Wednesday, October 22, 2008

Comment: More economic news to ponder

First there were CDSs, or credit default swaps, and now we're hearing about the CDO or "collateralized debt obligation."

The $1.2 trillion CDO market has lost about 90 percent of its value and that is threatening the recovery of corporate credit. A CDO is another type of derivative designed to protect investors against risk. Basically its a type of insurance to protect against loss and a large chuck of CDOs are tied to the mortgage industry.

The problem with these derivatives is that they attempt to create a risk-free borrowing environment for the big-time investor. They attempt to "hedge" all bets creating what appears like a rigged stock market for fat cats.

The CDO distributes risks and it was thought that this diversity would protect the investments as a slump in one area of the real estate market would be covered by strong regions elsewhere in the same market. What the derivative gurus failed to take into account was the possibility of a broad spectrum meltdown with mortage defaults from all sectors.

Because banks lost so much money on their CDO investments, they may now have to strengthen their reserves using the government bailout cash injections. Of course, the intent of that assistance was to provide increased liquidity so banks could lend again especially to other banks. So this will likely stall the recovery of the credit markets.

Further writedowns on the CDOs will likely push up the cost of default protection or hedging, causing more tightening of credit.

So, it's likely that Wall Street firms like fair damsels in distress will again let out the SOS to their shining knights in Washington, who no doubt will come galloping again to the rescue with more taxpayer money. The "stimulus" plan may be intended to butter up the general populace for the next wave of bailouts.

If the last round gives any indication, Wall Street will rake in about 17 to 20 times as much as ordinary citizens will receive in stimulus checks.

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