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Simple answers to Complex Questions and Complex Answers to Simple Questions. In real life, I'm a Greater-Toronto (Canada) Realtor with RE/MAX Hallmark Realty Ltd, Brokerage. I first joined RE/MAX in 1983 and was first Registered to Trade in Real Estate in Ontario in 1974. Formerly known as "Two-Finger Ramblings of a Forensic Acuitant turned Community Synthesizer"

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Tuesday, February 09, 2010

The Junk Bond/ Derivatives/ SubPrime/ CDO mess explained

Bankers' Liverpudlian Stew Disguises CDO Scraps as Tasty Morsels
By Mark Gilbert

From Bloomberg.com

Feb. 9 (Bloomberg) -- Since its inception, the derivatives market has echoed the fairground hawkers’ call to “scream if you want to go faster.” Among the new derivatives, collateralized-debt obligations (CDOs) were particularly hot.

To make a CDO, bankers bundle together a package of other kinds of securities, such as corporate bonds, asset-backed securities (ABSs) or credit-default swaps (CDSs) that are tied to company creditworthiness or mortgage performance.

By carving the resulting collections into slices of differing quality, the creators can make the riskiest portions absorb any losses on the underlying assets first, thereby cushioning the higher-rated slices.

No Clear Idea

As with almost every other investment vehicle, CDOs were designed to reward investors according to the amount of risk they took. Those who bought lower-risk securities typically earned a smaller rate of return from successful investments than did those who took bigger risks, who received either a larger payoff if the investment performed well or nothing at all if the investment failed.

Trouble was, no one had a clear idea of just how risky any given slice was or any sense of how to quantify and value that risk.

In the same way that Liverpudlians disguise overripe meat and vegetables by cooking them to mush in a stew called scouse, investment banks, rating companies and plain old market peer pressure turned the investments inside most CDOs from inedible chunks of the financial markets into bite-size morsels palatable to pension fund trustees.

No pension fund -- and only a few other investors -- would buy a structured transaction whose worth depends on what happens to the stock market and company creditworthiness, which way commodity prices go and whether the wind blows on a Sunday. They did, however, happily purchase CDOs that offered strong credit ratings and the promise of top-flight returns.

...snip...
read whole thing on Bloomberg

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