CDO and CDS – what are these? And how did they cause a global recession?

There are two acronyms that are at the heart of the recession talk, the CDO and CDS. But very few people know what they are and how they had such a pivotal role in the current recession.

CDS -

So what do the acronyms stand for? A CDS is a credit default swap. The loan seller can purchase a CDS , for this the loan seller pays a fee and in return if the loan is defaulted upon the CDS seller pays out compensation (usually the face value of the loan). As a financial instrument it’s highly effective at spreading risk without diversification of the loan seller’s portfolio. So, for example, banks can sell loans to homeowners or small businesses and not need to balance the risk in the portfolio with more secure loans sold to more established businesses. The advantage of this is that loans to small businesses and homeowners have higher interest rates attached and therefore are more profitable, so by loading the portfolio with these with CDS taken out makes for a highly profitable and low risk portfolio.

CDO -

The second acronym is the CDO, which is a collateralised debt obligation. Again, in its basic form this is a collection of loans that have been packaged together. By packaging loans together it reduces the risk of the package and also allows them to be sold on. There are three main advantages to banks for selling CDOs. Firstly its shifts the risk of loan defaults onto the investor. Secondly it turns small monthly payments that would normally be received from the loan repayments, into a large capital payment from the investor buying the CDO, which gives the bank more capital to give out as new loans. Finally by increasing loans and profits made from CDOs it boosts the financial performance, which results in increased share prices and boosts manager’s bonuses.

Why did they rise in popularity?

Both options sound great, they reduced risk and increase the debt capital available to the market, which should be a self supporting cycle of growth. However loans are highly dependent on interest rates. And the US interest rate had been consistently low since the early 90’s.

With interest rates being low over such a long time it encouraged everyone to borrow more and more. Banks were happy to lend as they were shifting the risk by selling all these loans as CDOs and reducing risk with CDSs as well as receiving cash from selling them, which again increases the amount of loans they can sell. Banks had so much cash they were struggling to lend it all out, so they increased the amounts they were giving out, in some cases offering 140% of the value of property loans and 6 or 7 times annual salaries of the receivers.  But look what happens when interest rates increase slightly.

Many loans start to be defaulted upon, but banks think they are covered with the CDS and CDOs that they took out. But they didn’t realise the extent to which CDOs and CDSs had flooded the market and the amount of companies whose balance sheets were loaded with these instruments that were so sensitive to changes in interest rates. The results of these errors are well documented and this blog doesn’t aim to discuss the results but to questions who was at fault for allowing it to get this far.

Who is to blame for the CDO and CDS issue?

Ok, so let’s line the main groups up who played some part in this over saturation of CDOs and CDSs. Firstly there is the US governments for consistently low interest rates. Secondly there are the homeowners taking loans they couldn’t afford. Thirdly, banks for offering loans that were up to 140% of property values and 6 or 7 times annual salaries. And finally the credit rating agencies that managed to rate CDOs incorrectly.

US Government to blame?

The US government kept interest low to encourage growth in the economy, however should they have realised growth is never expediential? And surely they saw the public debt levels increasing and should have stepped in by increasing interest rates to deter the public taking out more debt. It seems the American government became ‘blinkered’ and only saw the growth benefits of low interest rates. But because interest rates are low does it give other people and institutions the right to exploit that?

US homeowners to blame?

The US homeowners used the low interest rates to take out mortgages, which is great when the mortgage is manageable. The low interest rate would have enabled millions of young family’s gain the first step on the housing ladder and secure their futures. However greed kicked in and people took mortgages that were on the limits of their financial capabilities. It seems there was an over confidence of the public and as a result they didn’t try and ‘keep up with the Jones’, they bought the Jones’ house! It depends how harsh you want to be on the average American family, on one hand you could say it’s their entire fault for being so greedy, but personally I think the average American family is unlikely to understand the complex economics or the financial instruments that are involved when they take out a mortgage. Therefore they trusted the banks.

The banks to blame?

Should they have trusted the banks? Well, yes. The banks have the financial and economic knowledge and it was indeed the banks selling CDOs and taking out the CDSs, so they were in the best position to understand the extent to which the markets were exposed.  The banks also chose to lend huge sums of money to low earning families, it could be called predatory in some cases. However the banks thought they were spreading the risk, they believed they were being safe. You must understand that everyone believed that these CDOs and CDSs were truly safe and therefore you can’t land all the blame at the banks door step. Why did the banks think they were safe?

Credit rating agencies to blame?

The banks thought they were safe instruments because they are banded in terms of risk. Credit rating agencies rank CDOs from AAA to C or D.

The three main credit rating agencies (Moody, Standard & Poor and Fitch) were effectively fooled when it came to CDOs. Somehow they managed to band secondary CDOs into the same categories as primary CDOs. This in turn fooled the market into buying CDOs that were far more risky than they were labelled. The markets are so reliant on these ratings that if errors occur at this stage, the consequences can be catastrophic. It seems unbelievable that such a small error can have such large impacts, and errors that were made by the ‘experts’. The era of bank bashing began as soon as the financial crisis hit the headlines, but it seems that the error was made by the credit rating agencies and maybe instead of slashing the bonuses of the banking executives a little more digging should be done into the salaries of the rating agencies...