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You Know You’re in a Bubble When…

by Richard A Reagan

If you thought the worst excesses of the 2008 financial crisis were well behind us then think again. While the first few years following the crisis brought a return of some sort of sanity on the part of financial markets, lenders, and investors, the lessons of the crisis are increasingly being forgotten. That’s especially the case with collateralized debt obligations (CDOs), which contributed greatly to the severity of the financial crisis. While their issuance is still far lower than it was during the crisis, it’s starting to pick back up again, demonstrating that bubble-era financial practices are on the rebound.

CDOs during the financial crisis included many mortgage-backed securities. Financial companies took mortgages that were subprime, from borrowers who were bound to have trouble paying off their mortgages, packaged them together into bundles, chopped those bundles into various tranches paying a variety of interest rates, then sliced and diced those tranches into securities that were sold to investors.

In many cases those securities were rated as AAA, as the low interest rate environment made people think that housing prices would increase forever and interest rates would remain low forever. As many investors and financial institutions found to their detriment, those securities weren’t AAA quality. That cost many investors their hard-earned money, and led to the downfall of Wall Street titans Bear Stearns and Lehman Brothers.

CDO issuers like to say that CDOs are safer now than they were back then. But CDOs are now backed largely by corporate bonds, which are riskier than ever. Nearly 60 percent of corporate bonds today are rated only one level above junk, and the risks for downgrades as interest rates rise are greater than ever. While CDO issuance may not be as high as it once was, it’s not insignificant. And defaults on CDOs could once again put the health of many financial institutions at risk and lead to a cascading series of defaults during the next financial crisis that will worsen the effects of the coming economic downturn.

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