CDOs - The terror beneath the TARP

Business Spectator - The terror beneath the TARP: "The subprime mortgages that started all the trouble have mostly been written down already and the capital replaced. What’s left on the balance sheets – the problem US Treasury Secretary Timothy Geithner is now trying to grapple with – are the collateralised debt obligations, and especially the synthetic ones.

Three months ago I wrote an article about synthetic CDOs called A tsunami of hope or terror? that is once again at the top of Business Spectator’s most-read hit parade. It seems it is time, once again, to try to figure them out. Perhaps all the new hits on the article are from US Treasury staffers working on the Geithner bailout plan.

To recap, CDOs are collections of loans assembled into various tranches that are then rated according to the underlying loans in each tranche; synthetic CDOs are securities that are not based on actual loans but on credit default swaps (CDS). That is, they are derivatives of derivatives.

The CDO entity writes CDS with the issuing bank covering a large number of unrelated companies. This can be anything from 50 to several hundred – some banks, some industrials. The deal is that if a certain number of those firms default – usually between seven and nine – the money invested in the CDO goes to the bank.

It’s essentially an insurance contract – otherwise known as a bet, or rather a series of bets – a bit like a quaddie."