CDOs: Can the market be resurrected?

Abstract

CDOs and other securitized and exotic mortgage instruments have become synonymous with the word “moribund” post the sub-prime crisis. After more than a trillion dollar in write-downs, several firms having filed for bankruptcy and several others taking their last breath, the horror stories of Bear Sterns, Lehman Brothers and AIG among others, the TARP and the liquidity crunch, the world decided that they do need to take stock of what happened and avoid anything that was even remotely connected to the crisis. A sincere thought indeed! However, the only problem is that in the wake of the crisis, we will lose out on the several good features of the product that was christened as the biggest financial innovation at one point of time. CDOs resulted in loan securitization and helped banks and financial institutions to replenish their loan reserves and disburse fresh loans, leading to market growth. The demand hence created lead to tremendous market growth at one point of time, which is when credit derivatives were hailed as the biggest thing in the world of finance with a book value of ~$60 trillion. This project is aimed at discussing the things that went wrong, the supervisory and regulatory aspects that could have helped, and the erroneous and unrealistic mathematical models to quantify and hedge risks. We believe that given a chance, the market for CDOs, given the immense potential, can be resurrected. It will take a lot of regulation to keep the monstrous growth of the market under control, however, it can be done. The project also looks at certain features in the Indian financial market which have been hindering the introduction and future development of credit derivatives market, with an aim to suggest possible changes. It is evident that the investors will approach such exotic investments differently than in the past. They will wish to have a much better understanding of the instruments they're buying than they had during the market's golden days. However, letting the CDOs disappear from the face of the financial markets would be acknowledging defeat to the vices of mankind, namely greed and carelessness.