What is a CDO? CDOs are complex structured financial products. CDOs pool different securities, often including bonds backed by mortgages, and sell slices that carry different risk and payout levels. The major banks said the majority of its CDO holdings were considered to be the safest slices but the downgrades had affected even these securities. The most troubled CDOs bundled together only subprime bonds that had low investment-grade ratings such as BBB. Many of these bonds are now rated junk. One $873 million CDO slice was rated AAA- the highest of 10 investment-grade rankings. It was cut 10 notches to a junk rating of Ba1 by Moody's. The CDO downgrades show there is no quick fix for subprime problem. Subprime mortgages were collateral in these investments, and it is eroding faster than the rating firms had expected.
What makes it worse is that the downturn would also impact bond insurers, who are committed to pay investors if a bond issuer defaults. Since these guarantors depend on solid credit standing (usually AAA) for access to capital and to win business, a possible downgrade on their credit rating could detriment banks that bought credit guarantees from the insurers on bonds they hold (generally in the form of credit default swap agreements).
Reasons for this collapse:
a. Soaring rate of delinquencies and foreclosures; about two million adjustable-rate mortgages prepare to adjust in 2008
b. Aggresive bank lending amid lax lending standards
c. Falling prices make borrowers owe more than the house is worth
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