Financial Crisis 101: CDOs explained
Investment instruments known as collateralized debt obligations are partially to blame for the mortgage crisis. They're complicated and hard to explain, but Rico Gagliano gives it a try with help from Marketplace Senior Editor Paddy Hirsch.
Marketplace Senior Editor Paddy Hirsch explains collateralized debt obligations. (Marketplace)
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TEXT OF STORY
Kai Ryssdal: The thing about this credit crisis is that it reaches out and touches you, sometimes without you even knowing. For instance, I don't think many of you ever went out and actually bought yourself a collateralized debt obligation. But chances are your bank did. And your retirement money's probably tied up in 'em through mutual funds. Yet here we are a year and a half into this crisis, and it seems people don't understand what CDOs are. Much less how they work. So for today's explainer, we turn to one of Marketplace's most brilliant economic minds.
Rico Gagliano: Ha ha, Kai, very funny. I'm reporter Rico Gagliano and like most Americans, as of a week ago, I'd never even heard of these . . . [sign] what are they called again?
Paddy Hirsch: ollateralized debt obligations, or CDO's.
Gagliano: That's Marketplace Senior Editor Paddy Hirsch. Now he knows CDOs. He's been reporting on 'em for years. In fact, to prepare me for this story, he gave me a simple, elegant lesson explaining the things. So to save myself some effort (and before he has a chance to copyright it), I present, in audio form, Paddy's ...
Announcer voice: CDO Champagne Metaphor
Gagliano: OK, so a CDO is an investment that works kind of like a champagne bottle. An investment bank creates the bottle and fills it up. With what? Mike Hatley manages CDOs at Westgate Horizons Advisors.
Mike Hatley: High yield bonds can be the collateral in there. You could have aircraft loans, credit card loans, lots of different things, as long as they pay interest on some sort of monthly or quarterly basis.
Gagliano: The interest goes to the CDO's investors; it's how they make money. Now during the housing boom, the banks got a great idea. They'd create lots of CDO's, and fill them with . . .?
Hatley: Uh, those were based on the subprime mortgage-backed securities.
Gagliano: [scary movie music] That's right: investors were betting big on the modern equivalent of a witch's curse: subprime mortgages. So you know this isn't gonna end happily. At the time, though, it was awesome. Almost all homeowners made payments on their subprimes, with interest. And you can think of that interest money as the foam in the CDO champagne bottle. [sound of a cork popping] The foam popped out the top [sound of cheers] And flowed to happy, happy investors. Now, explaining how the investors divvied up that cash requires yet another metaphor. Ladies and gentleman, Paddy Hirsch.
- Paddy Hirsch on Collateralized Debt Obligations
- (Marketplace)
Hirsch: When that foam comes out of the bottle, imagine a pyramid of glasses there. The champagne flows out of the top, [pouring sound] fills the first glass, then the next two glasses, then the next three glasses . . .
Gagliano: The glasses are the CDO investors. Those at the top of the pyramid get filled with interest foam first. Actually that sentence sounds kinda disgusting, so I'm gonna rephrase it: they get paid first. Lower-tier investors get paid, only if there's enough interest to trickle down that far. In return for their risk, those investors get bigger returns. And during the housing boom, CDO investors got nice and drunk off subprimes. Interest flowed all the way to the bottom of the investor pyramid. Then the bust happened. Subprime loans started defaulting. So there's less and less interest bubbling out of the CDO champagne bottles.
Hirsch: Which means that only maybe the top two or three layers are gonna get filled, and that bottom layer of glasses, well, they're fresh out of luck; no champagne for them.
Gagliano: That'd be bad enough. But it gets worse. See, during the boom, that bottom layer of glasses was full? And the owners recycled the champagne. they poured it into new bottles, which were supposed to fill whole new pyramids of glasses. These secondary CDO's were now full of risky securities, based on the riskiest kind of mortgage. It wasn't champagne -- more like Mad Dog 20/20. But investors didn't know it, because ratings agencies didn't label this stuff as risky. Now, says Westgate's Mike Hatley, there's hell to pay.<.p>
Gagliano: How much money is tied up in these secondary CDO's?
Hatley: Hundreds of billions of dollars. I've seen some predictions that the ones that were done based on subprime mortgages in the year 2006 and 2007 will default. Every single one. Even the ones that were originally rated Triple-A.
Gagliano So investors are out tons of money. They no longer trust Collateralized DDbt Obligations, even ones that aren't filled with mortgage debt. They don't trust rating agencies. And we could all . . . [sound of cork popping] use a drink.
In Los Angeles, I'm Rico Gagliano for Marketplace.
Comments
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From London, 04/22/2009
If you are interested in explanation of financial crisis go to It's a pyramid, stupid - blog - by greg pytel http://gregpytel.blogspot.com/
"The greatest shortcoming of the human race is our inability to understand the exponential function."
Professor Albert Bartlett
From Mandan, ND, 03/22/2009
It goes without saying the real villains in this mess are those who repealed laws put in place in the depression to stop these kinds of things before the economy became unsound. So, you can't blame Wall Street for being greedy and taking advantage. It is what business is designed to do after all. But you can and should blame the politicians who allowed a de-regulated Wall Street and Banks to take advantage again and bring about what is likely to be another great depression!
02/19/2009
I have no quibble with the explanation. It is accurate. What really gets me is how the purveyors of these instruments manage to convince people that these instruments are either hard to understand or value. You need a spoonfull of probability theory, a pinch of statistical reasoning and maybe some freshman calculus.
From Saint Augustine, FL, 02/19/2009
Brilliant explanation.
If this is the root cause of the economic crisis, I would like to understand not only the path forward, but how we, as a society, will not repeat. Do we outlaw secondary CDOs?
I have tried to stay away from derivatives all my life, but it seems that they are difficult to avoid.
From Melbourne, FL, 02/14/2009
The champagne analogy is catchy, but not too accurate.
I suspect the real root of the problem is poor or nonexistant risk assessment.
The faulty assumption was, that if you bundle a bunch of high risk debt together in one security, the risk is reduced. The idea had been working for junk bond funds for quite some time.
The fault was in not realizing that bundling low quality mortgages did not result in diversification because, unlike junk bonds, they were all affected by the same conditions. That is, if some of the individual mortgages went bad, they all were likely to go bad, and at the same time.
It seems pretty stupid in hindsight, but nobody thought of it the right way until they were seeing it happen.
For the future, we need a reliable way to rate the risk associated with other than tradional investment vehicles, and especially for securitized debt instruments.
This may also be a good time to remember the principle that states that it's what you don't see coming that kills you.
11/04/2008
no comment
From New Braunfels, TX, 10/25/2008
Fraudulent Mortgages perpetuated upon the masses, then collateralized 200 times, is how 300 Billion in so called Sub Prime Mortgages becomes 60 Trillion in bad debt effecting the entire World! The theives who are responsible, who made 20 Trillion in fees, need to be ounded up and Hung!!! Retirement accounts, entire economies have been ruined by this group of theives!
From Mountain View, CA, 10/10/2008
The current fall in the stock market is not really a fall but a correction. The stock market was a pyramid scheme where the prices were hyped up with naïve people falling for the 'hyping'. It was a huge industry. On one end was the individual stock buyer, who was the ONLY source of cash. As long as the buyer keeps putting money into the market, the entire industry reaped a benefit. From the 'underwriters' like GoldmanSachs, who bought stock by the bulk from the originating company, to Marketplace.org, who got a piece of the action from GoldmanSachs (or the like) via donations, -the entire industry, brokers, advertisers, news agencies, they all got a piece of the action. But there was only one problem. There were only so many foolish investor individuals, -and sooner or later they were all invested. Marketplace.org did its own part in the propaganda. Remember Tess Vigeland (spelling?)'s interviews with the 'stock clubs'? Old women in virginia explaining there 'techniques' in choosing stocks? And did you notice how these interviews all ended at the height of the bubble? Where are these old women now? Why is not Ms Vigeland interviewing them now? Because the industry doesn't pay Ms Vigeland or Mr. Risdal (a navy soldier turned stock market guru?) for telling the truth. They are paid to spin a tale, -a tale of excitement, of success, of riches. Well, let us hope this teaches the naïve people a lesson, and the likes of Mr. Risdal and Ms. Vigeland (and their editors and sponsors) a lesson. Human civilization has produced many clever technologies that has given it some extra cash. Instead playing or gambling with that cash, and letting the stock industry get rich in the process, the cash can now go to real savings, real banks and real investments. At least for a generation. Then the new generation will come with their own naivete, and new Ms. Vigelands and Mr. Risdals will be there to tell new lies to them. But for now, evil has been defeated. It is time to celebrate.
From New York, NY, 10/08/2008
Paddy - your seasoned explanation rocks! The lighting lends itself to an ivory tower professorial air...
From herriman, UT, 10/08/2008
Whoa!
From chicago, IL, 10/06/2008
I think home own should be blame for mortgage crisis. The equal is getting high than people can afford to pay there mortgage.
From Alpharetta, GA, 10/06/2008
"But investors didn't know it, because ratings agencies didn't label this stuff as risky"
How is this not fraudulent? It seems that perhaps worse than Greenspans's not warning of irrational exuberance during the housing bubble, this failure to properly rate this stuff has really (civil words escape me) this economy. And now credit has dried up because (surprise) no one trusts the ratings agencies.
Thanks for the explanation. At least I can understand why we’re (civil words escape me).
From Chapel Hill, NC, 10/06/2008
This was a great explanation; in syntax and format. There's just something about a dry erase board that helps get things across. Keep it up!
From huntington beach, CA, 10/05/2008
Can you also explain Credit Default Swaps?
Also, how is it that CDO investors were able to get 3, 5, 7, 10% from mortgages? Does that mean the homeowner was paying over 20% interest?
From Colorado Springs, CO, 10/05/2008
Based on your explanation, the CDO is just another fraud! How can the investment bankers repackage securities that were less than AAA rated into AAA rated securities. I doubt anyone of these investment houses involved in these fraudulent CDO's ever get to jail! We have been manipulated by politicians and the well connected again! Hope the rest of America understands why many of the rest of the world do not trust us.
10/05/2008
Great Stuff!
From Richeyville, PA, 10/04/2008
Thanks for the best explanation of this that I have heard or seen! Please keep up the good work in these challenging times.
From Farmingdale, NY, 10/04/2008
It is just as a feared, our economy is a fiction and a pyramid scheme is doing us in.
From Aurora, CO, 10/04/2008
This is a GREAT explanation of CDO! I have heard of it but never knew what it was.
So, are we bailing out the 2ndary CDO in that big package?
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