Word: cdos
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Dates: during 2007-2007
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...last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies such as Standard & Poor's and Fitch Ratings wave their magic wand over these top tranches and declare them to be a golden AAA rated. Top shelf. If you want to own AAA debt, CDOs have been about the only place to go; hardly any corporation can muster the credit worthiness to garner an AAA rating anymore. Here's where the potion gets its poison potential. Some individual parts of CDOs are about as base as bonds can be - some are not even investment grade...
...problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds. After all, the last few stress-free years have not exactly provided much of a testing ground for what can go wrong - until, that is, subprime mortgages started their death march. Suddenly, investors realized things can actually head south in a big way, even stuff completely unrelated to CDOs. Like your stocks...
...fund, it gets a margin call and has to sell assets to reduce its exposure. Naturally, as it sells, prices drop. The falling prices mean a further decline in the fund's collateral, forcing yet more selling. And so goes the downward cycle. Hedge funds that hold the toxic CDOs can easily undermine those that don't. It can be difficult to sell the stuff that's causing the problem; those markets are beyond redemption. So if you can't sell what you want to sell, you sell what you can sell. The fund looks at its other holdings, focusing...
...obligation, or CDO. The recipe: buy home loans, blend them, then slice up the result into different securities (reflecting different levels of risk) to sell to investors. Many such securities carry AAA or "investment grade" ratings despite subprime mortgages being in the mix. From there, things get really complex--CDOs created from other CDOs, synthetic CDOs crafted from credit-default swaps, none of which had experienced a down market. "The problem is that CDOs were untested. There was not much history to suggest CDOs would behave the same way as AAA corporate bonds," says Richard Bookstaber, a hedge-fund manager...
...that the foundation is shaking, there are scant buyers for the lower-grade issues built on top of the pooled mortgages, and the values of those CDOs have plummeted. Losses in the subprime market drove Bear Stearns to declare two of its hedge funds, once topping $1.5 billion, all but worthless, and banks as far afield as Germany and France have frozen funds or received bailouts because of exposure to U.S. mortgages...