The risks of CDO meltdowns have been well-recognized for at least the last decade. CDOs are necessarily dependent on the underlying collateral portfolio because CDOs necessarily separate the performance of the issuing bank from the performance of the issued notes. The inherent risks of CDO nonperformance have long been known and discussed. In her November, 1998 analysis, Karen Spinner gives an exceptionally cogent listing and explanation of these risks. For example, Model Risk dictates that the investor consider the possibility that the rating agency’s models “may not bee 100% accurate.” Liquidity Risk means that it is hard for an issuer to unwind a closed CDO structure.
Her excellent piece is entitled “CDOs Under Fire – What will happen to CDOs if credit fears paralyze financial markets?”. Too bad more institutional investors and other players apparently did not pay enough attention here. Apparently the credit fears have now virtually paralyzed the financial markets and we’ll have to observe the actual consequences to these derivative instruments.
Link to Spinner piece here: