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A major factor in the credit crunch and subsequent economic downturn was a financial tool called a CDO, or ‘collateralized debt obligation’. If you’re not familiar, it was a profitable vehicle for banks to throw a bunch of mortgages into a pool and sell slices of that pool to outside investors.
Read on for a description of what a CDO is and how it screwed the economy.
How CDO credit ratings got messed up
Why banks they didn’t really know what they were doing
“Disastrously, it was just simple enough for untrained financial analysts to use, but too complex for them to properly understand. It appeared to allow them to definitively determine risk, effectively eliminating it. The result was an orgy of misspending that sent the U.S. banking system over a cliff.”
But by this point, the inertia in the banks might have been too big for this to have made a difference:
“Maybe he sensed the danger inherent in the system he’d help establish. By 2005, Li was among those warning about the limitations of his model. “The most dangerous part is when people believe everything coming out of (the model),” he told The Wall Street Journal.”
For a bit of sobering foresight, read this 2005 (!) article from the WSJ (somewhat long but very well written):
My favorite passage:
(just after a note on losses in the 2005 CDS market)
“The credit-derivatives market has since bounced back. Some say this shows that the proliferation of hedge funds and of complex derivatives has made markets more resilient, by spreading risk.
Others are less sanguine. “The events of spring 2005 might not be a true reflection of how these markets would function under stress,” says the annual report of the Bank for International Settlements, an organization that coordinates central banks’ efforts to ensure financial stability. To Stanford’s Mr. Duffie, “The question is, has the market adopted the model wholesale in a way that has overreached its appropriate use? I think it has.”