Drew Burns

ECON 1740

CDO’s and the Financial Crisis

There were multiple different aspects to the fall of the US economy in the late 2000s. The

mortgage market collapse was the ultimate cause but within the failing mortgage market, there

were edgy financial tactics happening which were keeping our economy walking upright, but

onto thinner ice. This paper will discuss the connection between one of these tactics, CDO’s, and

the financial crisis.

CDO’s are collateralized debt obligations which were financial tools used by the banks to

“repackage individual loans into a product sold to investors in the secondary market”. CDO’s

dealt with all kinds of loans, but mortgages in particular involved more money to make… or

lose.

Banks would rank their loans in correspondence with the risk of the loan otherwise

known as mortgage back securities. Investors were more likely to buy mortgages that had a safer

rating. The main reasons this happened at all were that the funds received from a sold mortgage

gave banks more cash to make new loans, it moved the risk involved with the loans to the

investors, and it gave banks more profitable products to sell which boosted share prices and

manager’s bonuses.

CDO’s provided more liquidity to the economy and allowed banks and other corporations

to sell off their debt. This allowed opportunity for more investments or loans which created a

chain of investing and selling loans. Although it sounds like a sure process, eventually things

would go south.

Since banks didn’t worry about people defaulting on their debt, they became less

disciplined in following strict lending standards and because the more loans the merrier, they

started making loans to borrowers who had terrible credit. These borrowers’ loans should be
Drew Burns
ECON 1740

considered insanely risky yet banks ranked risky loans to be safe investments. Once housing

prices started to drop, mortgages of homes bought in the year prior turned upside down and

totally failed. Banks, investors, and borrowers alike lose money on the failed loans and the

financial crisis is ushered in.