The complex mortgage instruments at the center of the 2008 financial crisis went so spectacularly wrong that many observers have said they were designed to fail. A new paper by Oliver Faltin-Traeger of the investment firm Blackrock and Christopher Mayer of Columbia Business School lends a lot of credence to that assertion.
Faltin-Traeger and Mayer — who are scheduled to present their preliminary results Saturday at the annual meeting of the American Economic Association — focus on collateralized debt obligations tied to asset-backed securities, or ABS CDOs. For the most part, these were mortgages that had been pooled into bonds, which in turn were repackaged into CDOs.
The process typically resulted in the creation of triple-A rated securities, but also made it difficult for investors to understand what those securities actually contained. Hundreds of billions of dollars in CDOs went bad as of 2007, causing heavy losses for investors and banks and triggering a broader panic that ultimately sent the global economy into recession.
Using a unique database published by the investment firm Pershing Square Capital Management, Faltin-Traeger and Mayer identified the underlying bonds in some 528 ABS CDOs issued between 2005 and 2007, and compared their performance to similar bonds that weren’t included in CDOs.
They found that the bonds in the CDOs performed a lot worse. Even if one holds observable characteristics such as initial ratings and yields constant, the bonds in the CDOs suffered ratings downgrades that were 50 percent to 90 percent more severe. As of June 2010, for example, bonds with initial triple-A ratings had been downgraded by an average 11.84 notches, compared to 5.99 for those not in CDOs. The bonds in the CDOs were also more likely to have been rated by all three major credit-rating firms.
http://www.bloomberg.com/news/2012-01-06/goldman-citigroup-cdos-were-tip-of-iceberg-the-ticker.html
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