Friday, August 29, 2008

Collaterized Debt Obligations: Instigating the Global Credit Crunch?

Somewhat unfairly blamed as the instigating agent of the 2007 Global Credit Crunch, are collaterized debt obligations or CDO, really deserving of such infamy?

By: Ringo Bones

After reading the latest book by the billionaire investor guru George Soros titled “The New Paradigm for Financial Markets”, I recently had an epiphany that stability and equilibrium are not our Wall Street controlled global economy’s natural state of being. Instead, the quixotic adventurism in search of quick and easy profits undertaken under unacceptable levels of risk is the rule, rather than the exception. Thus explaining the inevitability of the global credit crunch and the current yo-yoing price of crude oil pegged against the US dollar. Even the rise of asset backed security based on synthetic constructs marketed as investments to anyone who likes to experience first-hand what it's like to be financially devastated by an Enron-type scheme.

Often referred to by everyone’s friendly neighborhood financial advisor as an asset backed security product that works just like a home insurance against losses from fire and theft. Except that it applies to big corporation’s credit insurance which you – a mere civilian – can easily get rich of off. By the start of the 21st Century, CDO s was being sold-off to with alarming frequency to financially ignorant civilians – i.e. people like you and me. Your friendly neighborhood financial advisor might – and it’s very likely – to have made ungodly amounts of money relatively easily. Surprisingly to you – the financially ignorant - through the sheer inherent complexity of structured financial transactions of CDO s that he or she –your financial advisor – might seem like a saint for helping you, the financially ignorant retail chump, to experience your friendly neighborhood financial advisors new found get-rich-quick scheme. Except your financial advisor forgot to mention one tiny but very important detail. You must sell – i.e. pass on / dump them – your CDO s once the financial markets turns into a “Bear”. But most of all, are collaterized debt obligations or CDO deserving of their infamy? But first, let us first explain what is a CDO.

Collaterized Debt Obligations or CDO s are often described by financial academics as a type of asset-backed security and structured credit product. CDO ’s are constructed from a portfolio of fixed-income assets. The assets are divided into different credit rating tranches: senior tranches which are rated AAA or “triple a”, mezzanine tranches which are lower on the credit rating “food chain” are rated AA to BB, and the equity tranches, which are unrated. The first CDO were issued back in 1987 by bankers of the now defunct Drexel Burnham Lambert Inc. for the Imperial Savings Association. A decade later, CDO s became the fastest growing sector of the asset-backed “synthetic” securities market.

A major factor for the further growth of CDO s at the start of the 21st Century was the 2001 introduction of Gaussian Copula Models by David X. Li. Which allowed the rapid pricing of CDO s. Because of this, Collaterized Debt Obligations became a major force in the so-called derivatives market were the value of the derivative is derived from the value of other assets. But unlike some fairly straightforward – i.e. “real” derivatives – such as stock options, calls and even the much-maligned Credit Default Swap, CDO s were nearly impossible for the average person to understand. To me at least, the higher mathematics used in creating synthetic securities constructs like Collaterized Debt Obligations and its related variants like Collaterized Insurance Obligations are better to be used in designing weapons systems that will allow a 250-gram projectile to be thrown at 2,700 feet per second. Most of all if anything goes terribly wrong, asset-backed synthetic securities are really worth less than the paper they are printed on, or the bits – one’s and zeroes – they are encoded on.

The complexity of CDO products – which the investor savvy swears by for making him or her earn easy money – is the reason why CDO s are often blamed by the mainstream news media for the 2007 credit crunch. This inherent complexity is often blamed for the failure of risk and recovery models used by credit rating agencies to value these products. Worst of all, CDO s and their ilk are just mere “financial constructs” – as opposed to concrete assets like gold or land. Complicating matters even more was that there was no market on which to sell the CDO s – i.e. CDO s aren’t traded on exchanges. Causing many CDO customers to be mauled by the impending Bear Market. Which is no Bull by the way.

Given that the math used for credit rating various CDO products is about as complex as the higher mathematics used to quantify the dynamics of certain complex sociological phenomena, its best to be pragmatic. It might lead some to some desperation in embracing Sharia Banking Laws in order to retain a semblance of financial stability in our post global credit crunch environment. Were the sobering fact fiscal austerity are forcing credit and bond insurance underwriters to finally remember what it means to be prudent in doing business.

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