This diary is my attempt to lay out a layman's view of the two principal investment vehicles underlying the current financial crisis.
I was originally going to make this diary my view of the bailout and alternatives, but I decided that I needed to provide background first. I'll get to the opinion-based diary tomorrow.
I'm an actuary, which means that I've had just enough education on these things to be truly dangerous, but anyone who reads further does so with the caveat that this is not my field of expertise.
I welcome comments from Kossacks who have more knowledge than I do.
There's this stuff floating around in our financial system, and two kinds of stuff are important for understanding the current crisis.
One is called a collateralized debt obligation, or CDO for short. When the debt is a mortgage, they are called CMO's or mortgage backed securities. These are products that were first popularized in the late 1990's. People who want a lot of education on this topic can go to wikipedia, but here's a quickie explanation.
Let's say that you are a bank that has issued 1,000 mortgages this month at a 5% interest rate. In good times, you expect that 95% of these mortgages will be paid as expected, another 4% will have late payments and other problems, and 1% will default entirely. If you want to sell these mortgages to investors, you could sell them individually, but there is more of a market if you tailor the risk and reward to investors' needs.
So you tell investor A, who is cautious, I will pay you 4% interest, and you are guaranteed to get all of your payments unless 10% of the mortgages go into default, and investor B, who is aggressive, I will pay you 10% interest, but all defaults up to 10% come out of your share (The numbers in this example may not work out, but it gives the flavor of what is going on).
In real life, there are many middlemen, and usually more than 2 types of investment vehicles created out of packages of mortgages, so it gets very complicated to follow the money.
The take-away from this is that solutions that I have seen on dKos that assume that individual mortgages can be tracked are off the table because that would require reassembling mortgages that have been broken into many non-equal pieces.
The other important Stuff, and the one that brought down AIG in particular is called a credit default swap. Again, wikipediahas good information, but I'll simplify here.
A credit default swap (CDS) is essentially insurance. Lenderinc holds a loan made to Borrowerco. They are getting 5% interest on the loan, but they are worried that the loan may not be repaid. Lender inc. pays a third party, Guaranteeltd., 1% interest on the loan with the condition that Guaranteeltd will repay the loan if Borrowerco fails to. The mechanics of the transaction are complex, but this gives the essence. The problem is that if the market gets bad, Borrowerco may default at a time when Guaranteeltd cannot pay, leaving Lenderinc high and dry. This is especially a problem because credit default swaps were not regulated as insurance, so there are no statutory requirements as to the amount of money that Guaranteeltd has to hold to make sure it can meet its obligations.
Of course, once CDS's are created, they can be bought and sold by other parties, both to hedge against risk, and to speculate. e.g, if Borrowerco has a good quarter, the market might think that its risk of defaulting went down, making the CDS that Lenderinc holds worth less than it originally was. Lenderinc may decide that it no longer needs the protection, so it sells the security to a speculator, who is betting that Borrowerco's next quarter will be bad and it can sell the security to yet another party for more money than it paid.
The take-away here is that after these things have been bought and sold a few times, they can be on the balance sheets of companies far removed from Borrowerco and Guaranteeltd. People asking for full transparency on these transactions are asking for a huge amount of detail that simply cannot be provided in a short amount of time. Because these markets were unregulated, the mechanisms for tracking these transactions and the information systems for providing transparancy were never developed, and there is just no way to do so in a hurry.
I hope that the people who know even less about this stuff than I do find it useful, and that the people who know more will correct me, but remember that I have tried to keep this at a layman's level, so I know I'm oversimplifying.