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Collateralized debt obligations (a.k.a CDOs) refer to financial tools banks employ to bundle individual loans into a single package sold to investors on the secondary market. Many believe CDOs, especially subprime mortgage loans, majorly contributed to the 2008 financial crisis.
In this article, the Zero Theft Movement will explain what CDOs are and how they went down in infamy for helping crony capitalists come out with millions causing irreparable financial and emotional damage to countless Americans.
Read more on how the 2008 financial crisis came about:
What are Collateralized Debt Obligations?
USEFUL DEFINITIONS
Asset-backed securities (ABS)—credit card, student, business, and auto loans
Mortgage-backed securities (MBS)—mortgage loans
Debt security—borrowed money that needs to be paid back, under the stipulated terms (e.g. the size of the loan, interest rate, and maturity or renewal date.
CDOs are a type of derivative (i.e. a financial product that’s value comes from one or more underlying assets.) They pool together asset-backed securities and mortgage-backed securities into one offering. These products, offered by banking institutions, started to become popular offerings in the early 2000s.
CDOs, like MBSs, package different ‘tranches,’ pools of securities (usually debt) divided up by risk, rewards, maturity time, etc. Tranches generally come in two broader tiers, from high credit ratings to low: senior and mezzanine/junior.
Banks sell CDOs primarily to:
- Fund new loans
- Transfer the risk of default to investors
- Create new and profitable products to increase share prices and managerial bonuses.
Do you know that high-frequency trading firms could be accessing dark pools to make millions of financial transactions in a millisecond? Don’t believe us? See what your fellow citizens are saying on Zero Theft…
How do CDOs Work? Securities and CDO Tranches
CDOs ‘re-securitize’ debt securities. Unlike MBSs, for example, that directly deal with the mortgage payments themselves, CDOs create securities out of securities (MBSs).
The diagram below, included in the ‘Financial Crisis Inquiry Report,’ depicts how CDOs work.
CDOs further distribute the risk of their composite securities by re-tranching and create liquidity because new packages/products are available for sale. The ability to generate more capital and sell off debt made this particular financial tool appealing to corporations and banks.
DID YOU KNOW?
According to a report by the think tank Brookings Institution, “Annual CDO issuances went from nearly zero in 1995 to over $500 billion in 2006.”
This is to say, CDOs initially contributed to creating a robust and productive economy, while adding air to a balloon that was reaching its bursting point.
Economic Growth
In the early to mid-2000s, adjustable-rate mortgages attracted many borrowers due to the former’s highly appealing low initial interest rates. This, of course, came with higher interest rates a few years later. Borrowers seized the opportunity, even though they knew they could not afford the higher interest rates. They intended to sell off the house before the high interest rates kicked in.
‘Quant jocks,’ thousands of college and higher-level graduates working for Wall Street banks, developed computer programs that modeled the value of loan bundles included in the CDO. The quant jocks designed CDO tranches to create products offering singular rates. High-interest, high-risk mortgages for aggressive investors; low-interest, low-risk mortgages for conservative investors. CDOs were being given out freely, without much regulation or supervision perhaps due to their novelty. As long as housing prices and the economy continued to grow, there would be no issue.
The banks also hired thousands of salespeople to acquire investors. In truth, for all of their calamitous effects, CDOs did generate many new job opportunities for however long it lasted.
A 2017 Forbes article reports, “For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed…Buying back company stock can inflate a company’s share price and boost its earnings per share — metrics that often guide lucrative executive bonuses.” See what the ZT community has uncovered about stock buybacks…
The Bubble Bursts
All the liquidity and all the CDOs contributed to creating an asset bubble in housing, credit cards, and auto debt. Housing had reached prices far beyond its actual value. Debt, so readily available and provided, resulted in hefty reliance on credit cards by many, piling on debt to an all-time peak of $1.028 trillion.
Imprudence and greed led to myriad forms of corruption and obfuscation. According to the Financial Crisis Inquiry Report, “CDOs were constructed out of CDOs, creating CDOs squared. When firms ran out of real products, they started generating cheaper-to-produce synthetic CDOs—composed not of real mortgage securities but just of bets on other mortgage products. Each new permutation created an opportunity to extract more fees and trading profits.” The market, at a certain point, included securities on securities on securities, as well as CDOs based wholly on speculated values and not real figures. The constant re-tranching and redistribution of risk and assets created a complicated and complex system, entangled like a seeming infinitude of strings.
Banks selling CDOs did not worry about borrowers defaulting because they’d sold the loans to other investors. These financial institutions, due to their lack of debt ownership, did not adhere to strict lending standards and issued loans (many of them subprime mortgages) to those who were not credit-worthy. Predatory investors, on the other hand, intended to capitalize on the impending market crash, buying up credit default swaps (CDS), insurance for defaulted CDOs, so their ‘high-risk’ investments would definitely pay out handsomely.
Subprime Mortgage Loans, the First to go
CDOs including subprime mortgage loans plummeted first, as housing prices started to drop in 2006. Regulators and legislators somehow operated under the assumption that the housing market and economy would continue to rise, even though it was getting pumped up with CDOs citizens were likely to default on. The Federal Reserve believed that the issue would remain confined to the housing market, and some even argued that a drop in housing prices was long overdue.
Clearly, they were wrong. Countless jobs were lost globally and we have been setback by an estimated $2 trillion+ in GDP. The world’s economy came close to ruins. The Federal Reserve and the Treasury decided to save many of the massive corporations who had caused the crisis by buying these CDOs. They believed that these companies were ‘too big to fail,’ i.e. would have potentially calamitous effects if they went bankrupt.
After the fact, the U.S. government passed the Dodd Frank-Wall Street Reform Act of 2010. The legislation established regulatory agencies to ensure the areas widely viewed as responsible for causing the crisis, including banks, credit agencies, mortgage lenders, are not participating in any foul play or schemes. Unfortunately though, instead of punishing those responsible for taking advantage of the system and the global, not just American, citizenry, the companies themselves were bailed out. The predatory investors, the crony capitalists, not only ran away with millions in their pockets but most never even faced trial.
Conclusion
The Financial Crisis Inquiry Commission made it clear that the 2008 financial crisis could have been prevented. Their report states: “The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire.”
The Commission claims that a major portion of the blame should go to the regulatory bodies:
“The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not…financial institutions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mortgage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines.”
Crony capitalists and dubious officials created trillions in lost production and hundreds of thousands, if not millions, of lost jobs. So many honest, hardworking individuals suffered because of the avarice of those who continue to rig the economy against the public.
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