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Collateralized debt obligations: A double edged sword of the U.S. financial system

  • Alakh Niranjan Singh

    ()

    (Thunderbird School of Global Management)

  • AKM Rezaul Hossain

    ()

    (Division of Bussiness, Mount Saint Mary College, Newburgh, New York.)

This paper points out a design flaw in Collateralized Debt Obligation or CDO, one of the heavily traded financial instruments by investment banks. The paper suggests that financial design of CDO was not incentive compatible among the players involved in the production, marketing and investing in this instrument. In a CDO, the underlying debt holders (borrowers) have the incentive to default and mortgage service providers (lenders) have the incentive to go for foreclosure because the mortgage insurance providers end up paying for the loss. The biggest losers in this transaction are the mortgage protection sellers like the AIG (American International Group) or the Lehman Brothers and CDO equity holders.

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Article provided by Instituto de Investigaciones Económicas y Sociales (IIES). Facultad de Ciencias Económicas y Sociales. Universidad de Los Andes. Mérida, Venezuela in its journal Economía.

Volume (Year): 34 (2009)
Issue (Month): 27 (January-june)
Pages: 37-56

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Handle: RePEc:ula:econom:v:34:y:2009:i:27:p:37-56
Contact details of provider: Postal: Facultad de Ciencias Económicas y Sociales. Instituto de Investigaciones Económicas y Sociales. Campus Universitario Liria, Edificio G, Tercer Nivel. Mérida 5101, Estado Mérida, Venezuela
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