Complexities of Debt and Securities Market I

With housing market crashing down, market is behaving quite cautiously. The effects of housing crash took two of Bear Sterns hedge funds to cleaners. Failures of these two respected hedge funds, which has more than $20 billion of investments, bares the inner world of extremely complex debt and securities market of Wall Street. I will try to shed some light on these intricacies.

Since last few years US housing market was going through housing boom. This was possible because loans were given to the people with bad or not-so-good credit history. These home loans are known as sub-prime lending. But institutions who loaned money to these people didn’t wanted to carry this risk entirely. So, they packaged those loans into bonds and sold them to investors further. Thus, if they are lending money with 10% interest rate, they packaged this loan into bond and sold them to the market by promising say 5% interest rates. Since 2000, more than $1.8 trillion of such bonds back by home loans are sold in the market. Now value of these bonds are affected adversely as number of defaulters or late payments are increasing. But the underlying concept behind this procedure is simply to spread the risk by repackaging and selling an already sold financial product.

The next step of this chain is to pool these bonds, that in derive their value from some other entity, into one product. They are known as Collateralized Debt Obligations (or CDO’s) So, some CDO’s contain less risky bonds and some contain high risk (and obviously high return ) bonds. But the funny thing is institutions and hedge funds that invest in these CDO try to further stretch the risk potential of their investments. So, for example, if a Hedge Fund decides to invest a grand in CDO’s, they will invest only 100 bucks of their own money and they will borrow rest from some other institution. Thus, it is clear if a particular set of CDO went down, it sends shivers through out the market. Because directly or indirectly lot of investors are involved in it.