NPR logo Question: What Did Those Wisconsin Schools Buy?

Question: What Did Those Wisconsin Schools Buy?

Listener Aloke Prasad asks a good question about our project with the New York Times:

I saw Adam and Charles on the NewsHour with Jim Lehrer show.

They kept mentioning that the school district purchased "toxic" asset called CDO. I think they meant CDS (credit default swap) and not CDO (Collateralized debt obligation).

CDO is not a "type of insurance policy" etc etc. It is collected instruments of debt that has been sliced into tranches of different risk (and reward). Here is the Wiki entry:

"Collateralized debt obligations (CDOs) are an unregulated type of asset-backed security and structured credit product. CDOs are constructed from a portfolio of fixed-income assets. These assets are divided by the ratings firms that assess their value into different tranches: senior tranches (rated AAA), mezzanine tranches (AA to BB), and equity tranches (unrated). Losses are applied in reverse order of seniority and so junior tranches offer higher coupons (interest rates) to compensate for the added default risk."

CDS (Credit Default Swap) is what you guys meant (I think). Here is the Wiki entry:

"A credit default swap (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.[1] CDS contracts have been compared to insurance, because the buyer pays a premium, and in return receives a sum of money if a specified event occurs. However, this is a slightly misleading comparison because the buyer of a CDS does not need to own the underlying security; in fact the buyer does not even have to suffer a loss from the default event."

Please clarify.

The thing with CDOs is that each deal is hand crafted by some devilishly clever math whiz, so it's almost impossible to define these kinds of products with any one statement.

The Wisconsin School District bought a special thing called a synthetic CDO, which is a CDO made up of CDS.

It's really complicated, and I'm actually crashing to finish my part of our big story for Friday's All Things Considered, so I won't go into the whole thing.

A "normal" CDO is made up of lots of fixed-income securities, basically bonds. But, a Synthetic CDO is made up of CDS.

Confused?

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