When we last left Joe, he was defending against the Ninja Bills. Today’s episode finds Joe thinking about the mortgage crisis, the mass of failing banks, and the continuing write-down of billions of dollars of loss by corporations across Wall Street.

This can only be the work of the elusive Collateralized Debt Obligations (CDOs)!! For those that don’t know what one of these monsters are,..

Collateralized debt obligations (CDOs) are a type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk. CDOs serve as an important funding vehicle for fixed-income assets.

From Wikipedia – Collateralized Debt Obligations

Simple right? Not very.

So What Does the Beastie Do?

The CDO is a complex investment ‘vehicle’ thought up by some smart little investment specialist on Wall Street to protect investors from the dangers of investing in Sub-Prime mortgages. Because individual Sub-Prime mortgages were so risky, it was decided to ‘wrap up’ a huge number of these mortgages, and spread the risk of individual defaults across the entire investment.

Banks and lending institutions liked this so much that they decided to create about $47 Trillion dollars worth of them! To make things even better, since these are a new type of investment, they aren’t covered by government regulations!

What has happened is that there’s a whole shadow brokerage universe, similar to the stock market, that deals with buying, selling, and trading these CDO’s. They were so successful that a significant percentage of all the Subprime Mortgages were ‘bundled up’ into one CDO or another.

The Monster Awakens

All seems well. The CDO’s are trading like hotcakes, and even if they lose 10% of their value, they’re still making the banks a HUGE profit.

Then BOOM! The housing market starts to decline at a pace no one anticipated. Now the CDO’s aren’t losing 10%, but 20% or more! Panic sets in, for a couple of different reasons.

Huge amounts invested – As mentioned before, the money being talked about is in the Trillions range, and since there is no regulation, the ACTUAL value of the debt obligations has been determined by the ’shadow’ market (supply and demand) , so there is no one that knows what the REAL values of the assets are.

Liquidity drops – As these are supposed to be safe, low-risk investments, many banks have bought these as a hedge against HIGHER risk investments. That means that they depend on these constant revenue streams for day-to-day operating expenses of the banks. When these streams are disrupted (even by 10%) it can cause a cascade of troubles, adding up to liquidity problems (Bear Stearns) and a lack of confidence in the bank itself.

Om Nom Nom Nom

What are the banks to do now that around $200 billion in investment value has been ‘eaten’? With the Subprime crisis in full swing, you can’t give these things away any more. The value is dropping like a rock, since price is determined by demand (like stocks) and demand has dwindled to almost nil.

What to do?!?? Write it off (of course). Since the banks themselves don’t know exactly how much the investments are actually worth, it’s easier to err on the high side, and declare write-offs of the MAXIMUM amount they COULD be worth. That’s why the huge spate of banks and lending institutions announcing profit reductions and write-offs IN THE BILLIONS. It doesn’t look particularly good on the bank’s part, but at least it’s off the books, and they get to count it as losses when it comes tax time.

The banks had a good thing going, but the complexity of these CDO’s and the sheer AMOUNT of greed and money involved, set them up for unexpected consequences.

Burp!

One good thing. Even though the banks are hurting now, it seems like much of the worst is over, and the market is slowly correcting itself. Banks are shifting back to more conservative investments, and licking their wounds from the write-offs. The weakest or most over-leveraged have fallen (think Bear Stearns) and the surviving banks won’t be tempted to get too over creative with their investment strategies again.

For a while.

Do you think the banks are out of the woods yet? Betting on any other big-bank blowups? Tell us about your predictions and leave us a comment.