Did Collateralised Debt Obligations (CDOs) cause the GFC 1?


… a walk down memory lane in the GFC series

It is important to understand what happened last time !

The beginning

  • In the Lead up to 2008 credit easy to obtain, interest rates were low, there was an excess of capital, risks were ignored and Greed was rampant.
  • This Spawned Collateralised Debt Obligations (CDO’s) which we call Weapons of Mass(ive) Destruction, which were extremely illiquid once markets weakened.
  • CDO’s are sophisticated financial tools that banks used to repackage individual loans into a product that was be sold to investors. They did this because; it was a source of funding to make new loans and grow faster; it moved the loan’s risk of defaulting from the bank to the investors; and greed ie CDOs gave banks new and more profitable product to sell, which boosted share prices and managers’ bonuses.
  • CDOs allowed banks to avoid having to collect on them when they become due, since the loans are now owned by other investors. This made them less disciplined in adhering to strict lending standards, so that many loans were made to borrowers who weren’t credit-worthy — ensuring disaster.
  • Unfortunately, the extra credit availability created an asset bubble in housing, credit cards and auto debt. Housing prices became unrelated to their actual value, and people bought homes simply to sell them. The easy availability of debt meant people charged too much.
  • Worse still was that CDOs became so complex that the buyers didn’t really know the value of what they were buying. They relied on their trust in the bank selling the CDO without doing enough research to be sure the package was really worth the price.

What goes up… must come down

  • The computer models based the CDOs’ value on the assumption that housing prices would continue to go up. When they went down, the computers couldn’t price the product.
  • The first CDOs to go south were the mortgage-backed securities when US housing prices started to drop in 2006, the mortgages of homes bought in 2005 were soon in negative equity. The first to default were the subprime mortgages. By 2006, the subprime mortgage crisis was well underway. However, most economy-watchers believed it was confined to housing. How wrong they were.
  • The US sub-prime turned feral in August 2007, causing most credit flows to dry up. It turned nasty quite quickly.
  • The Credit Crisis had begun. During this time we learnt a new acronym from the American Housing – “KIM” or “Keys In Mail”. A peculiarity of the US housing system is that a home owner can walk away from their financial obligation without retribution. During the credit crisis those who couldn’t afford their mortgage were encouraged to walk away from their mortgage by talk show hosts (!) leaving the CDO owners stranded and the CDO’s effectively worthless.
  • What few realised was how derivatives multiplied the effect of any bubble — and any subsequent downturn. Not only banks were left holding the bag, but also all types of investors, all over the world.
  • Overnight, the market for CDOs disappeared. Banks refused to lend each other money because they didn’t want more CDOs on their balance sheet in return. This panic caused the 2007 Banking Crisis.

Credit in 2008

  • The Credit Crisis quickly turned into a Global Banking Crisis by Sept/Oct 2008. During this period many banks faced melt-down. The monetary authorities reacted en-masse. Rivers of money flowed from Governments with ongoing commitment to fix it. What alternative did they have?

The Context : 2008

  • Having one of the following in a year would be extraordinary: credit crunch scale; global banking crisis; significant losses on shares; losses in house prices; commodity markets; monetary and fiscal policies.
  • Having all of them in one year was extraordinary.
  • 2008 can be seen as an outlying year in a comparison period which includes two depressions, two world wars, the Cold War and all sorts of other shocks.

By 2009 we had forgotten all the major lessons. From 2009 it has only been a matter of time until the next GFC.

Did CDOs cause the GFC1? No, CDOs were a mere outcropping of greed.  Greed caused the GFC1 and it will cause the GFC2.

What do we do?

At pivotal times, knowing when to sell is invaluable.  We follow the changes in our Pythagoras Investment Timing Indexes. They offer a mathematical understanding of the stock market through volatility, which show that price sensitive events are predictable from changes in Volatility (i.e. in advance of price moves). These changes lead to buy/sell recommendations.

We recommend selling when the market/stock is at risk of going down, or no-where. At these times we invest in cash, and patiently await the buying opportunity. When the market/stock is less risky, and it’s going to go up, we reinvest to profit.

Conclusion: The key to making money is selling

The key to making money in any market is selling before any negative event. Pythagoras generates the sells before the events with share price effects – its proactive not reactive.

Investors know it’s rare for all stocks to go down all the time, all at once. Even in a bear market there are upward moves to profit from – if you have the right Buy/Sell recommendations.

Therefore Pythagoras can make money in any market regardless of the investment environment – in fact its best in the tough markets.   We worry less about the events and their timing and focus on Volatility changes. At Pythagoras we follow changes in volatility which precede the events. This places us at the forefront of investing.


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