Correct. CDO’s are not derivatives. But they are how institutions like Fanny Mae and Freddie Mac work.
Derivatives are a bit like insurance. They are also where the term “hedge” as in “hedge fund” get their name. Risk has a negative value and there are usually people you can pay to take on the risk.
All is well as long as everything works within an assumed range of conditions. Someone gets a loan. Lenders diversify. And can accept a lower average rate of return in exchange for a less volatile rate of return.
It’s when economic conditions shift outside that range that things get ugly. The insurers can’t cover the losses and the lenders don’t get paid from either the loans or the insurance. The most critical time for the insurance, and it of no use. Anybody left holding cash refuses to lend until they feel safe again.
The solution isn’t necessarily to ban CDOs or derivatives. The first step is to ban bundling or reselling of CDOs and derivatives, which tends to mask the risk and assumptions in the base loans of the original CDO. Second is to put limits on derivative leveraging (the ratio of bets to cash assets). Those two alone will significantly shrink the number of CDO’s and derivatives without freezing up credit availability.
