I just did a little web research to find info about this hi-finance sort of stuff because I want to understand it, and finally settled on Wikipedia as a resource. FWIW, this is what I found:
Credit Default Swaps (CDS)
This started out as simple insurance for the holder of a loan or bond. Then, in 2000, the commodity rules were loosened. Now, anyone could buy a CDS on anything, not just the debt holder and the insurance seller. It became a way to bet on various companies, even other CDS’, sort of like the paramutual betting: anyone can place a bet. These are totally un-collateralized and unregulated, to the tune of $62T.
Collateralized Debt Obligation (CDO).
Investment banks (which no longer exist) and FNM and FRE (which also do not exist anymore, exactly), would consolidate sub-prime home mortgage loans. Slice and dice, shake ‘n bake, and out pops neat little slices of investments (CDO’s) that pay a little more % than ordinary commercial paper. They are given investment grades by the various rating agencies, and ordinary banks buy and sell them alongside stocks and bonds and Treasury paper. Problem: housing bubble bursts, and defaults increase dramatically. CDO’s plummet in market value; now, every financial institution holds CDO’s of uncertain value.
OK, So What Is The Connection?
Based on what I read, there may not be one: CDS and CDO are big problems, but connected only insofar as the same bank may hold both instruments. I know that some blame the current crisis on allowing LEH to fail, but I am not so sure: this would cause the CDS writers to make good on the CDS’ they sold, but CDO seems to be a different problem. OK, so if $1B (I am just making this up; do not know the real #) of LEH paper becomes worthless, and $10B of CDS were sold for LEH paper, the insurers would have to pony up $10B. How is this related to the failure of Mortgage Backed Securities (MBS) and ordinary people defaulting on their home loans?
The problem with CDO’s is that they are being treated differently by different banks: some have huge write downs based on the current market value of the CDO, others theorize that if they hold it to maturity, it will be worth full face value. So, no bank is totally sure what the exposure to CDO’s is by another bank, they become wary, and voila: no interbank lending. Who would have thunk that such an obscure financial transaction could cause a worldwide financial panic?
BTW: if you understand this any better than me, do not be shy: speak up!