Somewhere in the spring of 2007, one of the most complex and controversial corners of the binding world began to unravel. In March of this year, losses in the collateralized debt obligations (CDOs) market spread – squeezing high-risk hedge funds and spreading fear through the fixed income world.
The credit crunch had started
If the last story of the crisis is written, then it is likely that we will have a better idea of exactly what went wrong. But even now it seems clear that global debt markets, such as the CDO market, did not begin suffering as much in 2007.
What is a collateralized debt obligation?
So what exactly is a CDO? And how could something that your average American has never heard of cause so much effort for the economy today?
It is easier to ask these questions than to answer them. But let’s try.
CDOs were created within 10 years in 1987 by the banks at Dexter Hamburg Inc. The CDOs were a major force in the so-called derivatives market, in which the value of a derivative is “derived” from the value of the other assets. But unlike some fairly simple derivatives like options, calls, and credit default swaps, CDOs were almost impossible for the average person to understand (Heck, when I was an editor at Bloomberg News, my boss led us on a number of Wall Street meetings Insiders in an attempt, largely unsuccessfully, to get someone to explain the more obscure corners of the derivatives market to us.)
And that was the problem.
CDOs were not “real”. They were constructs. And you could argue they were constructs built on other constructs.
In a CDO, an investment bank collected a number of assets – often high-yield junk bonds, mortgage-backed securities, credit default swaps and other high-risk, high-yield products from the bond market. The investment bank then creates a corporate structure – the CDO – that would distribute the cash flows from these assets to the CDO investors.
That sounds simple enough. But here’s the catch: CDOs were marketed as investments with defined risk and reward. In other words, when you buy one you know how much of a return you expect in exchange for risking your capital. The investment banks that created the CDOs presented them as investments in which the key factors that were not the underlying assets. Rather, the key to creating CDOs was using mathematical calculations and distributing cash flows.
But what seemed to be the great strength of CDOs – complex formulas that protected against risk while generating high returns – turned out to be flawed. Because, as so often on Wall Street, we learned the hard way that the smartest guys in the room are often pretty stupid.
In early 2007, Wall Street began to feel the first earthquake in the CDO world. Defaults have been rising in the mortgage market. And contain many CDO derivatives that were built on mortgages – including risky, subprime mortgages.
Hedge fund managers, commercial and investment banks, and pension funds, all of whom were major buyers of CDOs, found themselves in difficulty. The core assets of CDOs went under. More importantly, the mathematical models that were supposed to protect investors against risk were not working.
What was difficult was that there was no market on which to sell the CDOs. CDOs are not traded on the stock exchange. CDOs are not really structured at all. If you had one in your portfolio, there wasn’t much you could do to unload it.
The CDO managers were in a similar tie. As fear began to spread, the market for CDOs’ underlyings began to disappear as well. Suddenly it was impossible to dump the swaps, subprime mortgage derivatives, and other securities held by the CDOs.
At the beginning of 2008, the CDO crisis had turned into what we now call the credit crisis.
Since the CDO market collapsed, much of the derivatives market collapsed along with it. Hedge fund folded. Credit rating agencies, which failed to warn Wall Street of the dangers, saw their reputation severely damaged. Banks and brokerage houses have been crawling left to raise their capital.
Then, in March 2008, just over a year after the first indicators of problems in the CDO market, the unthinkable happened. Bear Stearns, one of Wall Street’s largest and most prestigious companies, collapsed.
Finally, to the point the consequences that the surety company had distributed companies had lowered their ratings (creating another crisis in the bond market); State regulators forced a change in how debt is valued, and some of the larger players in the bond markets reduced their stakes in the business or abandoned the game entirely.
By mid-2008 it was clear that no one was safe anymore. As the dust settled, auditors began to assess the damage. And it became clear that winding up everyone – even those who had never invested in anything – would pay the price.