CDOs for Dummies

Good explanation of how CDO were constructed in today’s WSJ, and why the subprime mortgages were so problematic.

Various CDOs, including Goldman’s, “magnified the impact of toxic mortgages by replicating mortgage securities in debt pools known as collateralized debt obligations as well as CDO derivatives, and also in an index that tracks subprime bonds.”

A $38 million pool of subprime-mortgage bonds created circa June 2006 found their way into more than 30 debt pools. Total losses = $280 million.

Here’s the WSJ:

“The subprime mortgages that caused big losses generally were packaged into CDOs, in which dozens of mortgage-backed bonds were pooled together and slices of the CDOs were sold to investors. Another version of these CDOs didn’t contain actual mortgage bonds but were linked to them via derivatives called credit-default swaps. Through the use of derivatives, banks created many of these synthetic CDOs using the same mortgage securities, all of which would rise or fall in value depending on how the mortgages were performing. With synthetic CDOs, those who had bet that the loans would perform well were on the hook if their performance deteriorated.

In effect, the documents said, Wall Street was “copying and pasting” what turned out to be the worst-performing securities of the mortgage boom. Such activity helped multiply opportunities for hedge funds and traders who wanted to short the housing market, but magnified the losses of those on the other side of the trades. To short a trade, in this instance, is to bet the housing market will turn down.”

I am a sucker for a good graphic:

courtesy of WSJ

Senate’s Goldman Probe Shows Toxic Magnification
May 2, 2010

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