The Effects of Post Recession Legislation and Toxic Asset Write-Offs on Collateralized Debt Obligations
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In the lead up to the 2008 crisis derivatives, loose monetary and fiscal policy enabled debt to flow into the market. Prior to the 2008 crisis the commercial lending sector engage heavily in derivatives in a drive for profits in a low interest rate world and in efforts to keep pace with the shadow-banking sector. Mortgages were offloaded into collateralized debt obligation (CDO). The risk of the CDO defaulting was then insured by a credit default swap (CDS). The premium payments for the CDS were then used to fund a synthetic CDO. The financial industry had built a trillion dollar industry on billions of dollars of mortgages. Once the collateral and lower tranches of the derivatives defaulted this pyramid collapsed. Structured finance, when it works, provides a way to replicate a risk so you can offset it for a price. Once an asset manager acquires a pool of assets they are then structured into tranches according to their risk. Today the financial sector still engages heavily in derivatives. Since Dodd-Frank, Volcker Rule and Basel III were implemented CDOs are back as bespoke tranche opportunity. CDO levels took a precipitous dive after the recession and have been slow to recover. Why is this? Was Congress passing thousands of pages of legislation the solution or did its unintended consequences outweigh its contribution? Did legislation help change the risk of default of the asset? The hypothesis is that despite the CDO market being slow to recover post recession it is still at risk of failure due to inherent flaws in the CDOs pricing, liquidity and depth but due to legislation and the toxicity of the asset the effects do not pose a systematic risk to the financial industry.