Cdos Collateralized Debt Obligations Were Essay

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S. collapsed. It had been riding a speculative bubble fueled by low interest rates and creative financing. Lending to "subprime" borrowers was encouraged, in part by the liquid secondary market for subprime mortgages that was created by the popularization of CDOs. The widespread defaults in the U.S. mortgage market created a situation where CDOs were subject to considerable default risk. While individual-specific risk had been eliminated, market risk had not. When the market tanked, the value of the CDOs did as well. That many viewed them as investment grade products only complicated the issue -- now these investors needed to sell their CDOs because their risk profile was skewed. A European study of banks that held CDOs and banks that did not found that the banks with CDOs were riskier in the long-run than those that did not have CDOs (Hansel & Krahnen, 2007). Fender and Kiff (2004) determined that there are multiple different rating methodologies and the choice of methodology can have a significant impact in the assessment of risk. This calls into question the appropriateness of the methodologies used by ratings agencies and the banks that invested heavily in CDOs.

Recommendations and Conclusions

The first recommendation is that bond rating agencies -- and financial institutions interested in purchasing CDOs -- develop a better formula for pricing the risk associated with these types of instruments prior to issuing a rating.

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Essentially, investor confidence in the product was buoyed by the liquid secondary market and the investment-grade credit ratings. This lead to a proliferation of CDOs that introduced substantial risk to financial markets (Deng, 2008). The market would not have been so big -- CDOs would not have introduced the amount of risk into the economy that they did -- had the ratings agencies more accurately assessed the risk levels associated with CDOs.

The second recommendation is to regulate this industry more heavily. The system collapsed because the system had taken on too much risk. This occurred because firms were able to package off that risk and sell it -- thus they were given motivation to take on more risk. If firms were compelled to carry their own risk, the catastrophe would have been centered on those firms, perhaps driven a few subprime lenders out of business. However, the damage would largely have been contained, to the benefit of all.

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