Practical Applications of The Role of ABS CDOs in the Financial Crisis

Practical Applications Summary In The Role of ABS CDOs in the Financial Crisis from the Summer 2019 issue of The Journal of Structured Finance, authors Larry Cordell (of the Federal Reserve Bank of Philadelphia), Greg Feldberg (of Yale University), and Danielle Sass (of the University of Illinois at Urbana-Champaign) explain how investment pools called asset-backed security collateralized debt obligations (ABS CDOs) became increasingly risky in the mid-2000s. The securities produced total writedowns of $410 billion, of which $325 billion were borne by AAA and super-senior securities. The first ABS CDOs ever issued were invested in a well-diversified mix of securities. But between 2005 and 2007, newly issued ABS CDOs were backed primarily by subordinate classes of MBSs backed by nonprime mortgage loans and derivatives of those MBSs. Financial firms believed these undiversified ABS CDOs were ultra-safe, but incurred massive losses when the subprime mortgage market collapsed. The authors explain the reasons for this false sense of security and the huge losses. They say a primary catalyst of the financial crisis was the enormous leverage that regulators had let firms build up, leaving them in danger of insolvency when their ABS CDOs failed. The authors then examine whether the industry has learned any lessons. TOPICS: Asset-backed securities (ABS), credit risk management, financial crises and financial market history