CDS and CDO's, TOOLS OF DECEPTION IN FINANCIAL MELT DOWN, Still Used By Wall Street
With Goldman Sachs in the headlines it is obvious that Wall Street was involved in non transparent, "gambles", using complicated instruments which tried to "legitimize" dangerous hedges and gambles, to the detriment of investors around the world.
CDS's and CDO's were the instruments of choice, and so difficult to understand that only a few really knew that these instruments were really paper, that tried to disguise the risk. These instruments, in many cases were not worth the paper that they were written on.
DEFINITIONS:
A credit default swap (CDS) is a swap contract in which the protection buyer of the CDS makes a series of payments to the protection seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) goes into default.
Collateralized debt obligations (CDOs) are a type of structuredasset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.
A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the 2007-2008 credit crunch, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs.
Many CDOs are valued on a mark to market basis and thus have experienced substantial write-downs on the balance sheet as their market value has collapsed.
What appears to be happening is that companies were using CDS's and CDO's to try to make loan portfolio's look more secure than they were, and that some were cherry picking the good assets out of CDO's and then selling the bad assets to other investors, while hedging. If the Wall Street Company was smart, it made money if the investment performed well. But, they also made money if it failed. The true quality and value of investments were "papered" with the use of CDS's and CDO's to look better than they really were.