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.
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,
essentially markingthem as “safe” investments.
While the credit rating agencies have taken heavy criticismfor their role in mis-rating billions of dollars in CDO tranches,
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).
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,
According to CreditFlux Newsletter, as of January 8, 2008.
Moody’s, S&P, and Fitch.
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.”
See Roger Lowenstein’s article, “Triple-A Failure,” for an overview of the criticism of the ratingagencies.
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.