The ABCs of Collateralized Debt Obligations (CDO) & Credit-Default Swaps (CDS)

Collateralized debt obligations (CDOs) seem to be at the forefront of the current financial crisis and were certainly at the core of the meltdown in mortgage-backed securities last year.  CDOs are simply bonds backed by pools of loans or other debt instruments with the purpose of generating tiered cash flows from mortgages and other debt obligations.  Initially these cash flows, which are created by a group of CDO assets, are pooled together with the resulting pool of payments being divided into separate tranches which are then rated based upon their risk level.   Every tranche carries a debt rating ranging from the highest credit rating (or lowest risk level) of AAA on down to lower levels such as AA and BB, with the lowest end (or the highest risk level) being unrated or carrying the equivalent of junk bond status.  Due to the high demand for bonds, the supply of CDOs was insufficient to keep up with the demand and as a result so-called synthetic CDOs were created, synthetic CDOs are made up of credit-default swaps (CDS).  With a CDS, one party agrees to insure another in the event of a bond default in exchange for a fee, an idea similar to that of paying an insurance premium.  In theory there is no limit to the amount of credit- default swaps that can be created so when the market dried up for CDOs as a result of the sub-prime meltdown, synthetic CDOs or credit default swaps (CDS) were now in high demand and could be readily generated in the derivatives marketplace.  

The CDS is now the product of choice for those investing in credit as an asset class as the possibility of bond defaults continues to mount.  Essentially the creation of the credit-default swap (CDS) has made it possible for investors to take a short position on bonds.  Investors who believe that the credit condition of a company will worsen, may in turn buy a CDS on its bond whether or not they own the bond itself, thereby allowing them to place a bet on whether a corporate bond will eventually rise or decline in value.  However this pseudo insurance could eventually prove to be worthless if the insurer is unable to pay and the risk to related parties (also known as counterparty risk) proves to be so extensive and potentially calamitous that a government bailout of the company backing the bond becomes necessary.  This is the strain the financial system is currently facing as credit-default swaps have become a mainstay of an investment bank’s hedge fund.  The growth of hedge funds, which are lacking in government regulation, coincided with the growth in credit-default swaps (CDS).  It was believed that minor investors could not invest in hedge funds, mortgage-backed securities or credit-default swaps, therefore the need for the government to regulate them was precluded.  It was somehow lost on regulators and Wall Street that these very products could threaten the global financial system and that their misuse could spark a massive credit crisis of unforeseen proportions impacting all of us.  New York’s Attorney General is currently investigating whether credit-default swaps may have been manipulated by short sellers, driving stock prices down and leading companies such as Bear Stearns and Lehman Brothers into bankruptcy.  Perhaps no one saw the current crisis coming however the Oracle of Omaha Warren Buffett, had characterized these instruments as “financial weapons of mass destruction”.  It appears the days of destruction are upon us.

The Government Can't Seem to Cut the Checks Fast Enough

Sub-Prime Mortgage Crash

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