Word: cdos
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...like other institutions, was making a mint dealing in derivatives tied to the U.S. real estate market. The boom was financed in part by collateralized debt obligations (CDOs), securities based on subprime mortgages that have come to define toxic asset. Companies that held CDOs could offset their risk by buying CDSs from AIG FP. Or they could simply speculate with the instrument. It all worked fine until overbuilding by housing firms and overleveraging by consumers caused the bubble to burst. Which in turn caused the value of CDOs to plunge. Which caused holders of CDSs on such securities to demand...
...these bonds that the government's aggregator bank will have to deal with first. In a November survey officers at the nation's largest banks said CDOs were among the assets they would most like to sell should the government begin buying troubled bonds...
...Even among CDOs, Strata is more complicated than most. Unlike other bonds, it is not based on loans, but on bets other loans will go bust. Strata and its ilk were called synthetics, and could make up as much as a third of $1.5 trillion in CDOs issued in the past five years...
...wait, there's more. Unlike other CDOs, Strata is a so-called single tranche CDO. Most CDOs own hundreds of millions of dollars of loans. Those loans are pooled together and then various bonds are sold based on the portfolio. But all the bonds are not the same. They are stacked based on risk. The highest tranche bond gets paid its dividends based on the first loan payments that come in the door. Bonds at the bottom of the stack get paid last, which means those investments are wiped out first if borrowers fail to pay back their loans. Those...
...what is Strata worth today? Certainly not the original $20 million it's investors paid for it. According to research firm Markit, the average CDO tied to mortgage bonds lost half its value last year. CDOs based on corporate bonds have performed better. However, Strata sold insurance against high-yield corporate bonds, and those will be the first corporate debts to go bad if the economy gets worse. Indeed, one of the companies in Strata's bond pool, Hawaii Telcom Communications, recently filed for bankruptcy. In mid-January, Moody's put Strata on its list of bonds it was thinking...