CDO and CMO problems: a simple explanation

CDO's and CMO's are in essence nothing more than loans; there's complicated paperwork involved, but at the core there is what I'll call the primary lender and a borrower. Well, the problem these days is that the primary lenders borrowed money to make loans to the end borrowers. The lenders had to put some of their own money in, but most of the cash came from funds borrowed from what I'll call secondary lenders. So far, not all that different from how your neighborhood bank operates. However, these primary loans don't just sit on the primary lenders' books; they trade in similar fashion to stocks and regular bonds. So the value of the loan can go up and down.

Well, the value of a lot of these loans have gone down(because end borrowers are defaulting). The money that the primary lenders borrowed from the secondary lenders to make the primary loans is now a greater amount than the value of the primary loans, whereas when the primary loan was first made it was the same dollar value as the secondary loan.

If the primary loan defaults, then the primary lender doesn't have enough cash to pay back the secondary lender. Then the primary lender has two choices: cough up their own cash, or default themselves. If the primary lender wants to stay in business, they've got to find another secondary lender, or get the first secondary lender to essentially refinance them. If the first secondary lender doesn't think the primary lender is willing or able to come up with the cash and that the primary loans have actually defaulted, they take the collateral (which is the primary loans that were made) away from the primary lender and absorb a loss of the difference between what they loaned to the primary lender and what the end borrower can actually pay back. The primary lender, of course, loses all of its cash that it put into the primary loans.

So in the end, all of the hoo-ha in the financial press is nothing more than a debate about who is going to end up eating the cash losses.

There are deeper issues regarding whether the borrowers and lenders at every level were honest about their financial condition and creditworthiness, and also about self-dealing and graft in the whole process; but those are entirely different matters.