disynthetic

Collateralized Debt Obligations are a type of security that aggregated multiple assets into one, and its value is derived from the sum of many, many underlying debt contracts. Primarily, home mortgages. The idea behind this diversified portfolio approach is to balance out the assumed risk by strapping together mortgages that ranged from very low risk for default (with naturally low rate of return) all the way to very high risk for default (with naturally high rate of return, as long as they didn't default). The aggregated underlying securities combined into one security which paid out a cash flow that was the sum of every single underlying mortgage "tranch".

This was innovative because now these new securities could be given a credit rating that vouched for their inherent risk. Credit ratings companies were rating these securities on the low default-risk tranches of these CDOs and not considering the high default-risk parts.

Leverage was not properply taken into account when rating these things. The amount of momentum that could go into a value change was astronomical. Leveraging magnified what were actually microscopic price changes to make them seem like lucrative cash flows. The valuations for such things involved mathematics so complex that the people who designed them warned that they should not be applied to real markets. They were too complex to be certain of the results being accurate.

To make matters worse, additional tiers of complexity began being folded into CDOs, with the introduction of CDO2s, CDO3s, and sometimes even CDO4s and beyond. A real red flag was raised when Ben Bernanke openly joked about wanting to know what the things were worth, in 2007. The chairman of the Federal Reserve doesn't even trust their valuations, and by this time, these securities (among other innovations, these were just the most interesting type) have become embedded so deeply in the financial sector they could effect the values of unrelated securities. What was essentially happening here, is that the actual value of a CDO and the observed value grew so far appart. That's why they call it a bubble. It pops when the market discovers that those "record high stock/bond/etc values" are really only worth a fraction of that. This isn't so far fetched, as a large part of value is based on the expectations of people. Expectations of what is happening and what will happen are just as important factors as their more tangible counterparts.

This is a very brief description of one of the primary vehicles by which this damage was done. One thing alone couldn't create the perfect storm that the subprime crisis was. The mismanagement of these complex assets was just the surface. The far-reaching effects of the rapid devaluation of CDOs went world-wide, because of the amount of foreign organizations and people invested in our U.S. debt is very significant. They buy our debt, we use that money. What they get from it are regular interest payments that are a fraction of that debt. Latest figures show that China owns 24% of our debt, and Japan owns 20% of it. Great Britain owns a slightly smaller chunk, but were talking about trillions of dollars in value here. And with the amount of debt increasing like it is, our economic freedoms may be vulnerable to outsider influence now.

The really sad thing about all this mismanagement is that by making mortgage values so much more unstable, people who didn't even know they could be affected by something like this were hurt. People who previously had layers of safety between the value of their mortgage and the performance of their mortgage company, had that envelope removed. Not only that, they were essentially being made to suffer for a complete stranger's defaulting on their mortgage, since these had now been completely or partially tied together in their valuation. One bad apple spoiling the bunch, so to speak.

It's a very frustrating issue. It's equivalent to a kid getting a hot new toy for their birthday, and everyone else ones it. Then one day everyone finds out that it was made in China under lax safety conditions and it contains lead, mercury, asbestos, and DHT.