Wall Street’s CDO Mania

CDO’s as complicated as they sound we will try to explain them in order to understand the impact they had on Wall Street. A CDO stands for collateralized debt organisation, and originated in 1987 by Michael Milken, where a CDO back then included AAA rated CDOs. Unlike todays mixture of investment and corporate bonds that are mostly junk, of which “Wall Street’s CDO mania served to pump up investment-bank leverage.” (French, 2012) There are other variations of CDO’s, as such “[subprime] mortgages were bundled to become collateralized mortgage obligations (CMOs), which are a form of collateralized debt obligation (CDO).” (French, 2012)

People who describe the operation as a credit laundering scheme, may also say CDO’s are a fancy bankers term for repackaging bad loans of cash-flow generating assets, in order to re-sell them with good ratings to investors, who are willing to take on the risk or who genuinely think they represent the good risk rating. Alternatively, people seek in them because of their ability to increase asset prices rapidly. “”By the time it was over, the Street would create 64,000 AAA-rated securities, even though only 12 companies in the world had that rating.”” (Moynihan in French, 2012)

I would recommend the film The Big Short in which CDO’s are documented. The film is based on Michael Lewis’s book, based on the financial crisis of 2007-08, and follows the first people who caught on that the housing bubble was going to pop. Alternatively, see this YouTube short video explaining them in this film, here Source: (The Enterprise, 2016).

“It’s [Robert England’s] view that the CDO market “was the casino where the bets were placed.”” (England in French, 2012) The CDO’s in Wall Street made the few very rich, the few poker faces who were good at playing the numbers game. To use some poker terminology, the house dealer (banks) which dealt out the cards (bonds) to the players made up of financial banks and investors. As one player invests others are forced to make forced bets (investments on other bonds), usually an ante or blind bet based on future expectations. The dealer shuffles (repackages) the cards, and re-distributes them around the table (financial institutions).

This continues until you are left with only the joker cards (Credit-default-swap insurance, or betting against the market CDOs). Bundling the players hand (credit-default-swap) is what created the synthetic CDO. At the end of the round, all bets (assets) are gathered into the central pot. “Leverage like that requires either perfection or eventual government bailout for survival.” (French, 2012


References

French, D. (2012). Wall Street Math. United States: The Mises Institute. Retrieved [18/04/16] from <https://mises.org/library/wall-street-math>.

Further Reading

Tavakoli, J. (2008). Introduction to collateralised debt organisations. Tavakoli Structured Finance. Retrieved [18/04/16] from <http://www.tavakolistructuredfinance.com/cdo/>.

Mariano, J. & Polleit, T. (2011). Credit default swaps from the viewpoint of libertarian property rights and contract credit default swaps theory. Libertarian Papers. Retrieved [18/04/16] from <http://libertarianpapers.org/wp-content/uploads/article/2011/lp-3-32.pdf>.

Featured image supplied from Unsplash (edited).

Copyright © 2016 Zoë-Marie Beesley

Creative Commons License Licensed under a Creative Commons Attribution 4.0 International License.

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