It’s time that you and I had a little talk, my dear reader, about a subject your Mom and Dad never really explained that well. It’s gotten to a point where it is affecting your daily life, and you probably don’t even know why.

They didn’t cover it well in school, either, and if they had it likely would have just been one of those things you make jokes about later in the locker room.

That’s right…it’s time we discussed bond insurance, collateralized debt obligations…and how all of this is hitting you right in the wallet—and some comments about what’s coming next.

In other words, complicated economics, simply explained.

First things first: how does all this stuff affect your daily life?

For starters, these topics are the source of a lot of the bad economic news you’re hearing these days. If the value of your house is going down while your payments are going up…or your neighbor’s house is being foreclosed upon…or if India’s Tata Chemical Co. just bought the soda ash plant where you work…it’s already affecting your daily life.

If you invest (and that includes those of you with 401-Ks who might hope to retire someday) and you’ve been watching the Dow Jones Industrial Average (or your stock’s prices) slide downward this could be an even bigger part of your life than it is today—but as I said, I’ll explain about that before we’re done.

Trying to borrow money? This is a huge part of your life--so pay attention, and I’ll do my part to make it worth your while.

Are you an American who buys imported goods (don’t we all?), is thinking about a European vacation, or one who likes to hop over the Ambassador Bridge and spend a Saturday night out in Windsor? Notice how all those things are suddenly more expensive? This story affects you, too.

So exactly what is it we’re talking about?

All kinds of entities in “the market” have been investing in what are called “Collateralized Debt Obligations” (or other variations on a similar theme). The name seems quite esoteric, but actually it’s rather easy to understand, once it’s explained.

The way this works is you and I go out (along with thousands of our closest friends) and borrow money from our “friendly local bank” in the form of mortgages or equity loans. Our “friendly local bank” is limited in how much money they can lend—but if they can “sell” these loans to another investor they can use that money to make more loans…which means more “loan servicing” fees for the bank, and more interest money, over the long term, for all the investors.

Instead of selling one loan at a time, the loans are grouped together into “packages” of loans worth millions of dollars (the “Debt Obligation” part of the name of these “investment products”). Everyone who lends money loves collateral, and of course you can always foreclose on a house if the owner quits paying, which is where the “Collateralized” part of the name comes from.

And thus we have “Collateralized Debt Obligations”…also known as CDOs.
Make more sense now?
Good.
Let’s forge ahead.

So who might these other investors be? For starters, names that you’ve probably been hearing in the news, such as Merrill Lynch, UBS, and Citigroup. Other countries have been putting their nation’s money to work in these investments as well—and when national treasuries invest, they usually establish what’s known as a “Sovereign Wealth Fund” (simple translation: China’s money, or Dubai’s money, or…well, you get the idea)—and China, who really needs the money at the moment, has been very active in this market.

Now if you’ve been thinking about all this you might be saying to yourself: “Self, how can people in Dubai invest in the loans we took out at the bank if they have no way of knowing which loans will get paid, and which borrowers are going to be unable to repay?”

Well, that’s where “bond insurance” comes in.

There are companies in the market (AMBAC and MBIA are the two largest players) who, for a fee, will “rate” the quality of the borrowers behind the CDO that our friendly bank is attempting to sell to an investor. Some CDOs are sent to market by banks who only lend to the most carefully-screened borrowers…and from those banks we see the “AAA” rated CDOs. Because the risk of them failing to pay is low, they pay lower interest rates (after all, risk equals reward…).

On the other hand, some of our friends and neighbors have those “adjustable-rate loans”, and there are questions as to whether they’ll be able to keep up the payments. These “subprime” borrowers (and, eventually, the CDOs their loans represent) are more risky…but they pay much higher interest rates, especially after their “teaser” rates expire—and that’s obviously more appealing to investors, if some way can be found to limit the risk.

A solution was found: AMBAC and MBIA would essentially “insure” the continued stream of income from these CDOs for a fee that would be based on the risk of repayment, as they saw it—which would theoretically make “subprime” CDOs just as safe for investors as “AAA” CDOs…only with much higher interest being paid by the borrowers to the “subprime” investors.

Low risk, big reward...it was financial genius.

And for three years or so, every time you flipped on the TV you saw ads for loans from the Countrywides and the Ditechs of the world. Washington Mutual became one of America’s largest lenders on the strength of this market.

Investors and lenders/servicers made billions in fees and interest payments with a steady stream of income ahead for as far as the eye could see—as long as the borrowers kept up the payments. Mortgage lending became a much bigger business than it had been the decade before…investing in real estate became the fast way to make a buck…and homebuilders went nutty building on any piece of land they could buy or borrow. Brokerage firms could afford to give their most valued staff the kind of bonuses that make $1000 suits too cheap to wear to work.

Condos in Florida became the investment everyone wanted to have.

But have you seen the Florida real estate market lately?

That rhetorical question is actually not a bad description of what’s happened to lots of those investors: a huge run of lending to pretty much anyone, lots of those folks can’t make their payments, and there’s so much surplus real estate out there that foreclosure isn’t resolving the investor’s problems (if you can’t sell the foreclosed property it becomes an expense as you pay some third party to maintain the place until you can…and try to imagine what happens if you own an entire condo building that’s sitting vacant—as lots of investors do).

To make matters worse, the current “glut” of real estate has depressed the value of homes and land across the country…meaning you might owe more on a property than it’s current value. (As an example, new condos in San Diego are worth much less than they were 18 months ago.)

If all that wasn’t enough, those who took out “Adjustable Rate Mortgages” (ARMs) over the past couple of years are now seeing their interest rates “adjust”—and guess what? When they adjust, the payments are not going down…they’re going up. Meaning more and more borrowers can’t pay on loans that are supposed to be long-term “safe” income streams.

Now here’s where it gets ugly for some of the players.

If you are a lender who has sold loans you become the “servicer” of those loans. That means you collect the money from the borrowers, and then pass that money to the investors…minus your fees for the service, of course. But you take a risk: as part of the “service”, if a borrower should fail to make payments, you are on the hook to keep sending money to the investor for that loan until it’s classified as “nonperforming”…which might take a few months. If many thousands-or millions-of borrowers are not paying their loans, you’ll be in big trouble—and that’s why Countrywide is in the process of being acquired by Bank of America.

Ditech is a part of the GMAC Finance operation, meaning GMAC has to cover those losses for them…and Washington Mutual, according to some observers, is today “circling the drain”; with Chase or Wells Fargo mentioned as potential acquirers.

But what if you’re one of those “insurers”? Once these loans go “nonperforming”, the potential exists for the investors who own literally trillions of dollars worth of loans to seek restitution for their lost streams of interest income—which will immediately bankrupt the insurers. If that occurs, this type of business, as we know it today, would presumably come to an end, as there would be no way to create the same low risk, high return environment investors found so attractive.

Presumably this would also remove millions of potential homeowners from the market, further lowering the demand for all that surplus real estate, and potentially bankrupting America’s homebuilders.

Of course, all these investors now have to begin the process of trying to figure out what they actually own…and how much less the true value of their investments are than what they wanted to believe. And since they are not yet sure which loans will fail…there’s no way to determine the true value of those investments. A classic Catch-22.

And that’s why you’re hearing unfamiliar terms on the news like “writeoff” and “mark to market” and “Sovereign Wealth Fund”. Investors are having to admit they have billions of dollars less in these investments than they originally thought (Citigroup has already written down over $20 billion); and some banks and brokers are being forced to turn to outside sources for capital just so they can stay in business.

It’s also part of the reason the dollar is less valuable in the eyes of the rest of the world…meaning everything we buy from another country with dollars is made more expensive—things like clothes, and cars, and HDTVs, and iPods…and oil.

That’s a reasonably good recap of what’s happened so far.

However, I also promised you a glimpse of the future.
So here we go.

Most of the borrowers who took out these ARMs will see a “reset” of their interest rates 24 months after taking out their loans…and if they can’t make the new payments, the problem will become quickly evident.

There have been far fewer loans of this type written the past 18 months, which means in about 6 months most players in the market will begin to actually know just how bad their problems really are.

There are efforts to create a “bailout” for the bond insurers; but the concept there seems to be either that the investors will cover their own losses; which, from my limited perspective, seems a pointless exercise—unless some new source of investment capital can be found; or alternatively, that this function be made into a “quasi-public” corporation, not unlike Fannie Mae is today in the mortgage market.

An additional “bailout” is being considered for borrowers. Such a plan might involve not raising interest rates for some period of time on perceived risky ARMs, in order to keep the borrowers in their homes. Others have proposed a moratorium on foreclosures—but that may just be delaying the problem, not a solution.

The bottom lines of both plans seem to be that investors are going to eat some losses, either in equity or income stream—or both…and unless some lenders and investors are exceptionally patient, large numbers of borrowers are likely to lose their homes, suggesting real estate valuations will remain depressed for a few years to come—particularly in places like Las Vegas, Phoenix, Southern California…and most especially Florida, where, for a while, the run of building was most amazing indeed.

There’s an additional element to all of this that is just now becoming known.

In addition to the investors I’ve previously mentioned, we are now discovering that lots of other institutions we would never associate with the financial sector have been dipping their toes into this water; and we are now being told that states and municipalities, colleges and corporations, and various entities of all sorts have been using these investments as a way to earn money from idle cash that would otherwise have been in a Treasury bond at 3% or so.

As a result, you can expect over the next few months to hear a thousand stories about the discovery that someone or another you hadn’t thought could have will have lost money in the “subprime” market.

Having said all that, I’m here to tell you that this element of the problem is likely less of a news event-even though the effects will be more widely spread-than the problems we already are aware of in the financial sector. Why? Because the financial sector player’s losses are deep (billions of dollars each for several of those players, presumably with new discoveries through at least midyear); while this newer group of losses will likely be “shallow”—that is, lots of involved entities each losing relatively small amounts...and relatively few of them in need of “cash infusions” or bailouts to remain in business.

And now it’s time to get to the big summation:

An investment vehicle known as a CDO (and others like it) allowed banks to “sell” mortgages and other debt to a whole new pool of investors…which created a whole new pool of home buyers…which created a building boom…which led to more borrowing to cash in on that new equity…which made a ton of money for a ton of people…until the party abruptly came to an end, taking a ton of people down with it.

As a result, the Dow Jones Average is up one day, down two, banks and brokers are sweating bullets, someone in Dubai will eventually own a Florida condo complex no one wants to buy at current prices, and as many as 2,000,000 families might lose their homes.

The extent of the problem is not yet fully known, but things will be clearer by midyear; and as bad as things are now, there’s a decent chance by year’s end we’ll be getting to the other side of a great big mess.

The unexpected bonus?
Now you’re ready to talk about this stuff as if it actually makes sense.

And who saw that coming?