Collateralized debt obligations: A double edged sword of the U.S. financial system

This paper points out a design flaw in Collateralized Debt Obligation or CDO, one of the heavily traded financial instruments by investment banks. The paper suggests that financial design of CDO was not incentive compatible among the players involved in the production, marketing and investing in this instrument. In a CDO, the underlying debt holders (borrowers) have the incentive to default and mortgage service providers (lenders) have the incentive to go for foreclosure because the mortgage insurance providers end up paying for the loss. The biggest losers in this transaction are the mortgage protection sellers like the AIG (American International Group) or the Lehman Brothers and CDO equity holders.