Banks to sell first post-crisis managed synthetic CDO

Investors wan't leverage. Always. When you plug one leak, they will scramble and innovate until they find another way to get it. Buying on margin, options, CDS, structured products... the list goes on.

It has been argued that the current environment of low rates is driven by a safe asset shortage [0]. Many investors (e.g. insurance companies, pension funds) need to match liabilities with assets yielding reliable returns. With a constrained supply of safe assets, this demand drives yields down. Austrian economists argue that the resulting level of interest rates may be artificially low, leading to 'malinvestment' [1], a misallocation of investments that ultimately leads to economic contraction.

CDOs attempt to manufacture safe assets from riskier ones. Various debts are pooled, then the pool is divided into 'tranches'. Each tranche has a different rating, indicating riskiness of the tranche, according to the tranche's claim on distributions. A higher rated tranche will get paid before riskier tranches, allowing investors to choose their risk tolerance. Riskier tranches have higher yields commensurate with a greater risk of not being paid.

In theory, this structure is sound, provided that the debt being pooled has known characteristics. During the financial crisis, ratings fraud contributed to the breakdown of CDOs [2]. Lenders made unsound loans and lied about the characteristics of the collateral and the borrowers. Ratings agencies (Fitch, Moody’s and S&P) then rated this debt as being less risky than it actually was, due to having false information and perverse compensation incentives. Additionally, structurers assumed that diversifying geographically would prevent correlated defaults on individual debts (which was not the case). These assumptions led to CDOs having unsound risk pools. More exotic products, like CDO squared (CDOs composed of CDOs), further amplified problems.

Similar products (e.g. CLOs) have been in high demand, as there is a genuine need for safe assets. Ideally CDOs can be produced without succumbing to the issues they faced during the financial crisis. The current interest rate environment exhibits suspicious behaviors, including negative yielding sovereign debt and investment grade/high yield spreads [3][4] roughly as tight as they were prior the financial crisis. Increasing the supply of safe assets may help lead to a rates environment that would previously have been considered normal.

[0] https://voxeu.org/article/safe-asset-shortage-rise-mark-ups-...

[1] https://en.wikipedia.org/wiki/Malinvestment

[2] https://macromarketmusings.blogspot.com/2010/01/academic-vs-...

[3] https://fred.stlouisfed.org/series/BAMLC0A0CM

[4] https://fred.stlouisfed.org/series/BAMLH0A0HYM2/

Reminds me of all the scenes from the movie "The Big Short."

Your comment illustrates what I found so frustrating about The Big Short, and people who cite it whenever CDOs are brought up: the filmmakers made no effort in understanding the theory behind CDOs, nor did they attempt to explain the potential benefits.

Now... it's possible that the way human nature works, CDOs will always result in companies engage in collective delusion that results in a similar meltdown. I think The Big Short would have been more interesting if it made that argument, rather than merely "CDOs are evil."

EDIT: I was reacting to the movie adaptation; I haven't read Michael Lewis's book.

Might be a product of the generous bankruptcy system in the US. I.e., investors are rational in their willingness to take big risks because of the asymmetric payoff associated with highly-leveraged investing. It's a great system, but not without negative unintended consequences such as this kind of moral hazard.