CDOs have been the exclusive territory of large institutional investors to cover the risk of using debt to fuel the equity boom. It fueled subprime and the effect that mortgage debt had to push the consumer. It fueled Private Equity and the LBO debt to push the speculative premium in M&A.

By repackaging and bundling these individual obligations, it’s a very sophisticated way to reduce risk spreads and keep defaults in identifiable tranches from signaling weakness. In the subprime example, it allowed the risk and default of lower tier borrowers to be hidden for a while. All that time, the liquidity was permitted to continue running towards these deals. That’s one example but it is unwise and unfair to extrapolate that all CDOs are in as much trouble as the mortgage ones (subprime/Alt-A). Only time will tell whether we have similar problems with other derivatives.

The oft-mentioned “conundrum” associated with debt pricing has earned its definition because it was so hard to explain why yield curves and risk premiums were so hard to explain. It was inconceivable that we could be piling on so much debt to almost every asset class and not see the normal effects. I suggest that CDOs have something to do with the conundrum.