What are the Collateralized debt obligations?
A decade has gone since the 2008 financial crisis, a crisis that hit and damaged the foundations of the financial world in a way not seen since the thirties of the past century.
The years before 2008 witnessed a wave of irresponsible mortgage lending in the united states of America, money was given to subprime borrowers with poor credit histories. These risky mortgages were supposedly turned into low-risk securities, by grouping large numbers of these mortgages into pools. Pooling is a financially engineered process to maximize profit and minimizing risk; pooling works when the risks of each loan are uncorrelated. Financial institution argued that the real estate’s markets in different states are independent. A theory is proven wrong not long after.
Collateralized debt obligations (CDOs) were introduced, which are securities backed by pooled mortgages, tranches of these CDOs were assigned triple-A credit ratings by agencies such as Moody’s and Standard & Poors. Agencies were generously paid by the banks creating the CDOs, there for the rating agencies were generous in their assessments.
Low-interest rates world and high credit ratings drove investors and gave them incentives into the hunt for riskier assets with higher returns.
With the American housing market collapse, damaged financial systems were exposed, investors found out that the what seemed to be clever financial engineering and the supposedly safe CDOs are worthless.
Trust, the magic word in all financial systems, took a big hit. Banks started questioning the trustworthiness of their counterparts; short-term credit began to be withheld. Northern Rock, a British bank was an early casualty in the autumn of 2007. It was the first British bank in 150 years to fail due to a bank run.
Failures in finance caused the crash. But it wasn’t only bankers to be held responsible. Central banks, government entities, and regulators share the blame too, for the bad decisions they took during the crisis, and for not exercising an orthodox oversight of the financial institutions.