Lemons and CDOs: Why Did so Many Lenders Issue Poorly Performing CDOs?

50 Pages Posted: 29 Sep 2014

See all articles by Oliver Faltin-Traeger

Oliver Faltin-Traeger

Columbia University - Columbia Business School

Christopher J. Mayer

Columbia Business School - Finance and Economics; National Bureau of Economic Research (NBER)

Date Written: May 24, 2012

Abstract

Collateralized Debt Obligations (CDO) played a key role in the growth of Asset-Backed Security (ABS) issuance between 2004 and 2007 by providing a mechanism for lower-rated ABS to be used as collateral for the creation of AAA securities. Using a database published by Pershing Square Capital Management covering all of the assets underlying 528 CDOs and CDO Squareds issued from 2005 through 2007 and using rating history and other information from the ABSNet database, we compare the characteristics and performance of ABS observed in a CDO with other ABS not observed in a CDO. We find that CDO assets tend to be lower rated securities from the lowest quality asset classes and vintages, and with a higher spread at issuance. CDO assets performed much worse than comparable securities that were not included in a CDO. When we control for the initial rating, CDO assets have a downgrade severity that is at least twice as bad as comparable ABS not included in a CDO. Synthetic CDOs assets perform worse than cash CDO assets, but assets included in both cash and synthetic CDOs perform worst of all (with a downgrade severity about two and one-half times worse than the average downgrade severity). Even when we include controls for a wide variety of observable characteristics, including initial yield, CDO assets still underperform comparable ABS by between 50 and 100 percent. These results suggest that CDO originators successfully sold securities and insurance against the worst performing ABS assets, but also that buyers of CDOs would have had a hard time analyzing these securities based on observable characteristics alone.

Keywords: CDO, ABS, structured finance, securitization

JEL Classification: D04, D08, G01, G02

Suggested Citation

Faltin-Traeger, Oliver and Mayer, Christopher J., Lemons and CDOs: Why Did so Many Lenders Issue Poorly Performing CDOs? (May 24, 2012). Columbia Business School Research Paper No. 14-50. Available at SSRN: https://ssrn.com/abstract=2502607 or http://dx.doi.org/10.2139/ssrn.2502607

Oliver Faltin-Traeger (Contact Author)

Columbia University - Columbia Business School ( email )

3022 Broadway
New York, NY 10027
United States

Christopher J. Mayer

Columbia Business School - Finance and Economics ( email )

3022 Broadway
New York, NY 10027
United States

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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