Mortgage Rate News

On Tuesday, I wrote that one of the reasons that the credit crisis might continue is due to the fact that many banks have billions of dollars in undisclosed and underdisclosed risk. One of the investment products that carries this risk is what is known as collateralized debt obligation (CDO). I’ve received some questions about these CDOs, and thought I’d take a minute to address them.

Collateralized debt obligation

A CDO is an investment product. But it is an investment backed by debt. This means that a CDO can contain combinations of loans, bonds and assets that have collateral. Basically, banks have been investing in them, and not truly disclosing their risky nature. Because with debt, especially loan debt (and subprime loan debt has made up a great many CDOs in recent years), there’s the risk that the borrower will default, meaning that the risky investment is a loss, rather than a payoff.

With the subprime lending crisis, a number of CDOs went south, and that resulted in some of the more spectacular losses by financial institutions that had invested in them, leading in turn to the stock market downturn and continued volatility over the past couple of months.

What this means in the wider economy

The popularity of CDOs as investment vehicles is troubling because it reveals how much our economy relies on debt to keep it solvent. It is important to note that bigger mortgages and home equity loans have become the norm, and apparently, this uncontrolled debt, is largely what the recent economic boom has been built on.

What this means for the future, as borrowers start to collapse under the weight of the debt that has been supporting the economy, can be seen if something isn’t done.

Tags: home equity loans, mortgage blog, home mortgage loan, collateralized debt obligation,
CDOs, investing, subprime lending crisis