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What are CDOs and should they be banned?

What are CDOs and did they cause the GFC? If so, why aren’t they banned? It seems like we keep making the same mistakes and no one ever takes strong steps to get rid of dumb money market products that can rock markets.

A CDO is an investment-grade security with a pile of bonds, loans and other assets backing them. Now, a CDO can have a range of debts behind them and can be non-mortgage loans or bonds.

Investopedia says while they are similar in structure to a collateralised mortgage obligation (CMO) or collateralised bond obligation (CBO), CDOs are unique in that they represent different types of debt and credit risk.

“In the case of CDOs, these different types of debt are often referred to as ‘tranches’ or ‘slices’,” it explains. “Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.”

That’s what they are, so were they the cause of the GFC?

In the US, there was a Financial Crisis Inquiry Commission (FCIC) and no one cause was singled out. Greed, regulatory stupidity, bad rating by the credit agencies and other reasons have been cited.

CDOs were mentioned and inaccuracies in defining them as well as slack work by the agencies came in for a lot of attention. I think the sub-prime loans with low interest rates and with too-easy regulation meant that CDOs and CMOs became more risky and that put the financial system at too much risk.

CDOs by their diverse nature should become less risky but sub-prime mortgages were being passed off as prime mortgages and the agencies didn’t spot this problem. This rendered these CDOs toxic, and this ultimately undermined confidence in the products and that raised question marks over the stability of the banks in the global financial system. A credit freeze resulted and a recession ensued.

I blame the regulation and the work of credit agencies more than the actual product and that’s why they have survived but now we’re assured that regulators and the respective watchdog agencies have lifted their game – let’s damn well hope so!

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Important information: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. For this reason, any individual should, before acting, consider the appropriateness of the information, having regard to the individual’s objectives, financial situation and needs and, if necessary, seek appropriate professional advice.

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Published on: Monday, July 18, 2011

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