You have probably heard of a handful of smart investors who have made a fortune during this mortgage meltdown. You are wondering how they have done it. Is it legal what they did? Achieving rapid wealth on the backs of those who have lost their homes sounds kind of fishy. But just like anything in life, it is based on the zero sum game stock market theory: For every winner, there has to be a loser. What I am about to describe to you is no different than the investment strategy of how smart investors made money when the stock market crashed.
What Is Collaborative Debt Obligation And How Is It Different From Stocks From An Investment Point Of View?
Collaborative Debt obligations also known as CDOs are risky debt instruments (or loans) that have been bundled together with other credit worthy loans in order for them to be attractive to the investors who buy them. The reason why they have been bundled together is due to the merit of credit worthiness. Individually, these types of risky loans would not sell. That is why they are packaged together with other high quality loans to make them more attractive.
Big Mistake: Credit Rating Agencies Were Giving Collaborative Debt Obligations Triple A Ratings They Did Not Deserve
The role of credit rating agencies is to rate debt instruments (or loans) based on their ability to meet their payment obligations. The higher the rating, the safer these loans were. The big mistake they made was in their role of wrongfully giving a sub prime mortgage loan an triple A rating.
Investment Banks Were Qualifying People For Loans Who Could Not Afford Them
The Investment banks who made these loans (also known as sub prime lending) were largely responsible for the mortgage crisis that resulted in millions of Americans losing their homes. After making these loans to people who did not qualify, they repackaged them with other credit worthy loans and resold them off in different chunks to high risk investors who were looking for a better return on their investment. And these were investors who were not happy with the yield in a typical first grade government bond.
So in essence, these Investment banks were fraudulently hiding this risky sub prime mortgage debt inside what they called Collaborative Debt Obligations by transferring their risk over to other investors. The investors buying into them were not aware of the sub prime components of the debt they were about to hold. Why do they care anyway? All they were interested in higher yields.
This led to a higher demand by investors for these types of instruments. Under pressure, the Investment banks continue to loan more money to unqualified borrowers in order to meet the needs of investors who were hungry for collaborative debt obligations. This spiraled out of control to the point where interest rates began to rise sharply, resulting in massive numbers of homeowners defaulting on their mortgage debt obligations. Investors who bought into these collaborative debt obligations lost a lot of money in the process.
Who Actually Got Rich From This Sub prime Mortgage Mess?
The smart investors who bought what is known as Credit Default Swaps made a fortune on falling home prices that fell below the value of their mortgage (also known as underwater mortgages). The best way to describe it is like stock market investors who make money betting that stocks are going to fall via the purchase of put options. Put options are like insurance policies against drastic decline in the value of stocks.
Why Investors Of Collaborative Debt Obligations Did Not Buy Credit Default Swaps To Protect Their Investments?
Actually many of them did not know that they existed in the first place. Even if they did, there was still another underlying problem. Credit default swaps were not regulated like insurance companies, and were not subject to the requirements of keeping cash reserves on hand to pay off the insured parties in the event of a default. So buying them were risky because there was no guarantee that you would cash out on them. Many investors ended up holding onto underwater mortgages that were worthless.
Nevertheless, there were a still a handful of high risk speculators who invested their money in Credit Default Swaps solely for get rich quick purposes. As evil as it may sound, these speculators were betting that people were going to default on their mortgage loans and made a fortune when their predictions became a reality.
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