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Why CDOs Failed:
Collateralized debt obligation has some complicated structure. A senior trench in a collateralized
debt obligation, for instance, would be entitled to the safest position. If the underlying assets in
the collateralized debt obligation were to begin to go bad for instance, homeowners stopped
making their mortgage payments then the most junior tranches would absorb the losses first.
CDOs failed because rating agencies and institutions did not implement correct regulation. The
returns were so profitable in previous exchanges that it seemed to be unreasonable to end the
cycle.
Role of Credit rating agencies:
As CDO rapidly developed rating agencies came
under huge pressure to quickly handle CDO ratings
and the CDO market growing faster than the
knowledge or number of analysts. CDOs analysis
relying completely on automated models and has very
little human intervention & incentive for accuracy
checks of the underlying collateral ratings.
The rating agencies also failed to correctly examine
of their own previous collateral ratings accuracy and
in most cases, they used other agency’s ratings
without properly accuracy check. For shortcomings correction in the others agency’s rating
approach, rating agencies started the practice of “notching,” where they simply decrease the any
collateral security rating. They did not reanalyze the rating of other rating agencies and assumed
that reducing it by a notch would cover any shortcomings.



Similar ratings of corporate bond and structured credit products:

Since structured credit products are rated using the same rating scale as for corporate bonds.
This approach was fundamentally flawed and this lead to major underestimation of the risks
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involved with holding these complex securities. Corporate bond ratings are largely based on
firm-specific risk, while CDO tranches represent claims on cash flows from a portfolio of
correlated assets. Thus, the rating of CDO tranches relies heavily on quantitative models while
corporate debt ratings rely essentially on the analyst judgment.


Role of Underwriter and CDO manager:

CDO underwriters were somehow responsible for the problems in the CDO market. Controlling
for observable CDO asset and liability properties, it is clear that CDO performance was as much
a product of the underwriting bank as it was the type of collateral. The identity of the CDO
underwriter is a significant predictor for CDO performance, even after controlling for collateral
type. Variation among banks’ underwriting standards, with some banks consistently more careful
in their collateral selection. Banks converted the funded exposure to non funding exposure.
We think CDO managers also only acted “as a rubber stamp” for underwriters or deal sponsors
without fulfilling their duty to ensure the CDO
performed well for all investors. CDO
managers were instrumental in the creation
and fueling of the CDO markets during the
boom years leading up to the financial crisis.
They were third party advisers in charge of
looking out for the CDO's and, accordingly,
CDO investors interests.


Unrealistically simple risk models:

Value-at-Risk (VaR) has become the universal risk measure for financial institutions in
understanding their sensitivity to changes in market risk drivers such as interest rate, asset prices,
correlations and volatilities. They were not aware of any full-fledged extension of these models
that accounts for the complexity of structured credit products such as tranches of CDOs.
Since structured credit products are rated using the same rating scale as for corporate bonds. This
approach was fundamentally flawed and this lead to major underestimation of the risks involved
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with holding these complex securities. Corporate bond ratings are largely based on firm-specific
risk, while CDO tranches represent claims on cash flows from a portfolio of correlated assets.
Thus, the rating of CDO tranches relies heavily on quantitative models while corporate debt
ratings rely essentially on the analyst judgment.
VaR should have been complemented by other risk metrics such as “worst-case scenario
analysis” and “stress testing” in order to assess the extent of losses consecutive to extreme
market conditions


Over-reliance on short-term financing & ignored liquidity risk:

Banks have gradually shifted away from the traditional business model “originate and hold”
toward the new “originate-to-distribute” business model. Under this new business model, the
bank services the loans but the funding of the loans is sourced out to investors, and the risk of
default is also transferred out to these investors. In practice the implementation of this business
model was flawed and this crisis demonstrated that the redistribution of credit risk among final
investors that it was supposed to achieve was only an illusion.

Quality of Data:

It was essential to perform due diligence on the raw data but neither the rating agencies nor the
banks which structured the CDOs have done it. Clarity of data would have been used to reach a
rating. Rating agencies accepted the data from a third party and done nothing to check it.

Conclusion:

Failure of CDO was a combination of poor collateral quality, lax underwriting standards, and
inaccurate credit ratings that allowed the construction of a trillion-dollar CDO “house of cards.”
We think everyone was responsible, from investment banks to hedge funds, failed to question the
validity of the models that were luring them into a false sense of security.
In the end selling was not easy. The Glib promises of liquid market proved illusory. You could
not stay in, you could not get out. CDO quickly came to stand for “Crises in Debt obligation”