There's the war in Iraq, there's bird flu, there's soaring oil prices, there's the trade deficit, the Federal deficit, bad emergency response in Santa Ana season... but I bet you never worried about collateralized debt obligations.
Neither did I until I read the above link.
Instead of these old-fashioned relatively straightforward leases, airlines these days rely on something called "enhanced equipment trust certificates." These are bonds, backed by pools of aircraft.
Any single bond issuance is divided into what are called tranches. Often, individual tranches come with different yields and different risk profiles. Specific investors can pick through the tranches to find one that matches their demand for yield and their tolerance for risk.
But the change from something as old-fashioned as a lease on an actual airplane to a derivative that represents a share of a pool of aircraft doesn't stop there. In the old days an investor like Disney was stuck with the risk of the investment it had just made. Today the investor in enhanced equipment trust certificates can sell part of that risk to another investor.
That's done with another derivative called a collateralized debt obligation, or CDO. The buyer of a CDO is buying insurance against Delta or any other debtor defaulting on its obligations. The seller of the CDO is hoping that the debtor will not default and that the seller will be able to pocket the price of the CDO.
And you can sell a CDO if your risk tolerance changes, then buy another to fit your current needs...
Once upon a time, this was a tiny market, with banks arranging these contracts for a large investor such as an insurance company. Now, banks ...create CDOs for a wide range of investors. And those investors then trade these CDOs with each other, as they're estimation or appetite for risk changes. Today there are $8.4 trillion (yes, that's trillion with a T) in credit derivative contracts outstanding. That's up from just $919 billion at the end of 2001.
[N]ote that this is a huge financial market -- and the market for credit derivatives is just one part of the much larger market for derivatives of all kinds. For reference, the entire U.S. money supply (measured by M3, the widest definition of money) at the end of August was $9.9 trillion. The size of the credit derivatives market as of end of June 2005 was $12.4 trillion, up 128% in a year, according to the International Swaps and Derivatives Association. It's no wonder that the Federal Reserve has less clout than it did when this derivative money supply was a mere $919 billion.
Now, for those who don't know M3 = all physical money like coins and currency, includes demand deposits,(checking accounts and NOW accounts), all time-related deposits, savings deposits, and non-institutional money-market funds as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets.
Now, in case you don't get it why this is a "Holy Shit!" waiting to happen:
The problem, of course, is that this system only works until it doesn't. Because derivative contracts are frequently bought and sold by the original purchaser, it's hard to tell who is now guaranteeing whom against loss.
It's not very efficient. It's relatively illiquid. And, if a few big borrowers (say, like an airline or two) defaults on their CDOs, it could have a cascade effect on the CDO market, sucking in capital from other markets, driving down the stock market, the bond market and creating one big fat financial apocalypse.
And evidently a significant portion of debt is traded this way.
And you never heard of CDOs before, didya?