Collateralized Debt Obligations and the Credit Crisis

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In early 2007, one of the more complex and controversial corners of the bond world began to unravel. By March of that year, losses in the collateralized debt obligation (CDO) market were spreading, crushing high-risk hedge funds and spreading fear through the fixed-income world. The credit crisis had begun.

When the final history of the crisis is written, we'll likely have a better idea of precisely what went wrong. But even now, it seems clear that the global debt markets' woes began not so much in the housing market as in the CDO market of 2007.

Key Takeaways

  • In a collateralized debt obligation, banks collected assets and created a structure to distribute the profits from those assets to CDO investors.
  • The CDO market skyrocketed in 2001 due to the Gaussian Copula, which made pricing CDOs quick and easy, though these prices were often flawed promises.
  • In 2007, defaults were rising in the mortgage market which underpinned many CDOs, making them unstable and causing them to lose value quickly.
  • As the CDO market collapsed, much of the derivatives market fell, hedge funds and other major institutions folded, and the credit crisis was created.

Collateralized Debt Obligation

Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Within 10 years, the CDO had become a major force in the so-called derivatives market, in which the value of a derivative is "derived" from the value of other assets. Unlike some fairly straightforward derivatives, such as options, calls, and credit default swaps, CDOs were nearly impossible for the average person to understand—and that was the problem. CDOs weren't "real." They were constructs that one could argue were built on other constructs.

In a CDO, an investment bank collected a series of assets, often high-yield junk bonds, mortgage-backed securities, credit-default swaps, and other high-risk, high-yield products from the fixed-income market. The investment bank then created a corporate structure, the CDO, that would distribute the cash flows from those assets to investors in the CDO.

That sounds simple enough, but here's the catch: CDOs were marketed as investments with defined risk and reward. If you bought one, you would know how much of a return you could expect in exchange for risking your capital. The investment banks that were creating the CDOs presented them as investments in which the key factors were not the underlying assets. Rather, the key to CDOs was the use of mathematical calculations to create and distribute cash flows. In other words, the basis of a CDO wasn't a mortgage, a bond, or even a derivative—it was the metrics and algorithms of quants and traders. 

In particular, the CDO market skyrocketed in 2001 with the invention of a formula called the Gaussian Copula, which made it easier to price CDOs quickly. What seemed to be the great strength of CDOs—complex formulas that protected against risk while generating high returns—turned out to be flawed. We learned the hard way that the smartest guys in the room are often pretty dumb.

Downhill Slope

In early 2007, Wall Street began to feel the first tremors in the CDO world. Defaults were rising in the mortgage market, and many CDOs included derivatives that were built on mortgages—including risky, subprime mortgages.

Hedge fund managers, commercial and investment banks, and pension funds, all of which had been big buyers of CDOs, found themselves in trouble because the assets at the core of CDOs were going under. More importantly, the math models that were supposed to protect investors against risk weren't working.

Complicating matters was that there was no market on which to sell the CDOs because they aren't traded on exchanges. CDOs aren't structured to be traded at all, and if you had one in your portfolio, there wasn't much you could do to unload it.

The CDO managers were in a similar bind. As fear began to spread, the market for CDOs' underlying assets also began to disappear. Suddenly it was impossible to dump the swaps, subprime-mortgage derivatives, and other securities held by the CDOs.

The Fallout

By early 2008, the CDO crisis had morphed into what we now call the credit crisis. As the CDO market collapsed, much of the derivatives market tumbled along with it, and hedge funds folded. Credit-ratings agencies, which had failed to warn Wall Street of the dangers, saw their reputations severely damaged. Banks and brokerage houses were also left scrambling to increase their capital.

Then, in March 2008, slightly more than a year after the first indicators of trouble in the CDO market, the unthinkable happened. Bear Stearns, one of Wall Street's biggest and most prestigious firms, collapsed.

Eventually, the fallout spread to the point that bond insurance companies had their credit ratings lowered (creating another crisis in the bond market), state regulators forced a change in how debt is rated, and some of the more prominent players in the debt markets reduced their stakes in the business or exited the game entirely.

By the middle of 2008, it was clear that no one was safe. As the dust settled, auditors began to assess the damage. And it became clear that everyone, even those who had never invested in anything, would wind up paying the price.

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