The problem starts here. There are so many of these tranched securities out in the marketplace - and on the balance sheets of banks, investment banks, insurance companies, hedge funds and all manner of other unsuspecting investment entities worldwide - that when subprime borrowers began to default, it wasn’t long before the lower-tier tranches ran out of money to pay the so-called 1st- and 2nd-tier “AAA”-rated securities. The problem escalated quickly and almost all of these securities were downgraded. That’s not a surprise. Nor is it the whole story, for it leaves a key question unanswered.

What happened to the lowest-level tranches?

Those tranches were “ugly” to begin with because I started by pooling subprime mortgages (the high-risk borrowers). Then I made them “toxic” by “stripping out” their cash flow to support other tranches. This toxic waste was so bad, no one would ever rate it and only greedy hedge funds or crazy speculators would buy it for its high yield. Or, maybe, I think so much of my creation that I’ll keep this piece for myself, or maybe I’ll have to because no investor will ever buy it.

This kind of stuff is out there. There’s a lot of it. And only an act of God will bring these securities back from the depths where they now reside.

With their collateralized premise and structured nature, CDOs are very difficult to value - especially since no one trusts anyone else’s “internal valuation model.” Since everyone is afraid of these securities because no one really knows what they’re actually worth, no one wants to buy them.

However, when an institution - such as a Merrill Lynch (NYSE:MER) - gets desperate enough to sell a portfolio of these securities at 22 cents on the dollar, then everyone else who has to “mark-to-market” their assets now has to value similar securities of their own at 22 cents on the dollar. That causes massive write-downs at banks, investment banks, insurance companies, and other financial institutions. And these companies write down assets and watch their losses escalate, they are forced to raise additional capital to meet regulatory requirements.

CDS - Controlled Dangerous (Financial) Substances

It’s a vicious cycle - one that’s eroding our faith in our banks, and worse, banks’ faith in other banks. As a result, banks have ceased lending to each other out of the fear that the next round of write-downs and losses may imperil some of the trading partner banks that they used to lend billions of dollars to every night.

Not anymore.

It would be bad enough if that were the only problem facing the securities market. On top of these overly engineered structured securities I’ve just discussed, we also have credit default swaps with an estimated notional value of $62 trillion out in the marketplace. A credit default swap (CDS) is a financial derivative that’s akin to an insurance policy that a debt holder can use to hedge against the default by a debtor corporation, or a sovereign entity. But a CDS can also be used to speculate.

In Part II of our investigation, which ran Monday, I explained how problematic credit default swap pricing is and how the indexes against which the value of these swaps are determined are tradable themselves as speculative instruments and how the whole complex is driving the financial system into an abyss. That’s essentially what led to the collapse of the otherwise healthy insurance giant, AIG (NYSE:AIG). [For the latest news on AIG, check out this related story elsewhere in today’s issue of Money Morning.]

Unfortunately, I don’t see the U.S. Treasury Department’s much-needed rescue plan being effective without actually addressing the problems facing both the CDO and the CDS markets. The Treasury Department’s initiative will create more problems than they attempt to solve and will eventually saddle taxpayers with so much debt that they risk sinking the dollar, and worse, the U.S. government’s investment grade rating. That would be calamitous. [For the latest news on the federal government’s banking-system bailout plan, check out this related story elsewhere in today’s issue of Money Morning.]

Source: How Complex Securities, Wall Street Protectionism and Myopic Regulation Caused a Near-Meltdown of the U.S. Banking System

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