The CDO Post-GFC: A Comeback for Better or Worse?

By Maja Cvjetanovic

Maja Cvjetanovic is a senior at the University of Queensland in Australia studying law.

The late 1990s and early 2000s period saw the practice of diversifying credit risk through ‘special purpose vehicles,’ culminating in the Collateralized Debt Obligation (CDO). The CDOs housed different ‘collateral’ through a trust-like arrangement; the income flowing from the collateral was given to investors, according to the different tranches to which the investors belonged [1]. In essence, the risk inherent in the underlying collateral, represented typically by housing loans, was diversified amongst different classes of investors, in the event of a default. Since then, CDOs have been credited with playing a central role in the credit market’s demise of 2007. 

Indeed, CDOs have been referred to as ‘financial weapons of mass destruction’ with ‘lethal’ consequences [2]. Originating in the 1980s, CDOs had rapidly risen to provenance in the 1990s through to the early 2000s, following a move towards greater deregulation in the market [3]. But it is much too simple, and tempting, to scapegoat the vast use of CDOs during this time. A much better explanation of the Global Financial Crisis (GFC), as well as the unscrupulous use of the CDO, would consider the amalgam of stakeholders and contributors, who, whether major or minor players, played an essential role in bolstering the demand and creation of the CDO. In this way, the CDO is a pithy ‘vehicle’ to more powerful, human forces: cognitive and moral shortcomings [4]. 

Post-Dodd Frank: Wall St vs. Washington

Before considering the current practices pertaining to CDO creation, it becomes necessary to consider the political battle waged behind the scenes. The colossal nature of the Dodd-Frank reform requires an effective coordination of several government agencies to report, oversee and implement existing measures in the future. Unfortunately, at its mid-2013 anniversary, regulatos have missed the deadlines for over 60% of the required rules [5]. It seems as though the trend of increased deregulation that predated the crisisis also characteristic the post-crisis climate [6].

For instance, the Volcker Rule has been criticized for its complexity, leading to the implementation of highly detailed and complex exemptions [7, 8]. Furthermore, the over the counter derivatives provisions now define swap dealers as those who conduct trades in excess of $8 billion each year, a stark contrast to the intended $100 million ceiling [9]. The lobbying efforts have been met with an equally aggressive litigation campaign [10]. The Wall Street campaign, said to cost $3.3 billion in political campaigns from 1990 to 2012, and an additional $5.3 billion on lobbying from 1998 to 2012, is fueled by the age-old rhetoric that when it comes to complex and ‘innovative’ financial products, industry knows best and regulation is likely to do more harm than good [11, 12].

Interestingly, this cost-benefit rhetoric fails to factor in the cost of deregulation, namely, the $3 trillion used in government bail outs to support the financial industry during the crisis and immeasurable damage to the global economy whose effects are yet to be fully felt [13].

Return of the CDOs: Are We Smarter and Morally Responsible Now?

Since the economic crisis of 2007, CDOs have been virtually eliminated from the financial market. However, current reports are documenting a relatively unthreatening, yet apparent comeback [14].The comeback is said to have its genesis in the low interest rates, which have driven demand for higher returns than their government and corporate bond counterparts [15]. But have investors and securitizers learned from their previous mistakes?

The Wharton School of the University of Pennsylvania reports that the new CDOs are packaged toward investors seeking ‘complex securities—not necessarily those holding lesser-quality residential mortgages but other types of debt.’The Wharton news report also argues that ‘lenders are far more cautious [and] regulators seem to be waking up.’SusanWachter, a commentator in the article, is positive about the CDOs’ return, highlighting the fact that the raw material is now a higher quality corporate debt, rather than mortgage backed securities [16]. 

CDOs have not reappeared unaccompanied. In fact, reports suggest that Citigroup has sold a total of $3 billion uncovered CDOs, between 2012 and 2013 [17]. It is perhaps arguable that CDOs (unlike their nakedCDO counterparts) are not inherently flawed, but instead play a significant role in risk diversification, when engineered with assets and loans that pose minimal risks of defaults [18]. Besides, proponents argue that we ought to assume  investors have learned their lesson by now, such that they will expect nothing less than a high quality CDO investment [19].

The foregoing confidence displayed by some proponents of CDOs begs the question:  are investors increasingly willing to ignore bad memories amidst high demand for high returns, in a market characterised by ‘rock bottom’ interest rates? This more skeptical approach may suggest that history is about to be repeated with these new forms of CDOs. In fact, simply exchanging the ‘raw material’ from mortgage-backed securities to ‘boring’ corporate bonds does not resolve the issue [20]. Early realizations from Proctor and Gamble’s entry into the derivatives market (discussed above) illustrate the flawed nature of a naked CDO product even in a corporate context.

Further, the ‘London Whale’ fiasco is a more recent illustration how corporate debt can prove to be an equally hazardous ‘raw material,’ under questionable financial engineering practices [21]. It is a fallacy to assume that all corporate bonds will always be safe components of a CDO. What happens when corporation begin to default? How is this assumption supposed to protect investors, and indeed, the economy?

Rosner, a managing director of Graham and Fisher Co displays persuasive doubts about the situation. He comments that investors have little information on the kinds of ‘raw material’ used to oil the CDO production chain. In fact, he believes little has changed since before the crisis [22]. After all, part of the CDO appeal has always been its illusive allure: the ability to create higher profits from unlikely sources. The state of affairs is even more exacerbated by the financial industry’s aggressive lobbying and the regulators’ willingness to accede to industry demand. At the beginning of January 2014, the Volcker Rule was significantly watered down to allow financial institutions to bet with their own money, in the context of CDOs backed by ‘trust preferred securities.’ [23] 

Furthermore, and somewhat surprisingly, JP Morgan is reported as starting to sell its mortgage-backed securities with a $616 million deal. However, the circumstances of the transaction are far from ‘plain vanilla.’ Credit rating agency, Moody’s has reported that the deal suffers from some of the trappings of the pre-crisis market. As a result, the agency was not able to stamp the transaction with its AAA guarantee [24]. At least the most obvious signs of moral degrade have been addressed.

In conclusion, the situation concerning CDOs has come a long way from its pre-crisis milieu. However, the vehicle, filled with technicalities and questionable promises of risk diversification, is still a possibility for eager financial engineers. It therefore becomes apparent that the regulatory response is far from complete. The legislation has effectively addressed more obvious signs of moral decay, by quelling the motives of some stakeholders, such as consumer borrowers, loan originators and securitizers.

The more technical aspects of the CDO, including its logical offshoots (the CDS and naked CDOs), have been preserved as pillars of financial innovation. To use Kling’s categorisation, overestimating the CDO was a cognitive failure—many simply did not understand. However, can we claim this same, convenient pretext, in future instances of financial ruin? It would appear that the GFC is too much of a lesson to forget so soon. The next financial crisis spurred by exotic financial engineering will be perceived as a clear moral oversight from every actor in the game. 



[1] Robert Stowe England, Black Box Casino: How Wall Street’s Risky Shadow Banking Crashed Global Finance (Praeger, 2011) 96.
[2] http://www.fintools.com/docs/Warren%20Buffet%20on%20Derivatives.pdf
[3] Lynn A Stout, ‘Derivatives and the Legal Origin of the 2008 Credit Crisis’ 1 (2011) Harvard Business Law Review 1. 
[4] Arnold Kling, ‘The Financial Crisis: Moral Failure or Cognitive Failure’ 33 (2010) Harvard Journal of Law and Public Policy 507.
[5] William D Cohan, Does Congress Want Another Economic Meltdown? (11 June 2012) http://www.bloomberg.com/news/2012-06-10/does-congress-want-another-economic-meltdown-.html
[6] Arthur E Wilmarth, ‘Turning a Blind Eye: Why Washington Keeps Giving in to Wall Street’ 13 (2013) University of Cincinnati Law Review 1283, 1292.
[7] Phil Mattingly and Cheyenne Hopkins, U.S. Regulators to Defend Volcker Rule Ban on Proprietary Trades (18 January 2012) http://www.businessweek.com/news/2012-01-20/u-s-regulators-to-defend-volcker-rule-ban-on-pr oprietary-trades.html
[8] Arthur E Wilmarth above n 6, 1303.
[9] Alexandra Alper and Sarah N Lynch, Regulators Spare All But Biggest Swap Dealers (18 April 2012), <http:// www.reuters.com/article/2012/04/18/financial-regulation-swaps-idUSL2E8FI44Y20120418
[10] Arthur E Wilmarth above n 6, 1308.
[11] Ibid 1363.
[12] Ibid. 
[13] Arthur E Wilmarth, ‘Narrow Banking: An Overdue Reform That Could Solve the Too-Big-to-Fail Problem and Align US and UK Financial Regulation of Financial Conglomerates (Part 1)’ (2009) Banking and Financial Services Policy Report 1, 9.
[14] Katy Burne, One of Wall Street’s Riskiest Bets Returns (4 June 2013) http://online.wsj.com/news/articles/SB10001424127887324423904578525701936124838
[15] Wharton, University of Pennsylvania, CDOs Are Back: Will They Lead to Another Financial Crisis? (10 April 2013) http://knowledge.wharton.upenn.edu/article/cdos-are-back-will-they-lead-to-another-financial-crisis/
[16] Wharton, University of Pennsylvania, CDOs Are Back: Will They Lead to Another Financial Crisis? (10 April 2013) http://knowledge.wharton.upenn.edu/article/cdos-are-back-will-they-lead-to-another-financial-crisis/
[17] Mary Childs, Synthetic CDOs Making Comeback as Yields Juiced (21 March 2013)  http://www.bloomberg.com/news/2013-03-20/synthetic-cdos-making-comeback-as-yields-juiced.html
[18] Wharton, University of Pennsylvania, CDOs Are Back: Will They Lead to Another Financial Crisis? (10 April 2013) http://knowledge.wharton.upenn.edu/article/cdos-are-back-will-they-lead-to-another-financial-crisis
[19] Wharton, University of Pennsylvania, CDOs Are Back: Will They Lead to Another Financial Crisis? (10 April 2013) http://knowledge.wharton.upenn.edu/article/cdos-are-back-will-they-lead-to-another-financial-crisis/
[20] Mark Gongloff, Synthetic CDOs Return to Wall Street, What Could Possibly Go Wrong? (21 March 2013) http://www.huffingtonpost.com/2013/03/20/synthetic-cdos-return_n_2918704.html
[21] Mark Gongloff, Synthetic CDOs Return to Wall Street, What Could Possibly Go Wrong? (21 March 2013)  http://www.huffingtonpost.com/2013/03/20/synthetic-cdos-return_n_2918704.html. For an explanation of the London Whale case, see: Arthur E Wilmarth, ‘Turning a Blind Eye: Why Washington Keeps Giving in to Wall Street’ 13 (2013) University of Cincinnati Law Review 1283, 1431-1434.
[22] Alistair Barr, Beware: Wall St, Debt Re-Packaging Machine is Back (9 September 2013) http://www.usatoday.com/story/money/markets/2013/09/08/investing-risk-2008-financial-crisis-lehman/2766835/
[23] Tyler Durden, Volcker is LOLkered As TruPS CDO Provision Eliminated From Rule To Avoid “Unnecessary Losses” (15 January 2014) http://www.zerohedge.com/news/2014-01-15/volcker-lolkered-trups-cdo-provision-eliminated-rule-avoid-unnecessary-losses.
[24] Alistair Barr, Beware: Wall St, Debt Re-Packaging Machine is Back (9 September 2013) < http://www.usatoday.com/story/money/markets/2013/09/08/investing-risk-2008-financial-crisis-lehman/2766835/.

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