Uncorking CDOs: Financial Crisis Explained
Marketplace Senior Editor Paddy Hirsch gives a bubbly explanation of the intricacies of collateralized debt obligations those financial instruments that got us into this financial mess.
CARPE DIEM
Professor Mark J. Perry's Blog for Economics and Finance
Friday, November 28, 2008
About Me
- Name: Mark J. Perry
- Location: Washington, D.C., United States
Dr. Mark J. Perry is a professor of economics and finance in the School of Management at the Flint campus of the University of Michigan. Perry holds two graduate degrees in economics (M.A. and Ph.D.) from George Mason University near Washington, D.C. In addition, he holds an MBA degree in finance from the Curtis L. Carlson School of Management at the University of Minnesota. In addition to a faculty appointment at the University of Michigan-Flint, Perry is also a visiting scholar at The American Enterprise Institute in Washington, D.C.
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5 Comments:
The financial crisis can be explained with one word. GREED
given this simple explaination, then the question is, why did the bond raters rate the flows from the second "bottle" as AAA, AA, BBBB, etc.? As these were not primary CDOs, shouldn't these have been rated much lower, e.g., BB?
The financial crisis can be explained with one word. GREED
Blaming this crises on greed is like blaming a plane crash on gravity. Greed -- like gravity -- is always present. So "greed" doesn't explain what changed.
The root of this problem -- the source of all the income that attracted investors to these CDOs -- was the housing market and the vast increase in mortgages, both first and second mortgages, both prime and subprime.
So there are really three questions:
1) Where did all the money come from to finance all those mortgages?
2) What convinced the lenders to lower their lending standards so drastically?
3) What convinced the secondary investors that these investments were safe?
Concerning these three questions, we know these things for sure:
1) The market doesn't have the ability to create credit out of thin air -- it does not control our fiat money supply -- the Fed does.
2) The Federal Reserve, the Federal Housing Administration, the Federal National Mortgage Association and the Federal Home Loan Mortgage Corporation were NOT created in an effort to "rein in" lenders who were making loans that were too risky -- just as the Community Reinvestment Act was NOT passed because lenders were giving money to people that couldn't pay it back.
To the contrary, all those federal agencies and laws were created to achieve the opposite: to "encourage" the making of loans that lenders would otherwise not make .
3) The investors in the secondary market relied on the bond rating agencies, like Moody’s and S&P. We know that those agencies are essentially a cartel, protected from competition by the Federal government and overseen by the Securities and Exchange Commission.
We know that assigning a rating of “AAA” to CDO’s that contain subprime mortgages is an error that, in a free market, would destroy the rating agency’s credibility such that no one would use them and they’d go bankrupt. However, in our non-free market, they are still in business, and bond issuers are still required by law to use their services.
This last point brings up one last crucial thing we know about this mess: in a free market, irrational behavior is punished -- punished by economic losses including bankruptcy if necessary -- and all the players in the market know it. But we don’t have a free market -- we have a highly regulated market, featuring a central bank that acts as “lender of last resort” and a federal government that fosters a “too big to fail” mentality by repeated bailouts of those who acted irrationally.
From these facts, the answers to the three questions are clear. This mess is a failure of the unfree market.
Professor Perry, I also have the same question as anon, why were the CDO^2's ever rated AAA by the rating agencies? Was it truly that the agencies "did not understand" as Paddy claims. It seems hard to believe that such an oversight could be made by organizations as sophisticated as this.
Genius explanation.
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