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CDO’s helped the economic crisis develop

Back in 2006 CDO’s were the hottest thing in investments and banking. The individuals working on CDO’s would make millions based on how many they sold. And they sold extremely well. Small banks, pension funds, all kinds of investment firms wanted them.

CDO’s are collateralized debt obligations from a risky, large pool of people that ultimately make the entire cost of lending cheaper for the economy as a whole. In this case, the debt obligations came from sub-prime mortgages. The banks separated the pool of debt repayments into multiple streams of investments. This creates products that a much larger group of investors would consider in purchasing. For the banks, it was an exciting and profitable new way to take risky assets and reinvent them into a whole new investment product that everyone wanted.

Billionaire investors such as Warren Buffett and the IMF’s former chief economist Raghuram Rajan warned that CDO’s spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. The actual risk remained high, although the sale pitch to investors was the risk was properly mitigated and safe.

As time went on investors started to question why these sub-prime mortgages were being approved with lower and lower credit standards. No matter how much the banks wined and dined the investors it was too late. They lost interest in CDO’s and taking on the risk. The banks were left holding huge amounts of these toxic assets with no one to invest in them.

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