Fed's Kroszner: CDOs Will Be Clearer Next Time

Governor of the Federal Reserve Board Randall Kroszner foresees a more transparent CDO market in the future, according to a story by Market Watch.

Trade in Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations (CLOs) has been at a stand still since the August debt shock.

The market stagnation stems from the complexity of the instruments involved. CDOs and CLOs can be described as second level derivatives.

While it does not take a rocket scientist to make a CDO, it may require a couple to understand them.

In a standard mortgage backed security (MBS), mortgages are pooled together and securitized into a bond issue.

A CDO or CLO issue will pool MBS, at times together with a variety of other instruments, to issue another round of certificates.

The complex financial architecture operating behind CDO walls makes it difficult to assess their risk exposure.

We evaluate reward in the context of risk, hence the recent volatility has made it increasingly difficult to value CDOs.

Market Watch points out that investors had previously relied on rating agencies. Despite the recent wave of downgrades, as I have written earlier, the agencies themselves lost market trust because of their subprime involvement.

Kroszner, meanwhile, points the finger at naive consumers who did not do enough homework.

Kroszner said these markets broke down because investors didn't do sufficient due diligence and the products were complex and opaque.

"Put simply, investors suddenly realized that they were much less informed than they originally thought," Kroszner said.

The problem is, these complex structures often come with product disclosure statements (PDS) that are longer than Encyclopedia Britannica. Though most PDS are not as straight forward.

Kroszner views this as the catalyst for change.

In the future, investors are going to have to invest heavily to understand these products and sellers will have to make them easier to understand, he said.

"As a result, it is likely that these markets and instruments will look different than they did prior to the recent market turmoil," Kroszner said.

The question keeping me awake is: Why weren't they made clearer from the beginning?