Many investors and analysts assumed that CDOs were diversified, and hence made less risky, due to the large number of individual bonds that might underlie a given deal. But because many collateralized debt obligations (CDOs) hold the same types of bonds, and even in some cases bonds issued by the same MBS deal, lenders and investors were not as insulated against downturns as they thought they were.
This is because the investments within the CDOs turned out to be more highly correlated than expected. That is, they performed in step with each other to an extent that was not predicted.
Neither a borrower nor lender be
Lenders, feeling the impact of record numbers of foreclosures, are sharply curtailing their lending. This in turn is making it all the more difficult for homeowners in all economic brackets to refinance out of adjustable-rate mortgages and other loans that are scheduled to reset at higher interest rates. Unable to sell for enough to cover their debt, some homeowners are choosing to walk away from their homes.
Facing defaults even among some prime borrowers, many lenders have significantly tightened approval requirements for first-time homebuyers — even those with good credit and an adequate down payment. Some economists worry that stringent restrictions on potential homebuyers could further dampen the economy.
The impact on global markets
Meanwhile, with defaults threatening to affect all CDO tranches, not just the lowest-rated slices, the ratings agencies have been downgrading them. Many institutional investors, including international investment companies, banks, and hedge funds around the world, are facing steep losses. Some economists predict that losses are likely to add up to hundreds of billions of dollars, and could take their toll on the financial markets for years to come.
