Collateralized debt obligations (CDOs)
How were/are these instruments regulated (if at all) by the following regions?
* USA
* UK
* Eurozone
Clarification added November 16, 2008:
Thanks Frank for bringing Ponzi Schemes to the question.
Ponzi schemes reach back to the 1920's USA, so if CDO's are same/similar, how did they get to grow so unregulated?
Good Answers (4)
Frank F.
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To all intents and purposes they are not regulated.
My own recommendation would be that they should be banned entirely. They are no better than junk, at worst a Ponzi Scheme.
However, this weekend's G-20 Declaration spells out a number of actions to be undertaken, including on regulation. One clause in the Declaration states as follows:
"Supervisors and regulators, building on the imminent launch
of central counterparty services for credit default swaps (CDS)
in some countries, should: speed efforts to reduce the systemic
risks of CDS and over-the-counter (OTC) derivatives transactions;
insist that market participants support exchange traded or electronic
trading platforms for CDS contracts; expand OTC derivatives market
transparency; and ensure that the infrastructure for OTC derivatives
can support growing volumes."
But whether they can bring this Ponzi Scheme under control without banning them, remains to be seen.
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Hi Donald,
See:
http://en.wikipedia.org/wiki/Collateralized_debt_obligation
However it was CDS that make up ~10% of OTC derivatives that were in part responsible for the financail crisis. On December 21, 2000, Clinton signed the Commodity Futures Modernization Act of 2000 – deregulating credit default swaps - referred to as the "Enron loophole".
$62 trillion (notional value/gross exposure, through tear-ups $33 trillion) credit-default swaps - NY Fed takes the lead in organizing this market defining them in September '08 as an insurance product and organizes clearing. The Bank for International Settlements cites the total outstanding notional amount of OTC derivatives at $596 trillion (12/ 2007) - $400 trillion are interest rate derivatives. The Federal Reserve, CFTC and SEC announce that a central clearinghouse for the $33 trillion credit-default swap market will be running by December 31.
Consequences of subprime linked assets and CDS lossses:
1 - Enron's bankruptcy on November 30, 2001 "Enron loophole".
2 - Bear Stearns, the 5th largest U.S. investment bank, March 17, 2008 is purchased by JP Morgan Chase for $10 (down from $172, 2007) the Fed intervenes (non-recourse loan of $29 billion).
3 - Lehman Brothers, the 4th largest U.S. investment bank, files for the largest U.S. Bankruptcy, listed total debts of $613bn.
4 - AIG ($1.1 trillion assets and 74 million clients in 130 countries) receives an $85 billion Federal Reserve loan in return for relinquishing 79.9% percent ownership in the company.
5 - Merrill Lynch, the 3rd largest U.S. investment bank, is purchased by Bank of America for $50 billion.
JC Brandon
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Lynn W.
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CDOs were used two decades ago during the S&L crisis to obfuscate the underlying values (sell off for more than they are worth).
Home owner market used to be semi-regulated with regulated financial institutions making loans based on deposits. Unregulated mortgage originators could leverage packaging mortgages as CDOs as source of funds.
A couple weeks ago in congressional hearings on CDOs, testimony was that both mortgage originators and rating agencies knew that toxic CDOs weren't worth triple-A ratings but mortgage originators were paying the rating agencies to give triple-A ratings to toxic CDOs anyway ("fraud" was used to describe the activity). Being able to unload every mortgage (regardless of quality) as triple-A rated toxic CDO; 1) greatly increased market for CDOs, 2) greatly increased source of funds for CDOs, and 3) eliminated any motivation to manage loan quality (source of funds, contributed to greatly increased speculation in home owner market).
On the institution side buying these mortgages .... the institutions were 1) playing long/short mismatch and 2) heavily leveraging. Playing long/short mismatch (alone) has been known to take down institutions for centuries (in this case, even if the toxic CDOs had been worth their triple-A ratings). Comments were that Bear-Stearn and Lehman had marginal chance of surviving playing long/short mismatch. This was further aggravated with heavy leverage ... in some cases leveraging capital 40-80 times in buying triple-A rated toxic CDOs.
article from year ago about playing long/short mismatch (including transactions being carried offbalance ... and possibly may still be lurking)
http://www.forbes.com/entrepreneursfinance/2007/11/13/citigroup-suntrust-siv-ent-fin-cx_bh_1113hamiltonmatch.html
decade old article from SanFran FED on long/short mismatch
http://www.frbsf.org/econrsrch/wklyltr/2000/el2000-26.html
SOX required SEC to also do something about rating agencies ... but little appeared to have happened ... other than this study from Jan2003
http://www.sec.gov/news/studies/credratingreport0103.pdf
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The CDO is merely an instrument for selling the risk in and or financing of underlying pools of other asset-backed securities. In and of itself it would not be regulated. That would be like saying "how are treasuries regulated" or "how are MBS bonds regulated." It is hard to regulate things that don't really do anything. So let's look at who DOES something and their impact on CDOs:
The Issuers: Regulated by SEC rules for issuance - i.e. can only sell to institutional investors, etc.
Investment Bankers: Heavily regulated in their marketing of the CDOs
Investors: Must adhere to ERISA if pension funds, self-imposed charters, if banks - risk based capital requirements, Basel I and II, etc.
Originators of underlying collateral: Truth-in-Lending, Federal consumer protection laws, state laws and licensing, fair debt collection practices, etc.
Wall St. is perhaps the MOST heavily-regulated industry out there. It doesn't need more.
The problem behind what has happened is that EVERYONE was drinking the kool-aid about the US housing market - Rating agencies, risk departments, investors, the Fed, accoutning firms, issuers, and let's not forget the underlying borrower. It all started with his inability to repay the loan. There was this attitude that "hey, when my teaser rate is over, my house will be up another 10% and I will just do another cash-out refi at a new teaser rate."
Also, "the public" confuses "CDO" with "MBS". Even in these answers someone refers to mortgage originators issuing CDOs. Not really the case. Mortgage companies and Wall St firms issued mortgage-backed securities. The securities were tranched into classes with varying ratings and maturities. Often the junior classes from a whole bunch of issuances were repackaged by CDO managers into CDOs, also having tranches with various ratings and maturities. (Often in synthetic form as well.)
It is amazing how many "experts" there are out there that can tell us all about very sophisticated financial instruments. Just about every news article is full of inaccuracies. My favorite is the inability to distinguish between MBS/ABS and CDOs.
Cheers,
G
PS - Was Lloyd's Cancarra stuffed with CDOs?
More Answers (4)
Donald,
I believe most sold in the USA rely on registration exemptions but are subject to Reg 144a or Reg S.
Many are subject to the ISFRA prospectus regulations. You can find more info on that here:
http://www.ifsra.ie/frame_main.asp?pg=/industry/in_mark_intr.asp&nv=/industry/in_nav.asp
hope this helps
William D.
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As far as the United States is concerned, regulators felt that the financial community could self-police. Problem was that the Fed and other agencies failed to recognize the greed factor.
I would imagine that the same may apply for the UK and Eurozone.
And Frank is right, CDO's are/were nothing more than a Ponzi Scheme/\.
Marc A.
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There was an utter lack of regulation at the core of this industry.
Read the attached article for clarification
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Radu H.
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To say it straight, I did a lot of research and the only source of regulations are the indirect ones. The worldwide regulation is Basel II, which requires all the banks to review their assets (including the CDO's) based on their self-assement of the market values. in other words, I am a bank and i decide how much of a value is this to me. Which is of course a vicious circle and has led to a big splash portion of the recent credit crunch.
Furthermore, the CDO's have created a new market (as the Economist argues), by transferring the risk of default from on owner to another. But none were regulated in any way - the initial owner because he bought some insurance against it and the new owner because he was reinsuring this. The chain of events led eventually to the mass demise of the CDO's and to the massive bailout of AIG, which was reinsuring most of the European banks for the risk of default from their CDO's. And now they (OECD governments) are looking at ways of how to address this.
So another new financial instrument which will take a decade or so to be regulated.
