“than why did the banks insist on the creation of the CDO to mitigate risk?”
The derivatives industry including CDOs was developed by JP Morgan in London in 1994. You can read all about it in Gillian Tett’s “Fool’s Gold”. She was there at the beginning.
I’m quite certain CDOs were not created in response to an arcane American minority mortgage regulation. CDOs cover a much broader sphere of the credit markets than just mortgages. Any kind of loan is grist for the CDO mill.
CDOs were developed as a means of freeing up capital, diversifying risk, and increasing profits. They didn’t quite work out as planned, but that’s the price of letting financial engineers run amok without anyone paying attention to the risk involved.
http://www.lrb.co.uk/v31/n12/donald-mackenzie/all-those-arrows
“the bank remained on the sidelines as the once largely distinct worlds of CDOs and mortgage-backed securities became more closely linked from 2002 onwards. It was an encounter of two subtly different cultures, with, for example, quite different mathematical approaches.
The CDO world developed explicit and increasingly elaborate models of correlation – the ‘Gaussian copula’ that initially puzzled Tett is one of them – while the mortgage world handled the phenomenon entirely implicitly. In most investment banks, and also – as far as I have been able to discover – in the New York head offices of the rating agencies, separate groups or departments handled mortgage-backed securities and CDOs based on corporate debt.
In investment banks, for instance, those different departments seem to have had surprisingly little to do with each other. The two cultures never really merged; instead, the CDO, a structure invented by the corporate-debt world, was applied to the products of the mortgage world.
Members of both cultures now see the encounter as corrupting. ‘They’ – constructors of CDOs based on mortgage-backed securities – ‘took our tools’ and misused them, one specialist in corporate credit derivatives told me a few weeks ago.
Those with a background in mortgage-backed securities blame CDOs (with some justice) for being indiscriminate buyers of those securities, concerned only with their ratings and the spreads (increments over Libor) they offered.
Two experienced industry observers, Mark Adelson and David Jacob, suggest that a fatal point was reached when CDOs became almost the only purchasers of the riskier tranches of mortgage-backed securities.
Previously, those tranches had either been guaranteed against default by specialist insurers, or bought by canny investors, who would carefully assess the risks involved. These insurers and investors acted as a brake on the riskiness of the lower tranches, and thus on the overall riskiness of mortgage-backed securities, and they demanded a healthy rate of return for taking on the risks.
They were displaced by those buying tranches in order to package them into CDOs, who were prepared to buy them at lower rates of return, and who cared a lot less about their riskiness, because those risks were going to be passed on to investors in the CDOs.”
CDOs were first created by Drexel Burnham Lambert way back in 1987, actualy. But they allowed into the heavily regulated American banking industry as a result of the banking deregulation of Gramm’s bill, which Clinton allowed to pass on the condition that banks agree to minority lending rules.
CDOs are NOT inherently bad, providing the risks they contain are each sensible. But once banks found that they needed to go to ridiculous extremes to lend to a sufficient number of Limited-English Proficiency persons to support their other lending, the minimum safety criteria were destroyed, and banks simply offloanded all questionable loans to other willfully ignorant institutions, like Fannie Mae and Bear Stearns.
Bear Stearns’ complete lack of concern for the quality of the mortgages is probably why the Bush administration wouldn’t bail them out... to allow natural consequences to a “bad actor.” Little did he realize how terrified financial institutions were that they might be seen as bad actors, or vulnerable to ties to financial partners like Bear Stearns.
Exactly. Thank you.