Financial Innovation has become a byword for risk in the recent past; the newly formulated financial instruments were too complex to be understood by the bankers who bought them. The risk involved in them were not fully evaluated by the bankers who bought them, resulting in the massive losses on many securities during the financial and economic crisis of 2008 and 2009. Financial innovation can be of three types: Institutional innovation refers to change in reforms and introduction of legal and supervisory frameworks, process innovation: which includes improvements in business processes. For example: using new financial software and product innovation: represented by new products like collateralized debt obligations (CDO’s) or credit default swaps (CD’s).
A collateralised debt obligation is a tradeable derivative whose income payments and principal repayments are dependent on a pool of different financial instruments which themselves are loans and are due to pay interest and ultimately be repaid. CDO’s are called collateralized because the promised repayments of the loans are the collateral that gives the CDO’s value. In the case of CDO’s, mortgages might be packed with other loans, bonds or instruments. For example: When a bank issues a mortgage to a person, and does not want to keep it on its books, it can sell it to other investors in the form of an MBS, (Mortgage Backed Securities). If there are investors who want to get higher or lower returns that a normal MBS would provide, they can buy CDO – a derivative on the MBS. A CDO allows investors to get the risk return ratio they want, For example: if an investor wants higher returns, he can opt for lower level CDO tranches, but they will be the first one to suffer losses if the underlying mortgages are not repaid. Senior tranches pay the lowest rate of interest but are the safest investment because in the event of a default, seniors are paid first. CDO’s are effectively promises to pay investors in a prescribed sequence.
For example, a bank might pool together 5,000 different mortgages into a CDO. An investor who purchases the CDO would be paid the interest owed by the 5,000 borrowers whose mortgages made up the CDO, but runs the risk that some borrowers don’t pay back their loans. The interest rate is a function of the expected likelihood that the borrowers who make up the CDO will default on their payments. CDO’s are created and sold by major banks such as Goldman Sachs and Bank of America over the counter and not traded physically in an exchange. CDO’s are assembled in such a way that the return is higher but the risk is still relatively low. Bond risk is rated on a scale of “A” to “E”, with “A” being the safest “E” carrying the highest element of risk. Credit rating agencies have their own system of rating, however, the “A” to “E” scale is used by most agencies. A typical CDO has roughly 20 percent of its bonds with a rating of “A”, and another 15 percent with a rating of “B”, another 20 percent of the CDO is composed of bonds with a rating from “C” to “E”, and the rest is composed of equity.
Collateralised Debt Obligations hit the news at the time of the U.S. subprime mortgage crisis of 2006-07 which precipitated the global financial crisis of 2007-2008. Economists and experts said CDO’s hid the underlying risk in mortgage investments because the ratings on CDO debt were misleading about the creditworthiness of the borrowers. The crisis compounded when house buyers who should never have been offered mortgages because they were unlikely to repay their loans started defaulting on their loan repayments, the losses spread to the collateralised debt obligation market.
In February 2013 the U.S. Department of Justice accused rating agency S&P of defrauding investors in mortgage related securities of worth $ 5 billion. The department alleged that from 2004 until 2007, S&P “adjusted and delayed” updates to its rating criteria and models and continued to provide “AAA” ratings on mortgage related securities including collateralised debt obligations.
Historical data suggested that not more than 4-6 percent of house owners would default, so the holders of “AAA” tranches were considered be safe investors. However, once the U.S. house prices fell, subprime borrowers defaulted ‘en masse’, therefore the risk of the safest investors was almost the same as the ‘junk’ tranche, so as soon as U.S. housing prices stopped rising and people started defaulting, hundreds of billions of dollars of CDO’s were wiped out.
Collateralized Debt Obligations Explained