CDO Market the Recent Recession Essay

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Hansel & Krahnen (2007) conducted a study that noted the equity beta of banks engaged in the marketing of CDOs increased relative to banks that did not market CDOs. This again highlights the risk associated with CDOs, especially given that the impact on the firm's beta was more pronounced in smaller, less well-capitalized banks.

While CDOs introduced more risk into the banking system, they also encourage more risk in the credit markets. CDOs accomplished this by providing a secondary market for credit assets. There was only a limited secondary market for low-grade corporate debt and for subprime mortgages prior to the rise of CDOs (Deng, Gabriel & Sanders, 2008). The increase in the amount of subprime loans granted in the U.S. correlates with an increase in the availability of a secondary market for such debt in the form of CDOs. In turn, this encourage the adding of more subprime debt to CDOs, as occurred in 2006 and 2007.

Thus, there were two major failings in the risk management systems at the banks that marketed CDOs. The first failing was the inability to accurately gauge the risk or to price CDOs. Too many banks appear to have relied on the ratings agencies, and their methods of evaluating these products were flawed. The second major failing was the failure to manage the level of subprime debt in CDOs. As this level increased, the level of risk of these products increased as well. Banks earn significant interest income on subprime debt so they have an incentive to market this type of debt, if the bank feels that it can sell the risk associated with that debt. This act of spreading the risk around the economy as a whole was intended to better insulate banks, but instead it seems to have simply encouraged them to take on more risky debt and repackage that for public consumption.

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The result is that the crisis in the U.S. housing market and subsequently the CDO market spread throughout the economy as a whole, making a significant contribution to the economic downturn.

It is recommended that ratings agencies and banks devise better formulae with which to evaluate the risks presented by collateralized debt obligations. Valuing these complex is a complex task, but must be done accurately in order to ensure the health of the financial system. In addition, there needs to be increased financial regulation in order to reduce the adverse selection that occurs when banks can offload the risk associated with subprime loans and other risky forms of credit. Having a ready secondary market encourages banks to write these kinds of loans, so it is important that there be means built into the financial system to avoid this, in order to avoid similar crises from emerging in the future.

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