather than grounded in something that can be prevented if credits were looked at individually and managed individually."