Harvard Business School, Finance Working Paper No. 09-060
The subprime mortgage meltdown has managed to wipe out industry-leading firms in the banking and insurance sectors, but the underlying causes are still not widely understood. The authors of this paper explain how structured finance, or the ability to create large pools of highly rated securities from underlying pools of assets (e.g., mortgages) contributed to the meltdown. They discuss the complexity and riskiness of the specific mortgage-backed securities (known as collateralized debt obligations) that caused the problems, and show how the credit rating agencies came to mistakenly rate these securities as largely free of risk. The authors also highlight how a lack of historical information on default and delinquency rates in the subprime mortgage market led investors to overestimate the value of their investments. Finally, they question the future of structured finance and suggest ways the rating agencies should improve.
Collateralized debt obligations, once considered safe investments, turned out to be both widely misunderstood and incredibly risky when the underlying assets consisted largely of subprime mortgage-backed securities.