What are Collateralized Debt Obligations (CDOs), and how did they worsen the financial crisis?
Answer (1)
Collateralized Debt Obligations, or CDOs, are complex financial products made by combining many types of loans—like home mortgages, car loans, and credit card debt—into one big bundle. These bundles are then sold to investors as investments that earn interest. The idea is that the money from borrowers’ monthly payments will go to the investors.At first, this seemed like a smart way to share risk. If one borrower failed to pay, the others in the bundle could make up for it. But the problem began when banks started including subprime mortgages—loans given to people with poor credit history—inside these CDOs. These borrowers were more likely to miss payments or default. However, many of these CDOs were still rated AAA (very safe) by credit rating agencies, even though they were full of risky loans.Investors, including banks and even foreign institutions, thought these CDOs were safe. They bought large amounts of them. Banks also gave out more subprime loans because they could just bundle and sell them. This created a cycle of risky lending and false security.When house prices stopped rising in the U.S. around 2006, many borrowers couldn’t repay their loans. As a result, the value of CDOs dropped suddenly. Investors lost billions of dollars. Banks that were holding CDOs also suffered huge losses. Some collapsed.In Asia, while not directly affected by CDOs, countries like Japan, China, and the Philippines felt the impact through weaker exports, fewer investments, and less economic growth.
