Source: Mises.org
In the run-up to the crisis, US financial institutions heavily invested in particular types of CDOs called mortgage-backed securities, which essentially packaged together mortgages from a wide array of different locations. It was thought unlikely that house prices could decline across the whole of the US simultaneously…so packaging together mortgages from different locations into CDOs seemed like a profitable and risk-free investment. By the time house prices began to decline, however, key banks had invested so heavily in these mortgage-backed CDOs that the housing crash brought down the whole financial system with it…it can easily be understood why the financial press assumed such a worried tone when reporting on recent research by the Bank of England, which revealed the extent to which financial institutions around the world have again begun heavily investing in CDOs. The report revealed that international financial institutions have so far amassed a $405 billion exposure to ‘junk debt’ packaged within CDOs, while the broader market for this low-rated debt has swelled to $1.4 trillion…The key difference between this new wave of CDOs, compared with those that precipitated the 2008 crash, is that the new CDOs are packages of low-rated ‘junk’ business debt, rather than packages of ‘sub-prime’ mortgages…When the threat of inflation finally forces central banks to raise interest rates again…many of these borrowers will be forced to default…and the crash will have begun. The greater the extent to which global financial institutions have exposed themselves to these junk debt CDOs by that point, the more quickly will the crisis spread throughout the financial system…around 80% of the leveraged loan market consists of “covenant-lite” loans…Covenant-lite’ loans are loans which have partly or wholly discarded the ‘covenants’ which traditionally protected investors…As central banks continue to slowly normalize interest rates, the foundations of the overinflated junk debt market have already begun to crumble away.”
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