Many commentators on the current financial woes in the U.S. have blamed the credit crunch on the “CDO”–collateralized debt obligation. CDOs are an unregulated type of credit product, asset-backed securities constructed from portfolios of fixed-income assets. They come in many shapes and sizes, and they are rated in a similar way as bonds are rated. These are not simple products, and therefore the risks associated with buying and selling CDOs are not easy to quantify. It’s a tricky business, like option valuation.
As the current financial turmoil has made painfully clear, either the risk analysis done by credit rating agencies and by institutions buying and holding CDOs was not adequate or these risk assessments were optimistically ignored. Furthermore, some pundits have suggested that because CDOs are not sold on the open market, they are not priced according to their risks–in other words, they were too easy to acquire.
How should we evaluate investment risk in a package of many debts, each of which would be assigned a different value-at-risk at any particular point in time? We have a lot of slick statistical analysis techniques available, and perhaps these alone should have been up to the task. But as the current liquidity crisis demonstrates, the devil is not only in the details of risk analysis. It is in the failure to take these probabilities to heart.