Sub-prime Crisis: Collateralized Debt Obligations - Essay Example

Introduction The collateralized debt obligation (CDO) was largely attributed as being central to the sub-prime crisis. While these CDOs were recognized as central to the financial crisis, their means of operation is recognized as highly complex. During the late 1980s collateralized debt obligations had become recognized as an investment platform with returns higher than traditional bonds. CDOs most prominently emerged, however, between 2000-2006 (Clark 2011). During this period both domestic and international investors flooded money into the United States purchasing these CDOs.

It was not long before the housing crisis hit and the entire American financial system nearly collapsed as a result. This essay examines the structure of the collateralized debt obligation and then evaluates the extent that the major investment banks did not use proper risk management. Collateralized Debt Obligation (CDO) CDOs are classified within the field of structured asset-backed securities (ABS). These are securities that are backed by specific assets. In the case of CDOs there were multiple assets that were grouped together (Clark 2011).

These multiple assets were referred to as tranches. Just like varying securities in a mutual fund, each tranche offered differing levels of risk and return (Clark 2011). These investments differed from many mutual funds, however, in that they were constituted by fixed income assets (Clark 2011). The groupings of the securities within the collateralized debt obligations were classified according to risk, such that each CDO received a rating. The CDOs with the lowest quality securities were supposed to receive a low rating, and the CDOs with the highest quality securities were supposed to be given a high rating.

As these were fixed income securities the CDOs with the highest risk had the highest coupon payments or interest rates. Contribution to the Sub-prime Mortgage Crisis Even as there was an infusion of CDO investment, there was a relative dearth of strong and stable CDO investment options. While there were many different types of CDOs one of the most prominent types that emerged during this period was CDOs composed of subprime mortgages (Clark 2011). Although many of these CDOs were composed of subprime mortgage securities, the organizations involved in producing these investment options were able to procure safe ratings by the credit agencies responsible for investigating risk (Clark 2011).

Essentially, then Wall Street institutions were able to develop multi-dimensional investment options that allocated risk throughout an entire supply chain embedded deep into the American economy (Clark 2011). The extensive nature of this supply chain, rather than functioning through the interconnectedness of safety, ultimately force the government to back the risks or face the complete failure of the American financial system (Clark 2011). While there are a variety of concerns related to the government’s failure to regulate CDOs, from an overarching perspective it’s clear that in allowing risks to be spread throughout this extensive chain constituted the major failure of regulation.

In further understanding the failures of risk management by the banks involved, it’s necessary to link these risks to the comprehensive chain of the collateralized debt obligations. While some researchers place the blame on external investment demands for more CDOs as