On The Collapse of CDOs and ABCPs

According to Satyajit Das, a leading expert in credit derivatives and risk management, up to 53% of the global $2.2. trillion commercial paper is now asset-backed, with about 50% of that in mortgages. Earlier this year, the total value of these derivatives of these was about $485 trillion (with a "T"). To keep things in perspective, the total world GDP is about $65 trillion. How is this possible? What will happen when the value of the original housing that was used as collateral drops?

While many years ago banks used to have sufficient funds to cover the loans they made, such as for mortgages, today, banks repackage these loans, as well as credit lines, credit-card balances, and whatever else they "own", as CDOs, collaterized debt obligations. Banks then sell these loans, and the proceeds can then be used as collateral to buy more loans or sell more mortgages.

Pension funds, hedge funds, and Insurance companies bought these CDOs, so that they could generate higher rates if return. These are global entities from all over the world; they borrowed money at ridiculously low rates in Japan and the US (when rates were at 1%) . So, those american subprime loans, who were sold to people who could not afford to buy houses in the first place, ended up in every corner of the planet.

Therefore, in essence borrowed funds bought more borrowed funds. To those tech-oriented, this is like a positive feedback system, one that is self-powered and keeps increasing. A brilliant scheme, where 1 dollar of real stuff is the actual collateral for about $20 or $30 of loans, but what happens when the original mortgage borrowers start to default on their loans? The entire scheme starts to unravel.

Mr. Das is the author of a number of works on derivatives and risk management, and maintains a blog.