Monday, June 22, 2009

CDOs and Credit Default Swaps Explained

From Santa Clara Magazine (Summer 2009), here is Prof. Alexander J. Field's take on the economic crisis. He explains CDOs and credit default swaps particularly well:

CDOs emerged when financial institutions took a pool of mortgages and issued securities derived from them. Originally, mortgage-backed securities simply sold a right to a share of interest and principal payments from the underlying pool. Securitization reduced variance of the bond’s return, but the expected payout couldn’t really be different from that of the underlying mortgages. [Presumably, because the bond's payments were linked to actual mortgage payments.] CDO engineers, however, figured out how to perform the financial alchemy of turning junk into gold: Starting with a pool of risky mortgages, they created different grades, or tranches, of derivative securities...

Even then, some major investors and banks had to have known that the CDOs being issued weren't entirely halal/kosher. They demanded insurance:

Enter credit default swaps. For a small “premium,” institutions could insure themselves against the risk that the bonds might default. Since swaps were not technically insurance, they were beyond the reach of state regulators. American International Group (AIG) and other issuers did not maintain adequate reserves to meet collateral calls when mortgage defaults rose. In a sense, they simply pocketed the premiums without providing the insurance.

Oh, the mendacity.

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