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The Story of the CDO Market Meltdown:An Empirical Analysis
Anna Katherine Barnett-HartPresented to the Department of Economicsin partial fulfillment of the requirementsfor a Bachelor of Arts degree with HonorsHarvard CollegeCambridge, MassachusettsMarch 19, 2009
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The Story of the CDO Market Meltdown:An Empirical Analysis
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Abstract:
Collateralized debt obligations (CDOs) have been responsible for $542 billion inwrite-downs at financial institutions since the beginning of the credit crisis. In this paper,I conduct an empirical investigation into the causes of this adverse performance, lookingspecifically at asset-backed CDO’s (ABS CDO’s). Using novel, hand-collected data from735 ABS CDO’s, I document several main findings. First, poor CDO performance was primarily a result of the inclusion of low quality collateral originated in 2006 and 2007with exposure to the U.S. residential housing market. Second, CDO underwriters playedan important role in determining CDO performance. Lastly, the failure of the creditratings agencies to accurately assess the risk of CDO securities stemmed from an over-reliance on computer models with imprecise inputs. Overall, my findings suggest that the problems in the CDO market were caused by a combination of poorly constructed CDOs,irresponsible underwriting practices, and flawed credit rating procedures.
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I would like to thank the following people and businesses who willingly gave of their time and expertiseto help me tell the story of the CDO market meltdown: Michael Blum, Michael Blum Consulting, AnnRutledge, Sylvain Raynes, R&R Consulting, Eliot Smith, Sam Jones, Mark Adelson, Mark McKenna,Thomas Giardi, Arturo Cifuentes, Douglas Lucas, Paul Muolo, Nicholas Yukich, Richard Baker, EricSiegel, and Richard Gugliada. I am also grateful for the guidance and advising of the following HarvardProfessors and doctoral students: Efraim Benmelech, Paul Healy, Erik Stafford, Allen Ferrell, MartinFeldstein, Erkko Etula, Laura Serban, Jenn Dlugosz, and David Seif. All remaining errors are my own.
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1. Introduction
Collateralized debt obligations (CDOs), once a money making machine on WallStreet, have been responsible for $542 billion of the nearly trillion dollars in lossessuffered by financial institutions since 2007.
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Perhaps most disturbing about these lossesis that most of the securities being marked down were initially given a rating of AAA byone or more of the three nationally recognized credit rating agencies,
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essentially markingthem as “safe” investments.
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While the credit rating agencies have taken heavy criticismfor their role in mis-rating billions of dollars in CDO tranches,
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they were not alone intheir mistake. Indeed, almost all market participants, from investment banks to hedgefunds, failed to question the validity of the models that were luring them into a falsesense of security about the safety of these manufactured securities. How could so many brilliant financial minds have misjudged, or worse, simply ignored, the true risksassociated with CDOs? In this paper, I use novel, hand-collected data from 735 ABSCDOs to shed light on this mystery, investigating the causes of adverse performance inCDOs backed by asset-backed securities (ABS CDOs).
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I characterize the relativeimportance of general CDO properties, underwriting banks, and credit rating agencies incontributing to the collapse of the CDO market and document several findings.First, the properties of the CDO collateral, including asset class and vintage, arethe most important factor in explaining the variation in CDO performance. In particular,
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According to CreditFlux Newsletter, as of January 8, 2008.
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Moody’s, S&P, and Fitch.
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According to financial consultant Mike Blum, underwriters would often pay for all three agencies to ratetheir deals to “convey the impression that these bonds were rock-solid.”
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See Roger Lowenstein’s article, “Triple-A Failure,” for an overview of the criticism of the ratingagencies.
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ABS CDOs are CDOs whose collateral consists primarily of asset-backed securities, as opposed to CDOs backed by corporate bonds or whole loans. ABS CDOs accounted for more than 90% of the U.S. CDOsdowngraded in 2007.
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