Collateralised Debt Obligations (CDOs): An Update
By: Maja Cvjetanovic
Abstract: Collateralised Debt Obligations (‘CDOs’) are credited for the credit market’s demise in 2007. It is much too simple, and tempting, to scapegoat the vast use of CDOs during this time. A more complete explanation of the Global Financial Crisis (GFC) considers the stakeholders who created and bolstered the CDO. Ultimately, the CDO is a vehicle for cognitive and moral shortcomings.[1] This paper gives a detailed description of a CDO and chronicles its role in the 2007 Global Financial Crisis (‘GFC’). Legislative responses following the adoption of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010 (‘Dodd-Frank Act’) are described. Finally, the current status of the CDO in the United States economy is explored. While some human motives and indeed approaches to CDOs have been effectively hampered through regulation, there still exists a clear potential to create CDOs in the current economic climate. More efficient regulation is required to curb the making of CDOs, which provide a potential for ‘rent seeking’ practices amongst investors, while posing social costs for the economy as a whole. Thanks to cognitive shortcomings, the current rebirth of CDOs in the US ought to be managed through greater regulatory oversight to avoid another crisis.
I. What is a CDO and what is its use?
A. Keeping Up With the Demand for CDOs
The Collateralised Debt Obligation or CDO is a special purpose vehicle aimed at diversifying financial risk or spreading risk to multiple stakeholders or investors. It essentially is a specie of structured ‘asset-backed securities.’[2] This means it provides security to a financial transaction, supported by a pool of assets. In the present context, the relevant pool of assets is consumer mortgage loans.[3]CDOs encompass diverse financial instruments, including collateralised bond obligations, collateralised loan obligations, collateralised mortgage obligations and so forth.[4] They can be created by banks, non-banks and asset management companies.[5] CDOs are created via a ‘special purpose vehicle,’ a company, which administers the loan obligations and risks, but otherwise has no claim to the cash flow generated by the underlying assets.[6] In order for CDOs to work, they require subprime loans to fulfill the role of providing capital assets. In essence, subprime mortgage became the ‘raw material’ for the creation of a CDO.[7] At a broader level, Nayak connects the growth in demand for subprime mortgages, with two interrelated factors. Firstly, the slump in dot.com investments which marked the end of ‘large investments from the stream of technical innovations that had galvanized the investment climate during 1990s.’[8] In this regard, ‘[t]he GDP growth rate slumped from the peak of 4.8% in 1999 and 4.1% in 2000 to 1.1% in 2001 and 1.8% in 2002.’
* Maja Cvjetanovic is a final year law student at the University of Queensland. She is a former Vice President of the Justice and the Law Society at the University and a regular contributor to the University’s Pro Bono Centre.
[1] Arnold Kling, ‘The Financial Crisis: Moral Failure or Cognitive Failure’ 33 (2010) Harvard Journal of Law and Public Policy 507.
[2] Dennis Vink, ABS, MBS And CDO Compared: An Empirical Analysis <http://mpra.ub.uni- muenchen.de/10381/2/MPRA_paper_10381.pdf> (August 2007)
[3] Lemke, Lins and Picard, Mortgage-Backed Securities (Thomson West, 2013) [5.15].
[4] Hongwen Du et al, ‘On the Mechanism of CDOs behind the Current Financial Crisis and Mathematical Modeling with Levy Distributions’ 2 (2010) Intelligent Information Management 149, 149.
[5] Ibid.
[6] Ibid.
[7] England above n 1, 103.
[8] Satyendra Nayak, The global Financial Crisis: Genesis, Policy Response and Road Ahead (Springer, 2013) 12.
