Insurance Law

.... Part 1 -- What Are These Things?

      Collateralized Debt Obligations and Credit Default Swaps belong to a group collectively labeled "toxic securities" in the media.  See "Merrill CDO Sale Not As Good As It Looks:  Analyst," a Reuters report published online at washingtonpost.com, Wed., July 30, 2008.  A more polite name that they go by is "structured finance revenue," meaning revenue from "structured products" like CDOs and other securities backed by mortgages on peoples' houses or commercial properties, "and credit derivatives."  Jonathan Stempel, Reuters report, "Moody's Profit Tumbles, To Be Sued By Connecticut" (washingtonpost.com, Wed., July 30, 2008).

     Perhaps a little more sharpness in definition will aid in understanding.  Perhaps not.  It is worth a try.  CDOs are securities.  They "repackage pools of bonds and loans and divide" the cash flow from these pools of bonds and loans "into notes of varying risk and returns that are sold to investors."  John Glover, "Merrill CDO Deal May Be Model, Bank of America Says (Update 1)" (Bloomberg.com Friday, August 1, 2008).

     CDOs "package pools of securities, including those backed by subprime mortgages, and slice them into pieces of varying risk."  Christine Richard & Jody Shenn, "Ambac to Pay $850 Million in Citigroup CDO Settlement (Update 7)" (Bloomberg.com, Friday, August 1, 2008).  More simply put, "CDOs repackage bonds, loans and credit-default swaps and use the income to pay investors."  John Glover, "Merrill Gives Up Gains, Is 'On Hook' For CDO Losses (Update 2)" (Bloomberg.com, Wed., July 30, 2008).  [Emphasis added.]  

     So, then, "Collateralized Debt Obligations" include "Credit Default Swaps," it appears.  CDSs have been defined by the same financial reporter as "contracts conceived to protect bondholders against default, [they] pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements."  John Glover July 30, 2008, supra.  CDSs, in addition, are defined by their use "to speculate on a company's ability to repay debt."  John Glover, August 1, 2008, supra.  See also Christine Richard & Jody Shenn, August 1, 2008, supra.

     If this is confusing, try wrapping your mind around what the media describes simply as "complex European products known as constant proportion debt obligations (CPDOs)".  Jonathan Stempel, July 30, 2008, supra. 

     There is no present need to venture into the world of CPDOs.  It is enough to recognize that reporters, through no fault of their own, do not appear to understand what Collateralized Debt Obligations and Credit Default Swaps are all about, how they function, what they actually do.  They function like Insurance.  Although it is the job of reporters to report to the public what these things are all about, it is not at all the fault of reporters that they do not understand financial vehicles backed by or involving packages of subprime mortgages.  People and particularly regulators were never supposed to understand that CDOs and CDSs are really Insurance.  They function just like Insurance, and they insure credit obligations every bit as much as regulated Credit Insurance.  They are called seemingly impenetrable names for a reason, which is that their makers do not wish them to be understood for what they are:  Insurance.

     The title of this post reflects that it is a Continuation.  In many posts in this space, see, e.g., the post here of July 10, 2008, the similarity between these seemingly mystical securities and Credit Insurance was found to be identical.  The disguise worn by these securities has so far deflected closer examination and prevented any kind of regulation.  The damage done by this deception is the subject of the next post in this series, Continuation Part 2, Devalue, Destory and Divest.

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