How Do Collateralized Debt Obligations (CDOs) Work?

With recent fraud charges being brought by the SEC against Goldman Sachs as to its structuring and marketing of collateralized debt obligations (CDOs) the exotic and toxic investment instruments that were financially engineered by Goldman Sachs and other Wall Street firms are back in the news. Yet few investors outside of financial market specialists fully understand just what a collateralized debt obligation financial instrument is and how the collapse of the real estate housing market could bring such financial grief to the world investment community.

Finally, a video has been created that explains in simple terms how a CEO is structured and managed and why they were and are still financial instruments of mass destruction.

The insanity of the Wall Street financial engineers is clearly shown as so-called synthetic CDOs were created by assembling portions of previously created CDOs into new CDOs which contained the most risky segments of the existing financial instruments. These highly risky investments, which apparently in some cases were actually structured to fail, were then sold to unsuspecting investors in every corner of the globe by an army of Wall Street salesman. The Wall Street investment banks and brokerage firms, such as Goldman Sachs and Merrill Lynch, generated hundreds of millions of dollars in commissions from marketing these toxic financial instruments.

However, some of the clever Wall Street favored hedge funds, such as Paulson and Co., that were at least partially responsible for the structuring of the CDO’s, made billions of dollars as the housing market collapsed in 2007 and 2008 and the mortgages providing interest payments to the CDOs went into default. As the video clearly shows once the stream of income from the underlying mortgages was reduced, or in extreme cases stopped altogether, the value of the CDOs plummeted, even reaching zero.

How could this be? How could a hedge fund that owned part of a CDO that lost most if not all of its value stand to make massive profits as the CDO collapsed? The answer lies in the hedge funds ability to purchase credit default swaps from poorly managed firms such as AIG, that depended upon CDO ratings of risk issued by rating firms like Standard & Poors rather than completing its own due diligence. The credit default swaps work much like an insurance policy. The hedge fund use the credit default swaps to insure against losses that might occur from a loss of value by the CDO.

As an example, let’s say that the hedge fund took an equity position of $50 million in a $1 billion CDO. Should the value plunge to zero the hedge fund would lose the $50 million. However, depending upon the amount of the credit default swap purchased and upon how quickly the CDO lost value the hedge fund might make hundreds of millions of dollars from the transaction as it could purchase protection on the entire CDO, not just the $50 million portion that it had purchased. Therefore, it was highly profitable to participating hedge funds and Wall Street investment banks, which also purchased credit default swaps, when the highly risky structured to fail CDO’s completely blew up.

The current SEC charges against Goldman Sachs barely expose the tip of the CDO iceberg. Trillions of dollars of collateralized debt obligations and credit default swaps were engineered by Wall Street. The practice of marketing CDO financial instruments to investors who, even though they may be sophisticated, didn’t understand the investments, perhaps because they relied far too much upon the reputation of Goldman Sachs and other Wall Street firms to protect their investors against abuse, was wide spread and earned billions of dollars in commissions for the Wall Street firms.

The CDO cancer quickly spread throughout the Wall Street community. The probability of making out sized profits was just too great for top Wall Street executives to resist. Wall Street has always engaged in corrupt, immoral, and completely selfish behavior. Greed is a powerful emotion and has not been washed away by the financial meltdown of 2007 and 2008. With housing foreclosures expected to reach record rates in 2010 we will more than likely hear far more about collateralized debt obligations and credit default swaps during 2010. It is highly unlikely that any of the news will be pleasant.

It will be interesting to see just how serious the SEC is in its fraud charges against Goldman Sachs. No doubt Goldman Sachs top executives will engage in a “we didn’t know” and “a few bad apples” defense. Certainly, they will push back with all of the firepower that politically well connected wealthy executives who are also major political campaign contributors can muster. There is a real possibility that at the end of what is likely to be a drawn out investigation Goldman Sachs will receive little more than a slap on the wrist.

In my opinion, in recent years Goldman Sachs and other Wall Street firms have degraded to being little more than criminal organizations. They seem to think that it is quite okay to plunder and pillage the very investors they are supposed to serve. Unfortunately, at times it appears that the cooperation between the United States government and the Wall Street firms is so close and orchestrated that the entire relationship is designed to fleece investors wherever they may reside as well as the American taxpayer.

So how do collateralized debt obligations work? Technicalities aside they have worked to transfer trillions of dollars from investors around the world, including huge amounts of funds from pension funds and retirement accounts, to Wall Street bankers and to hedge funds that bet that the investments would fail. The SEC fraud charges against Goldman Sachs will be a test as to just how cozy the relationship is between the Wall Street fraudsters and the United States government.

In the much smaller in scale Enron and WorldCom scandals of a few years ago the top executives were given prison terms. If the SEC and government are really serious about curbing fraud and financial abuse the top executives at Goldman Sachs and other Wall Street firms will eventually be given free room and board at a federal prison. Not that that will recover funds lost by investors but it might make them feel a tad better about their losses.