So basically, mortgage bonds are nothing but thousands of individual mortgages. On average, it owns parts of hundreds of individual mortgage bonds. A mortgage-backed CDO owns parts of many individual mortgage bonds. It is also known as Mortgage Backed Securities (MBS). This also determines the CDO value.įor the 2008 financial crisis meltdown, our focus is precisely on the mortgage backed CDO. The investors hedge against default using the collaterals. Investors would even trade these CDOs in the debt market.īanks redirect the payments received on the loans and advances to the investors. Investors bought them to enhance their returns. This instrument helped the banks shift the risk to investors. The reason being they wanted to reduce their risks on the debt obligations (loans) they issued. Retail banks created CDOs because they were looking to sell them to investors. These assets are essentially debt obligations. It is a structured financial investment product. Let’s understand CDOs and its functions and why is it one of the reasons which triggered the downfall. Drexel Burnham Lambert, a former investment bank, created the CDO. To bypass this risk factor, Collateralized debt obligations (CDOs) were created. Recommended Read: How to analyse a bank and its business model Banks cannot use such provisional funds for any other operation. To safeguard the system, they need to set aside a percentage of funds on the loan amount. It means that the borrower might not be able to repay the loan money. When banks issue loans, they have to bear credit risk. They may face default risk, liquidity risk, provisional risk, etc. The banks, collateralized debt obligation (CDOs), and the risk associated with advances – The simplest answer is the bank’s greed to increase revenue at minimal risk. So how did this lead up to the housing bubble? Ultimately, liquidity enters the market and revives the economy. More borrowings increases the purchasing power in the hands of the borrowers. Lower interest rates encourage borrowing. The Federal Reserve lowered the federal funds rate target from 6.5% to 1.0% between 20. In an attempt to revive the economy, Federal Banks in the US started to lower their interest rates. To understand the meltdown, we need to go back to the root where it all began.Īfter the 2000s’ dot.com bubble burst, the US equity market was on a bearish run. We begin by how the events unfolded which shattered the economy. Let us understand their roles in the crises. George Walker Bush left the White House and Americans welcomed Barack Obama. The crash occurred during the presidential transition.
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