THIS WAS THE cutting edge of debt – where advanced mathematical technology was creating a toolkit where the cashflows on any underlying assets could be pooled, tranched and distributed according to investors’ appetite.
CDOs were deemed a great mechanism for enhancing yield. Suppose you were an investor limited to buying triple-A-rated securities but finding the low single digits yields available on sovereign and supranational securities not sufficiently attractive. No problem: bankers had the technology and the underlying assets to build something that would perfectly suit your needs – in theory at least.
CDOs were always subject to a certain amount of mistrust because of their, often unnecessary, complexity. However, CDOs are now held in disdain by many in the financial services industry. Their detractors argue with some force that they are dangerous products – in their own right and because of the wider negative impact they have had on finance.
It is remarkable that a dislocation in a relatively small sector (in terms of the size of all financial assets) could trigger as big a systemic shock as CDOs did in 2007. But despite the relatively modest scale of the sector, the role CDOs play in the new capital markets model meant that they had tremendous impact and reach.