The financial industry has two weapons of mass destruction, which they proliferated, with the same fervor of nuclear bombs during the cold war. These financial neutron bombs are the Collateralised Debt Obligation (CDO) and the Credit Default Swap (CDS). Arsenals containing both these weapons blew up in the face of the financial titans and are a primary cause for the systemic crisis and collapse of 2008. Now you are probably wondering; just what are these things?
Meet the Credit Default Swap
The Credit Default Swap (CDS) is one type of credit derivative. A credit derivative is a contract actually more of a bet between two players called counterparties. The value of the credit derivative goes up and down tracking the value of a specific corporate debt the bet was made on. Like a corporate bond or loan. (Note: The financial industry doesn't like the term bet it prefers the term contract so please just read contract wherever you see bet on this page. It will make the big financial players happy.) The company that issued the bond or taken out the loan is rarely involved in the credit derivative bet. The corporate bondholder or lender is one party of the bet and is paying the other to assume some of the risk of the corporate bond or loan.
The CDS is a form of insurance contract. The buyer pays an ongoing premium (at some fixed intervals) to the protection seller. If something were to happen to the corporate bond or loan (like default) then the seller has to pay the buyer the value of the CDS contract.
But the fun doesn't stop there. Investment banks, hedge funds and well just about any gambler just can't leave a good thing alone. They have to make it better and better to an investment bank or hedge fund means adding risk. Because with big risk come big rewards, bonuses and salaries. So once a CDS is created it can be traded. Sometimes they are bundled up into baskets and traded as indexes similar to the say stocks are traded on the S&P 500 index fund. This allows investors to bet on changes in the credit market as a whole not just individual companies. Betting that default rates in general with either rise or fall. Like the lotto you just have to keep inventing new games for the players.
The more curious of you by now might be asking; just who invented this holy hand grenade of financial fun? Why none other than JP Morgan. Yes wherever you find a financial instrument that can create havoc with an entire country threatening to set it back decades you will find the fingers of JP Morgan at work. A team of quantitative analysis working at JP Morgan in the 1990's invented the Credit Default Swap. Even though at the time they were entirely illegal. But unlike Dr. Kevorkian the government didn't put these people in jail but rather changed the laws in 2000 to make them legal and then prevented anyone in the government from regulating their use. Specifically it was the Commodity Futures Modernization Act, which said that products offered by banking institutions could not be regulated as futures contracts. This little tidbit was added because the head of the Commodity Futures Trading Commission (CFTC) wanted to regulate them (that party pooper with her head screwed on straight). The friends of banking in the Senate just couldn't have something like that (regulation) spoiling the party. The party that would come to a climax than a decade later.
The Collateralised Debt Obligation
This is where the fun really begins. The Collaterlaised Debt Obligation (CDO) was invented in the late 1980s by a person you may have heard of, Michael Milken, who worked for Drexel Burnhan Lambert. The CDO was a financial instrument used to bundle asset backed securities with the same ratings into tranches (a French word for slices) that could be sold to investors. This way investors would only need to know the ratings of the CDOs and not need focus on the securities. Similar to focusing on the cards in front of you on the blackjack table and not on the cards in the shoe (blackjack dealing shoe).
Drexel you might recall is no longer around, it went bankrupt in February of 1990. Milken had already been arrested and indicted for securities fraud in 1989 a year after Drexel pleaded guilty to six felony violations of security laws. None of this has anything to do with CDOs but it is interesting to know the lineage of this financial hell spawn. You might also want to know that in 1994 the General Accounting Office (GAO) would report; "when Drexel Burnham Lambert failed in 1990, federal involvement was necessary to keep payments flowing among Drexel's various debtors and creditors and to avoid financial system gridlock." [ 1 ] The GAO always does such excellent investigative work and nobody in the US government seems to read these reports, nobody, never ever! Or maybe they do and willfully (gleefully?) choose to ignore them.
Once you open a can of worms
Now we get to the synthetic CDO. This is a Collateralised Debt Obligation that is composed of Credit Default Swaps instead of the physical debt securities. Reality twice removed. But wait that's not all. Typically these synthetic CDOs contain CDSs from over 100 companies and then the CDO is sliced into several tranches and sold separately. The tranches are not all equal. There is a high-yield, high-risk slice and safer (that is a relative term) and a low-yield slice and maybe one or two slices in the middle. The problem is once you have a slice of 100 companies Credit Default Swaps which are bets on a bond or loan and the bond or loan goes bad what do you do?
The idea (which also sunk Long Term Capital Management) was that the good times would roll forever and very few of the underlying real debts would go bad. When too many start to go bad then the buyers of the tranches start to panic because they hear the ticking and don't know in which case the bomb is hidden. They start to abandon the game all at once. As we all know, an empty casino loses money
[ 1 ] General Accounting Office, Financial Derivatives: Actions Needed to Protect the Financial System (Washington, DC: General Accounting Office, May 1994). Pg. 43
[ 2 ] Surviving the Cataclysm, Webster G. Tarpley