OSTRICH ECONOMICS: EXPLAINING CDOs & CDSs ...

I was responding to a writer, and thought I should share this part of the discussion ...

... A CDO is a collateralized debt obligation. This is “finance-speak” for selling you the monthly payments that someone makes on a home mortgage or a credit card. The monthly payment, as you can imagine, is tied to the debtor’s ability to pay their debts. When you bundle a bunch of debt contracts together you have a CDO. If the debtor can’t make their monthly payments the holder of the CDO is in trouble.

A CDS is a Credit Default Swap. In (hopefully) even simpler terms, a CDS is insurance. AIG believed they could sell a CDS and insure investments like they insured a house. The seeds of collapse were planted when CDS-Insurance instruments were bought up by "investors" who were more concerned with getting access to monthly premiums, but not so keen about the idea of providing insurance. Things got really ugly when AIG and other market players began insuring CDO instruments tied to subprime mortgage contracts, and other market garbage.

AIG, however, isn’t the only institution involved in the CDS-insurance mess. Keep in mind, market players of all stripes were looking at the CDS market as income. As a result, CDS contracts were shipped around so much, and viewed as income streams to such a degree, that no one actually thought they might have to pay up if the market tanked. This is Ostrich-Economics.

CDOs and CDSs are like alchohol - good in moderation, but toxic if everyone’s drinking beyond necessity. And when you do it daily, well ... What Fannie Mae and other financial institutions did was purchase and trade CDOs and CDSs on levels that were not prudent. Think about this little nugget of information. The CDS market - which makes sense on the surface - jumped to twice the value of the U.S. stock market between 2001 and 2007 (from $1 trillion to $45 trillion). Market players effectively stacked CDOs & CDS’s on top of one another like a child stacks Legos. At some point, while each block looks strong, the whole thing will fall.

While this is another gross oversimplification, selling CDS insurance tied to cover toxic CDO contracts would be like me taking the insurance policies of homes destroyed in Hurricane Katrina and Hurricane Ike, and using them to apply for a loan - and then having the bank accept them as collateral! Financial institutions did this for a long time until the mess collapsed on itself.

So, yes, like your children, the guys who brought us this mess thought they could stack financial Legos into the sky indefinitely.

This is what the Bush administration wants you to bailout.

- Mark