Introduction
The 2007/2008 global financial crises followed an accumulation of subprime mortgages in the US. It resulted in a period of financial instability leading to contagion in all financial markets across the world. The contagion led to adjustments in financial institutions that were prompted by bank failures as well as diminished investment banking. In addition, the federal government increased the insurance premiums on normal deposits of the banks, bailouts and new investments. Particularly, the government increased insurance accruing the sovereign fund investments leading to further polarization of the financial markets (Adelson 2004, p. 38).
Subsequently, the credit markets across the world came to a standstill leading to an increase in uncertainty about the safety of the financial investments. Market participants and authorities raised questions about the prevalent financial derivatives including the collateralized debt obligation (CDOs) among other derivatives (Paddy 2008, p. 32).
A collateralized debt obligation (CDO) refers to a financial derivative product whose objective is to transfer the risk of specific assets such as mortgages from the issuer to the investor (Paddy 2008, p. 34). It utilizes securitization technology that pools and collects all the assets and uses them to create securities upon the issuance of the same. In fact, Benesova and Teply (2010, p. 2) say that various categories of debt can be used as a form of collateral or insurance against some of the underperforming assets. This paper seeks to unravel the valuation of CDOs and utilizes data before and after the liquidation crises that typified the world in 2008.
Due to the complexity of the financial derivative, many investors rely on other institutions to rate the CDOs to comprehend and understand the actual risk associated with each type of a CDO (Adelson 2004, pp. 45-47). Beyond the explanation of the process of valuation of CDOs, it is important to make a demonstration of the way that they affected the financial institutions in 2007-08. Besides, the paper will explain the weaknesses that are apparent with the continued use of CDO in the context of financial markets. As such, this paper entails a brief preface and a description of the primary principles that allow CDOs to thrive in modern financial institutions.
In addition, the paper will make a critical examination of the features of CDOs and their markets. This way, the paper will be in a position to illustrate some problems that have arisen due to CDOs, their role in financial systems and their sustainability.
Collateral Debt Obligations (CDOs)
There is no uniform definition for CDOs although various financial theorists have attempted to define them (Tavakoli 2003, p. 243). The rationale is that they reflect complicated financial products that are dynamic. CDOs take different forms every time they encounter different financial situations. According to Benesova & Teply (2010, p. 60), CDOs are structured credit securities that represent loans and bonds.
They are backed up by bringing together all types of credit securities. The CDOs allow the securitized interests to disintegrate in tranches. The tranches have different features including their modes of repayment as well as their stream of interests (Benesova & Teply 2010, p. 60). To that end, it is important to distinguish between various types of CDOs in terms of their means of acquisitions, objectives and underlying assets among many other ways of distinguishing them.
Since their entrance into the financial markets in 1980, CDOs experienced tremendous growth after two decades as many participants in the financial markets became familiar with them (Vink & Thibeault 2008, p. 56). It is in early 2001 that the CDOs registered impeccable performance leading to high credit ratings from the authorities. According to Zandi (2009, p. 213), CDOsâ popularity increased in the early 21st century. In 2004, the issuance of CDOs amounted to $96 billion across the world.
However, the issuance of the derivatives increased in the succeeding years amounting to approximately $440 billion by 2006 (Fabozzi 2008, pp. 45-102). The global financial crises of 2008 led to their diminished growth and stalled their popularity. In particular, Benesova & Teply (2010, p. 6) say that the CDOs issuance reduced to about $155 billion amidst the global financial crisis of 2008. From the onset of 2001, structured CDOs became popular due to the increase of credit default swaps (Schaber 2008, p. 172). Their growth increased tremendously until the peak in 2006 that prompted the downfall of the financial stocks in 2008.
Companies and lenders were advancing their profit interests. Hence, they provided a thriving ground for accelerated growth in the issuance of CDOs. Not all types of CDOs precipitated the initial downfall of the financial markets and institutions. In other words, there were specific types of CDOs that led to the crises that we will explore in this discourse.
It is common to relate CDOs to mutual funds. A mutual fund is used to purchase bonds although it differs significantly from CDOs especially in the manner of acquisition. While CDOs securities reflect bonds, mutual funds have shared on the contrary (Tavakoli 2003, p. 247). In other words, CDOs are some arrangements in which bonds are issued to investors. The investors then proceed to sell the bonds in a bond portfolio called tranches. According to Zandi (2009, p. 231), CDOs can refer to a wide array of products depending on their structural classifications. The basis of classifications revolves around the sources of funds of the CDOs.
In this category, CDOs belong to either cash flow or market value. Second, CDOs can be classified according to the main motivation behind their issuance. Financial institutions can offer CDOs based on either arbitrage motivation or the transactions of the financial records. Cash and synthetic CDOs reflect a category of the financial instruments that represent cash assets and collateralized mortgage and loans respectively (Schaber 2008, p. 183). Some of the most outstanding CDOs are collateralized loan obligations (CLOs), collateralized bond obligations (CBOs) and collateralized synthetic obligations (CSOs) among many other types.
As financial instruments, CDOs invite markets from various participants in the financial markets. At the outset, Raynes & Rutledge (2003, p. 251) argue that CDOs major market emanates from the investors whose motivation is to increase their yields by focusing on the tranches that have the highest returns. It is important to mention that different types of CDOs may have different returns despite their similarities in their ratings. Second, underwriters provide a market for CDOs (Vink & Thibeault 2008, p. 58).
In fact, the underwriters represent the banking institutions that issue the CDOs. The underwriters work with other partners in the financial market to evaluate the feasibility of specific collaterals and increase their profit margins by acquiring cash flow that is in essence, a mortgage or a loan. Further, it is important to note that CDOs seem to be profitable in the short term and as such, they invite other partners in their issuance. Asset managers, attorneys, accountants and financial regulators become important partners and provide a market for the CDOs and their transactions (Mrudula 2006, p.131).
Despite the seemingly lucrative nature of CDOs during the period that preceded the global financial crises, they contributed substantially to the eventual fall of the financial markets in 2007. Numerous financial analysts pointed out that the nature of the risk that the CDOs predisposed the investors to was unprecedented. Besides, they suffer major risks in terms of valuation, issuance, rating and promoting human excesses in the context of banks and lending institutions.
Major Weaknesses of Collateralized Debt Obligations
Amato & Gyntelberg (2005, p. 83) highlight that investors in CDOs do not make a critical analysis of the underlying assets. In many CDOs, the amount of outstanding bonds is usually small when compared to the total number of the bonds. This implies that CDOs are vulnerable to systemic risk where low diversification can prompt a meltdown. This is was evident during the 2007 and 2008 financial crises where investors overlooked the importance of in-depth analysis into the complex nature and features of CDOs. Benesova & Teply (2010, p. 81) assert that the rating agencies failed to foresee the impact of low diversification on the market. Initially, low diversification and few defaults would not precipitate a financial meltdown. However, modern CDOs have become complex to the extent that few defaults in the markets can trigger a substantial systemic risk and contagion.
Another weakness of CDOs that were apparent during the 2007/2008 crises was the lack of understanding about the valuation model that the rating agencies used to rate CDOs (Fabozzi 2008, p. 29). As such, investors tend to ignore the basics of CDOs in the sense that they rely on the credit ratings of the bonds. Benesova & Teply (2010, p. 81) say that many investors do not understand the reason why an AAA-rated bond yields fewer returns than CDO tranches that have the same status. This implies that many investors and rating agencies do not understand the impacts of multiple credit events on the model they use to value the CDOs.
The rationale is that the basis of many valuation models is the expected cash flow. To that end, expected cash flows undermine the probability of defaults that could occur. In addition, CDOs capture the value for the investors who wait until the maturity of their bonds. In other words, they do not give an idea about the current market value of such a bond. For instance, if an investor purchases a CDO tranche, it would require numerous defaults for him or her to feel the effect of the defaults on his or her bonds. The reason is that his investment would remain unchanged since the defaults would have an intangible effect on the expected cash flow (Fabozzi 2008, p. 19).
Such assumptions are common when using the CDOs as financial instruments. Benesova & Teply (2010, p. 81) articulate that rating agencies tend to assume that the unchanged nature of cash flows due to defaults implies that their valuation model was appropriate. Nonetheless, the models fail to take into account the possibilities of losses due to the defaults (Mrudula 2006, p.144). In addition, the rating agencies and investors ought to have revealed the actual market value of the assets bought as bonds.
To counter such scenarios, CDOs financial instruments require that the financial agencies conduct a stress test on their model to comprehend the effects of multiple credit events prompted by massive defaults (Amato & Gyntelberg 2005, p. 87). This way, they can understand the complex nature of CDOs particularly when their mark-to-market value reflects expected cash flow from mortgages and loans. It is important to note that the complexity of the valuation models may prompt incorrect hypotheses about the financial outcomes.
Further, CDOs suffer the weakness of mispriced correlation in different valuation models adopted by rating agencies (Raynes & Rutledge 2003, p. 223). It is imperative to note that mispriced correlation occurs because of inflating the value of CDOs in the market without considering the probability of future defaults by debtors (Li 2000, p. 45). In 2007, investors underestimated the correlation level in financial institutions across the world. Consequently, this led to a systemic effect on the market participants at the onset of the global crises. In addition, the existing mark-to-market principles vary across the world and suffer major flaws.
Due to the defaults that were witnessed in 2007, the market for CDOs stalled and the value of various types of CDOs fell in an unsurpassed way. Nevertheless, many agencies and institutions persisted to value the CDOs using the same principles rather than valuing the actual values of the CDOs at their maturity. As elucidated by Benesova & Teply (2010, p. 83), the consequence of such a practice is to induce many types of losses to the investor. This feature of CDOs saw any US firms suspend their principles of valuation and accounting.
CDOs also promote banking practices that are unsustainable (Fabozzi 2008, p. 17). In 2007, many banks were giving out loans without substantiating the ability of the borrower to pay them back. This was in terms of loans and mortgages. By collateralizing the loans and mortgages, the bank stood to gain immensely only when the default risk was minimal (Tavakoli 2008, p. 67). The rise of default rates across the US financial markets prompted a backlash on the value of the CDOs issued as bonds to investors. Due to the high number of investors who had invested in collateralized loans and mortgages, the banks became irresponsible and provided loans to numerous people. In such a case, banks adopt poor accounting and banking practices leading to the catastrophic effect of overvaluation of CDOs and high rates of default (Raynes & Rutledge 2003, p. 261).
It is therefore important to presuppose that the features of CDOs provide thriving grounds for malpractices and improprieties by banks and other lending institutions. This does not only predispose the investors to multiple losses but also threatens the liquidity of the lending institutions. During 2007, such companies as Lehman Brothers and J Morgan Chase fell into the trap of lending money to numerous customers without substantiating their chances of default. The companies were motivated by profit motives and overestimated the ability of their customers to pay back the debts and the investors to withstand the multiple stressors.
CDOsâ Market Melt Down during the 2007 Global Financial Crises
While the 2007 financial crisis had multiple causatives and effects, the meltdown of CDOs was perhaps the pivotal cause of the global financial crunch. Zandi (2009, p. 216) asserts that the CDOs performed dismally in 2007 owing to the low-quality collaterals issued by banks. In the preceding period (2001 to 2006), CDOs had experienced rapid growth as the banks reached out to numerous customers to provide mortgages and loans (Calomiris 2008, p. 59).
In fact, borrowers who had poor credit records backed numerous collaterals. The excessive mortgage lending practices by financial institutions before the crises were the major drivers of the unprecedented growth of CDOs. However, the same practices led to the ultimate destruction of the CDOs. The complex nature of CDOs coupled with varied valuation models hid the true creditworthiness of the collaterals (Muolo & Padilla 2008, p. 184). This precipitated the continued production of even worse collateral to ensure that investments in CDOs continued.
Secondly, it is important to highlight that many underwriters of CDO were responsible for the CDO meltdown that precipitated the global financial crises (Mejstrik et al. 2008, pp. 34-83). It was clear that the underwriting banks suffered numerous inconsistencies in their CDO assets. Muolo & Padilla (2008, p. 184) say that similar CDO assets with identical values performed inconsistently across the banking and financial institutions.
This implies that the identity of the underwriting bank was a crucial element that contributed to the meltdown of CDOs in 2007 thus, prompting the liquidation crises. Zandi (2009, p. 56) articulates that the competency and quality of underwriters were attributable to other non-financial factors such as the market share. The financial institutions that rated best in underwriting were most responsible for low-quality collaterals that typified the 2007 global financial crises. It is vital to mention that the performance of CDOs varied among the banking underwriters partially because of the level that various ending institutions used to differentiate essentially similar securities (Tavakoli 2008, p. 67).
The most prolific financial institutions exploited their superior marketing strategies to convince investors to purchase CDOs that were of low quality (Mejstrik et al. 2008, pp. 34-83). The eventual collapse of the CDOs revealed the level of sophistication that various financial lending institutions used to differentiate and potentially distinguish securities that had similar ratings. This in turn made the investor unaware of the inconsistent performance of the financial institutions.
Further, Zandi (2009, p. 231) argues that CDOs contributed substantially to the eventual fall of financial markets in 2007. She says that investors were over-reliant on credit ratings that various rating agencies awarded to certain collaterals (Zandi 2009, p. 231). Consequently, the credit rating system failed to highlight the actual amount of risk that a particular investor would incur by investing in specific types of CDOs.
Apparently, the credit rating system had become redundant in the sense that most CDOs received similar credit ratings from the credit agencies (Fabozzi 2008, p. 286). Various financial analysts attribute this lack of variation to the fact that many financial institutions were able to access the software that the agencies used to rate the companies. As such, the institutions were able to ensure that the collateral selected by the rating agencies during the process would yield their high ratings to attract investors. According to Benesova & Teply (2010 p. 81-89), the banking underwriters were able to manipulate various types of collaterals and models to get an outstanding rating. In particular, correlation number was the most vulnerable input that various lending institutions manipulated to acquire an âAâ rating status (Mejstrik et al. 2008, pp. 34-83).
Numerous financial institutions whose CDO credit rating was unappealing managed to ensure that the rating agencies awarded them high points erroneously. Before the meltdown, Zandi (2009 p. 164) mentions that the credit rating systems were instrumental in predicting the performance of the CDOs until 2007. This was a period when numerous banks engaged in improprieties and malpractices typical of excessive and uncontrolled lending practices as well as inflated desires by banks and financial institutions to make profits.
Fourth, the CDOs contributed significantly to the housing bubble that also led to the eventual global financial crises of 2008 (Fabozzi 2008, p. 73) The US housing market provided an arena where investors would be able to make profits that exceeded the yields of treasury bonds owing to the fixed nature of the CDO securities. The amount of fixed capital for investments that were in the form of CDOs increased tremendously. Calomiris (2008, p. 216) says that fixed income investment capital increased by over 200% in the financial period preceding the crises. On the contrary, such rapid growth was not present in other income-generating investments at that time.
Financial institutions, therefore, addressed this apparent demand by the inclusion of mortgage-backed securities and collaterals. In other words, they were able to connect the housing sector with fixed income capital (Fabozzi 2005, p. 56). By 2003, many lending institutions utilized conventional methods that failed to address the demand for mortgages. This demand would later become the major force behind poor lending standards adopted by various lending institutions. The banks could provide lending services to their clients since they were certain that the mortgages could be bought along the brokerage and supply chain.
Despite the risky nature of the CDOs, financial institutions experienced growth in subprime assets. The rating agencies did not capture the risky types of the subprime assets in the name of CDOs and subsequently, awarded all CDOs similar ratings.
This prompted the lending institutions to liquidate when it became apparent that the default rate had increased rapidly in 2006. The major problem was that the combination of large sources of fixed income investorsâ capital and the housing sector through MBS did not dilute the apparent risk (Fabozzi 2005, p. 63). Instead, the risk affected numerous financial institutions since they were similar and correlated. In other words, the risk that precipitated the 2007 financial crisis was entrenched in the fact that default from one sector could cause similar trends in other sectors. Ultimately, many people began to default as the systemic contagion took effect (Li 2000, p. 47).
The initial indicator of the financial meltdown was the non-performance of various hedge funds. For instance, Bear Stearns recorded a decrease in the value of the assets that its hedge funds held. This was attributable to the fact that subprime mortgage crises had started. The shareholders demanded the company to give them back their investment (Vink & Thibeault 2008, p. 68). To address the serious issues that Bear Stearns’ investors raised, the management arranged the compensation of the investors. In what was referred to as margin calls, Bear Stearns had promised to compensate its investors.
However, the company liquidated as the assets held by its hedge funds continued to plummet at the onset of 2007. As such, the investors received little if any amount of money they had used to invest in subprime and prime mortgages. Bear Stearns was not the only company that experienced the itch of increased risk of default leading to eventual collapse. Lewis (2010, p. 152) pinpoints that other companies faced the same predicament since the financial risk was systemic. As aforementioned, when one market experienced default, it implied that default risk would spread across the financial markets and institutions. For instance, the growth of the popularity of CDOs led to the globalization of financial instruments.
Besides, the interconnectedness of the banks and interrelationships of their financial instruments meant a specific risk cut across all markets. As such, CDOs provided major lending institutions with an opportunity to exploit profits that were unattainable (Tavakoli 2003, p. 281). In addition, the major financial and banking institutions continued to overestimate the ability of the customers to repay their mortgages and loans (Vink & Thibeault 2008, p. 68).
Future of CDOs
Primarily, it is important to make a major point that CDOs are feasible financial instruments (Vink & Thibeault 2008, p. 69). The experience of the 2007 global financial crisis reveals their susceptibility when they encounter multiple credit events. As such, various partners in the financial markets must ensure that their valuation models adapt to the dynamic nature of CDOs (Kothari 2006, p. 74).
The valuation tools and models should be able to determine the value of CDOs at maturity as opposed to making valuations based on the expected cash flows (Lewis 2010, p. 152). This major counterproductive factor led to the amplification of the risk of mortgage-backed securities (Bonfim 2005, p. 107). In addition, financial agencies and institutions should be ‘responsible’ when offering lending services to a myriad of customers. In other words, banks should be able to determine the ability of the customers to pay mortgages and service their loans. The credit rating systems that were typical to numerous flaws should reflect the actual value of assets held in terms of CDOs. This should prevent the incidences of poor and low-quality collaterals receiving high ratings in the market (Kothari 2006, p. 74).
This way, the financial institutions will be able to achieve their major objectives of increasing the value of the investors. It is also important for the banks to understand the systemic nature of financial institutions and as such, understand that CDOs are hugely correlated (Lewis 2010, p. 152). With such knowledge, financial institutions will be able to predict the impacts of some events in other financial markets on their CDOs.
Nonetheless, Zandi (2010, p. 183) explains that the CDOs may diminish with time. The rationale is that the multiple factors that caused their meltdown are unlikely to disappear in the short term. They include misalignment of incentives, imperfect market conditions and human excesses that were prompted by the ‘greed’ to maximize on returns. The financial institutions need to analyze the meltdown of the financial instruments and device new approaches and practices to utilize in the future.
This will not only prevent the recurrence of such a meltdown but also ensure that the investors of CDOs benefit from the performance of the assets (Bonfim 2005, p. 117). It is also critical to ensure that CDOs operate in financial markets that are less risky to systemic failures and contagion. In other words, distinct financial markets should be able to shrug off the failures of mortgage-backed assets in other markets. This will increase the investorsâ confidence and enhance market responsiveness to future situations of multiple financial risks and events.
Conclusion
In summary, collateralized debt obligations (CDOs) refers to financial instruments that reflect assets backed by debt (mortgage and loans). Lending institutions offer such services as mortgages and loans to numerous customers and in turn collateralize the debts and issue them as bonds to investors. Although they made an entrance into the financial markets in 1987, their popularity grew significantly between 2001 and 2006. Depending on the quality of the CDOs (low or high), CDOsâ performance receives a rating that reflects their risks. However, the rating agencies were unable to capture the actual rating of the CDOs before the 2007 global financial crisis.
As such, CDOs contributed immensely to the escalation of the financial crises. The rationale is that the banks ignored the actual value of the collaterals and continued to offer an excessive number of mortgages to the customers. Besides, the CDOs contributed substantially to the escalation of the housing bubble. All these factors came into play and revealed the major risks associated with CDOs. In particular, they revealed the irresponsive nature of CDO models when faced with multiple credit events. In addition, they were pivotal in hiding the actual predicament that ensued. The valuation models had not been put into stress test and therefore succumbed when borrowers defaulted. To that end, it is important to articulate that the future of CDOs hangs in a balance since the multiple factors that precipitated their meltdown remain in play.
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