Problems in the CDO and CLO Markets to Continue
The Fed Governor, Kroszner, states that the CDO and CLO derivative markets may take some time to resume their normal activity and even once they do the markets will more than likely look different then they did before. Text in bold is my emphasis. From Market Watch:
The markets from some complex derivatives remain broken and may recover only gradually, said Randall Kroszner, a governor of Federal Reserve Board on Monday.
"I would suggest that....the recovery may be a relatively gradual process and these markets may not look the same when they re-emerge," Kroszner said in a speech to the Institute of International Bankers.
Trading in some derivatives, such as collateralized loan obligations, or CLOs, and collateralized debt obligations, known as CDOs, has ground to a virtual halt since August.
Some of these structured credit products packaged pools of subprime mortgages loans.
As problems in the subprime mortgage market became more apparent over the summer, investors shunned these products and also became unwilling to purchase products that could have any exposure to housing-related assets and other structured products more generally.
Many investors had relied on credit rating agencies assessments of the products. A series of rapid downgrades helped investors lose confidence in the quality of the ratings.
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.
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.
Kroszner did not mention any role for regulators in the market. There is some concern that many of these derivatives remain on the balance sheet of banks or their conduits.
Kroszner said the Fed will be reviewing the lessons of the financial market turmoil.
Kroszner said that the Fed's actions to cut interest rates and boost liquidity had helped improve market functioning "though strains, particularly in term funding markets, persist even now," he said.
Market participants seem to expect that pressures in term funding markets will persist for several quarters as banks hoard cash. "In the months ahead, the Federal Reserve will continue to monitor developments in the financial markets and act as needed to support the effective functioning of these markets and to foster sustainable economic growth and price stability," Kroszner said.