Wall Street financiers are supposed to be hard-headed, risk-taking, brilliant as cut diamonds types (see: Gordon Gecko) who can size things up and make the tough decisions. That's why they get paid the big bucks.
But that's all window dressing. They are actually starry eyed believers in fantasy. To give a recent example, they believed 1) that housing prices would never, ever go down in price; 2) there will always be cheap, easy credit available; and 3) investors love to get paid with IOUs.
You may ask, who cares about Wall Street? What does that have to do with me, or the 2008 election, or impeachment? Well, the delusionary mob on Wall Street has managed in enmesh the global markets in a multi-trillion dollar problem which has no end in sight. On a less macro level, if you care about getting a reasonably priced loan (or any loan) for a car, a house, or your kid's college tuition, if you hope your next door neighbor is not in danger of foreclosure and losing the entire value of their home, if you care if the country slides into recession, then this story might interest you.
Operating on their faith-based beliefs, Wall Street types created something called the Collateralized Debt Obligation (CDO) which is kind of a layered structure (like the Leaning Tower of Pisa) for individuals, pension funds, insurance companies, endowments and hedge funds to invest in. A CDO can have a tongue-twisting definition, but it basically is a debt structure (like a bond) divided up into slices that take on differing type of risk, backed by collateral such as mortgage-backed securities, home equity asset-backed securities and other stuff that's supposed to be valuable.
You know how much those Wall Street types like to sneer at the French, but they use a French word (tranches--which means "slices") to describe the different slabs of bonds that comprise a CDO.
The income from a CDO is paid to the most senior secured tranche to the most subordinate (unsecured) tranche. That process of cash flow is called waterfalling (isn't Wall Street lingo fluffy?). Senior tranche investors tend to prefer less risky investments (pension funds, insurance companies and other risk-averse investors).
The unsecured "junior" tranches are invested in by hedge funds and multi-millionaires seeking high returns.
There are 3 types of tranches: senior, mezzanine and equity (also known as "toxic waste". I'm not kidding).
The "toxic waste" tranche will absorb the inital costs followed by the mezzanine tranches which will absorb additional losses, then followed by the senior tranches. Because of the credit support created by the tranches, the most senior claims are supposed to be insulated from the default of the underlying asset.
There are risks to the CDO and tranching. It never trades (no one buys or sells it) so the market cannot value it. In fact, no one really knows what CDOs are worth. But everyone does know that foreclosures are increasing and the biggest home mortgage company in the nation can't pay its bills. If the collateral backing these CDOs are mortgage-based, the collateral is going down the tubes.
CDOs are complex structures. Most investors (and probably a lot of Wall Street types) don't understand them.
Tranching has led to bad, bad underestimation of the risks in these CDOs. A very low number of defaults on CDO assets can cause investors to lose their entire investment.
Never forget that administrative and performance fees get paid first off the top. Cash flow first covers these top-priority expenses. It doesn't matter if the CDO goes down. The fees get paid no matter what.
Well, it's happening. The collateral backing up these CDOs is proving to be almost worthless. No one wants to buy them. And no one knows what they're really worth. The big investment firms like Merrill Lynch and Goldman Sachs who structured these CDOs in the first place aren't talking about anything, whether it's their losses, what their investors lost or how they value the CDOs.
Again, you may well ask (if you've gotten this far), why should I care? This is a multi-trillion dollar problem which may lead to the evaporation of hugh amounts of assets (money), leaving only debt behind. This can have a global ripple effect, which is already happening.