cdo

CDOS AND ITS ROLE IN FINANCIAL CRISIS: 

CDOS AND ITS ROLE IN FINANCIAL CRISIS BRIJITH DS S3 MBA CIMAT

Collateralized Debt Obligations {cdo}: 

Collateralized Debt Obligations { cdo } are sophisticated financial tools that banks use repackage individual loans into a product that can be sold to investors on the secondary market. These packages consist of auto loans, credit card debt, mortgages or corporate debt. They are called collateralized because the promised repayment of the loans are the collateral that gives the CDOs value.

PowerPoint Presentation: 

CDOs are a special type of derivative. derivatives are any kind of financial product that derives its value from another underlying asset . CDOs are called asset-backed commercial paper if the package consists of corporate debt, and mortgage-backed securities if the loans are mortgages. If the mortgages are made to those with a less than prime credit history, they are called subprime mortgages

Banks sold CDOs to investors for three reasons: : 

Banks sold CDOs to investors for three reasons: The funds they received gave them more cash to make new loans. It moved the loan's risk of defaulting from the bank to the investors. CDOs gave banks new and more profitable product to sell, which boosted share prices and managers' bonuses

Benefits of CDOs : 

Benefits of CDOs They provided more liquidity in the economy. By allowing banks (and corporations) to sell off their debt , CDOs freed up more capital to invest or loan. The creation of CDOs is one reason why the U.S. economy was so robust until 2007. The invention of CDOs also helped create new jobs. Unlike a mortgage on a house, a CDO is not a product that you can touch or see to ascertain its value. Instead , the value of a CDO was based on a computer model.

PowerPoint Presentation: 

As competition for new and improved CDOs grew, these quant jocks made more complicated computer models. They broke the loans down into components, or "tranches ." Adjustable-rate mortgages often offered "teaser" low-interest rates the first three years, and in exchange for higher rates later. Borrowers often took the loans, knowing they could only afford to pay the low rates. They expected to sell the house before the higher rates kicked in. The quant jocks designed CDO tranches to take advantage of these different rates.

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One tranche held only the low-interest portion of mortgages, while another tranche offered just the portion with the higher rates. That way, conservative investors could take the low-risk, low-interest tranche, while aggressive investors could take the higher-risk, higher-interest tranche. All went well as long as housing prices, and the economy in general, continued to grow.

Downside of CDOs : 

Downside of CDO s Unfortunately , the extra liquidity ultimately created an asset bubble in housing, credit cards and auto debt. Housing prices became unrelated to their actual value, and people bought homes simply to sell them. The easy availability of debt meant people charged too much, and credit card debt nearly hit $1 trillion in 2008. CDOs allowed banks to avoid having to collect on them when they become due, since the loans are now owned by other investors . This made them less disciplined in adhering to strict lending standards, so that many loans were made to borrowers who weren't credit-worthy -- ensuring disaster.

PowerPoint Presentation: 

What made things even worse was that CDOs became so complex that the buyers didn't really know the value of what they were buying. They relied on their trust of the bank selling the CDO without doing enough research to be sure the package was really worth the price. The computer models based the CDOs' value on the assumption that housing prices would continue to go up. When they went down, the computers couldn't price the product.

How CDOs Caused the Financial Crisis : 

How CDO s Caused the Financial Crisis This opaqueness and the complexity of CDOs created a market panic when banks realized they couldn't price the product, or the assets they were still holding. Overnight , the market for CDOs disappeared. Banks refused to lend each other money because they didn't want more CDOs on their balance sheet in return. It was like a financial game of musical chairs when the music stopped. This panic caused the 2007 Banking Liquidity Crisis. The first CDOs to go south were the mortgage-backed securities. When housing prices started to drop in 2006, the mortgages of homes bought in 2005 were soon upside-down .

PowerPoint Presentation: 

The first to default were the subprime mortgages. By 2006, the subprime mortgage crisis was well underway. However , most economy-watchers thought (hoped!) it was confined to housing. In fact, some welcomed it and said that housing had been in a bubble and needed to cool down, anyway. What they didn't realize was how derivatives multiplied the effect of any bubble -- and any subsequent downturn . Not only banks were left holding the bag, but also pension funds, mutual funds and corporations. It was until the Federal Reserve and the Treasury started buying these CDOs that a semblance of functioning returned to the financial markets.

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