Thread by @antoniogm

Wonder if the world is finally ready for my “CDOs are good actually” take.

Have we all healed enough yet?

This was sparked by reading a crypto-hater’s take that crypto was the new CDO as

1. CDOs are bad,
and
2. they somehow went away as crypto will (they did not)

As long as we have sophisticated credit markets, we’ll have CDOs in some form.

What does Wall Street do?

It takes one type of risk that the economy produces and transforms it, via financial engineering, into another type of risk the capital markets actually want.

You’d think those two would be matched, but in a modern economy they often are very much not.

The credit markets are one such area.

Most capital wants relatively safe bets in lending; they’re not there to take wild swings.

Most borrowers, whether companies or people, have iffy credit histories.

CDOs turn the latter risk into the former investment.

(From Chaos Monkeys)

There’s no other way (AFAIK) to reduce the credit risk of a set of investments other than bundling them and structuring them into the tranched risk of a CDO (I won’t even try to explain bundled/structured credit here…the internet is your friend).

So long as the economy generates riskier credit than capital wants (which has always been true as long as I’ve been an adult at least), there will be structured derivatives that bridge the gap, whether in mortgages or corporate credit or whatever.

Or, the economy just ignores that pool of credit and lets it whither on the vine, which well, maybe (e.g. subprime mortgages). But the credit/bond world is the biggest market after foreign exchange (dwarfing equities), and such a disconnect will exist somewhere always.