Introduction
At the beginning of 2007, one of the most complex and controversial corners of the bond market began to reveal itself. By March of that year, losses in the collateralized debt obligation (CDO) market had spread, shattering important high-risk investment funds and spreading fear in the fixed-income world. The credit crisis had begun.
Collateralized Debt Obligations
Collateralized debt obligations were created in 1987 by bankers at Drexel Burnham Lambert Inc. Within 10 years, CDOs had become a major force in the derivatives market, where the value of a derivative instrument is “derived” from the value of other underlying assets. Unlike some relatively simple derivative instruments like options and calls, and credit default swaps, CDOs were nearly impossible for the average person to understand – and therein lies the problem. CDOs were not “real.” They were structures that one could argue were built on other structures.
The Downward Spiral
At the beginning of 2007, Wall Street started to feel the first tremors in the world of collateralized debt obligations. Defaults were increasing in the mortgage market, and many CDOs included derivatives built on mortgages, including subprime mortgages.
The Consequences
By early 2008, the CDO crisis had escalated into what we now call the credit crisis. With the collapse of the CDO market, many derivative markets imploded, and important investment funds were shut down. Credit rating agencies, which had failed to warn Wall Street about the risks, suffered severe damage to their reputations. Banks and brokerage firms were also left in a state of panic to raise their own capital.
Conclusion
By mid-2008, it became clear that no one was safe. As the dust began to settle, auditors began to assess the damages. It became apparent that everyone, even those who had not invested in anything, would pay the price.
Source: https://www.thebalancemoney.com/cdos-credit-crisis-417122
Leave a Reply