mastery-money.com

If you have been following the financial markets for the last few months, you probably would have noticed that the market is being driven by credit fears. More simply put- people are not paying for the things that they bought which is pushing the equities market down. In particular it has pushed Real Estate prices down.

Here is a brief explanation on how we got into this mess: Average Joe bought a house and took out a mortgage. Mr. Banker sold the mortgage to a financial house. The financial house then took 100 mortgages and pooled them together and then sold them as a C.D.O (Collateral Debt Obligation). The C.D.O was then broken up into 3 pieces (A, B and C).

For simplicity sakes this is how it worked for an investor who bought a C.D.O. Investor A earned a 20% yield as long as there were less than 20 defaults, Investor B got 12% as long as there were less than 30 defaults and Investor C received 8% so long as there were less than 40 defaults. Well there have been more than 30 defaults, which have meant that investor A & B have been wiped out. Investor C is still standing, but barely.

This is where it gets complicated; in order for the financial houses to make even more money they did the following: They placed the A and B tranches into a new C.D.O- and called that C.D.O (squared). Then they resold the C.D.O (squared) to new investors with three new tranches (A, B and C). It gets worse… from the new CDO (squared product) they did it all over again and created a new C.D.O (cubed).

Because the investment houses placed so many of the same mortgages into the C.D.O’s, there was significant correlation risk. Because many of the C.D.O’s are tranches of one another- and as one defaults, it triggers another default which triggers another and so on. So if an investor wanted to value 1 CDO- more than likely he would have to know the value of over 10 tranches of other CDO’s. And in doing so would probably have to value another 10 tranches of more C.D.O’s. As you can see it becomes very hard to value- which is why the banks are struggling in telling the regulators how many losses they have on their books. Another way to look at is like pulling a thread on a sweater- once you begin to pull on one string, the whole thing begins to unravel.

If you find that all a bit confusing, don’t worry because it is. What is most disappointing is that the best and brightest minds of Wall Street managed to screw this up so badly.