How to cure the CDO madness

December 14th, 2009

Naive British and European regulators, which allowed European banks to gorge on toxic assets seemingly without restriction, have been accused of playing a major role in stoking up the crisis.

In a blog post, Reuters’ Felix Salmon accuses European regulators of giving out-of-control banks such as RBS free rein to bulk up their balance sheets with trashy CDOs. We are all painfully aware of the consequences of this.

His blog, which credits an earlier article in the Wall Street Journal, also provides a useful insight into the lifecycle of your average CDO (collateralized debt obligation).

However one seemingly well-informed commenter on the blog post accuses Felix of talking poppycock. NajDorf said the problem has nothing to with size. NajDorf wrote:

“The real problem with all the transactions in this CDO chain is that every participant thought that they were being paid real money to take a non-existent risk, and therefore they took as much of this “risk” (which they didn’t really believe in) as possible.

“While this may be feasable (sic) on very small scales (e.g. for five minutes there is a risk-free arb that you can put a few million into to make a tiny spread), it’s unlikely that our financial system is such that people can earn spreads over Treasuries for years on billions of assets without taking any risk. The smarter players eventually recognized the risk and did everything they could to get rid of it.”

So it was bankers’ naivete and greed that did it then? Trouble is, these are human characteristics that are somewhat harder for the authorities to limit than the size of banks.

• To read How smaller banks would have helped shrink the CDO market, click here

Short URL: https://www.ianfraser.org/?p=993

Posted by Ian Fraser on Dec 14 2009. Filed under Blog. You can follow any responses to this entry through the RSS 2.0. You can leave a response or trackback to this entry