Wednesday, December 24, 2008

Credit Default Swaps and Collateralized Debt Obligations

Tricky mortgage insurance schemes did not cause the financial crisis, but they did contribute to the marketing of subprime mortgage loans that contributed to the 2008 financial crisis. Fannie and Freddie insured the mortgages they purchased in order to make their mortgage backed securities (MBS) appear to be more attractive investments. Of course, the more-than-implied (and now real) government backing of these two government sponsored organizations (GSO) represented a large share of secondary mortgage market purchases. Other similar institutions are equally culpable in selling insurance as a way to sell MBS. To the extent that poor and minority toxic mortgages contributed to the financial crisis, so too did exotic financial instruments, such as good credit ratings for GSO's insurance-backed MBS.

Credit default swaps (CDS) are insurance policies against companies or investment vehicles going bankrupt and being unable to pay their creditors. Government approved credit rating agencies gave the AAA stamp of approval on what would turn out to be toxic mortgages. It is speculated that much of the subprime disaster could have been avoided if these credit raters had never agreed to put the AAA tag on collateralized debt obligations (CDOs). These obligations, similar to MBS, have even less transparency than MBS. But although there was not that much knowledge about these exotic financial instruments, investors understood AAA ratings, so they bought away. The AAA rating means sound, conservative investing instruments to potential investors. Hopefully, such ratings and insurance will be reformed along with reforms at Fannie, Freddie and other secondary mortgage market institutions. (The Wall Street Journal, 10/29/08)

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