Were CDO's & CDS, the real cause of the Great Recession? The Role CDO's & CDS played in The 2008 Crisis! (#81)

 

Were CDOs & CDS the Real Cause of the Great Recession?

CDOs and CDS played a genuinely significant role in the 2008 financial crisis — the full mechanics are covered in detail in the dedicated case study below.

→ Related: The Global Recession/Crisis of 2008(#49), How Do Banks Work?(#72)**

Today, rather than retell that full story, let's focus on the actual question: were CDOs and CDS themselves the real cause of the crisis — or just the mechanism through which a deeper problem played out?

A Quick Recap of the Mechanics

In short: banks began issuing home loans to borrowers who genuinely couldn't afford them — known as subprime loans. Investment banks bundled large volumes of these mortgages into a complex derivative called a CDO (Collateralized Debt Obligation), which credit rating agencies then rated — remarkably, close to 70–80% of these CDOs received the highest possible AAA rating, despite the risky loans underlying them. Insurance companies then introduced CDS (Credit Default Swaps) — effectively insurance policies that would pay out if a CDO failed.

When large numbers of subprime borrowers began defaulting, the CDOs backed by those loans collapsed in value, and insurers had to pay out massive CDS claims — pushing the whole system toward crisis.

→ Related: What Are Derivatives? The 4 Types of Derivatives(#11), What Are Futures?(#8), What Are Options?(#10)

So — Were CDOs and CDS the Real Cause?

Here's the more precise way to think about it: CDOs and CDS weren't the root cause — they were the mechanism through which risk that already existed (the subprime loans themselves) got packaged, mispriced, and spread throughout the financial system. If the underlying mortgages hadn't been risky in the first place, the CDOs built on top of them wouldn't have failed the way they did.

Put simply: CDOs derive their value from an underlying asset — in this case, mortgages. When that underlying asset was fundamentally unsound, everything built on top of it (the CDOs, and by extension the CDS insuring them) was destined to be unstable too.

CDS, specifically, functioned as intended — as insurance. The real failure was in what they were insuring: CDOs built on loans that should never have been issued in the first place.

A fairer, more complete answer: most serious analyses of the 2008 crisis (including the U.S. Financial Crisis Inquiry Commission's official report) point to multiple contributing factors working together — reckless subprime lending, failures in credit rating, excessive leverage, weak regulatory oversight, and the risk-concentrating effect of derivatives like CDS. It's less a single "real cause" and more a chain of failures, where each link made the next one worse. If there's one place the chain most clearly starts, though, it's with the decision to issue risky loans to borrowers who couldn't realistically repay them.

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That's the more precise answer to whether CDOs and CDS caused 2008 — they were central to how the crisis spread, but the root failure traces back further, to the lending decisions that created the risk in the first place. Let me know your thoughts in the comments.