What is a Collateralized Debt Obligation?
While the above question is a key to understanding the mess we're in (get your face masks out, when the walls hit the floor, a lot of dust will fly up), a better question would be “Why was there a massive buying of puts and shorting stock in Bear Stearns” in the options exchanges two-three days before Bear Stearns went down? Take the time to understand the definition of a put and then you will understand (discussion at the bottom of the page helps in this endeavor) that Wall Street seems to be canalizing itself. However, it also appears to this casual observer that Wall Street is helping the Federal Reserve and the Treasury pile up the wealth of this country in the hands of fewer and fewer people. The federal government has truly become the tool to leverage wealth of a global scale into the hands of a few people.
This link helps explain the concept of a put, the idea is basically: Wall Street’s has discovered a way of gambling on a particular stock so the bettor will play on the stock to go in a specific direction. In the case of Bear Stearns, the inside traders bet the stock would go down substantially and swept off the floor with some $200 million afterwards—just in the bets alone not to mention the profit JP Morgan & Chase made in acquiring some $170 billion in assets for a few measly hundred million. I guess we could spend all day in trying to figure what motivates people on Wall Street—in polite conversation it's called incentives. Laurea Kodres, at the International Monetary Fund, explains the concept of a Collateralized Debt Obligation. Here is her take on the dangers:
Despite repeated warnings from the official sector that financial stability could be compromised by the intense “search for yield,” private sector incentives continued to encourage further risk taking. By the spring of 2007, even top managers in some of the largest financial institutions began to express public concern, particularly about structured credit securities backed by sub prime mortgages and the leniency of the loan covenants and conditions backing leveraged buyout activity. But, given still-low interest rates and ample liquidity, demand for structured credit products carrying the AAA rating and earning higher-than-normal yields continued unimpeded until mid-2007
Collateralized Debt Obligations
A mortgage is thought of as a cash flow, as is a credit card, or personal loan. These cash flows are bundled together like strands of dough,flattened, sprinkled with some sweet looking high yield debt and bonds are created. Voilá! Now the problem with these sweet rolls of debt is that deep in the dough (no pun intended) is usually some pretty cheap stuff that is about to crumble into nothingness-you guessed it-those 19% credit cards and other goodies that will not yield to the end of the loan. But if you can catch a person in need-like someone buying their second mortgage, then maybe they’ll pay on it long enough-12-18 months, to give the backer a good return. The rest of the roll is chopped of in chunks (picture a baker making cinnamon rolls) and sold off to the hungry hoards at various funds along Wall Street.