That’s a lot of money, even in the Fountain household.
The structure of the CDOs focused the bets not on subprime borrowers as a whole, but on the subsection of those borrowers most likely to default. That made the outcome binary: If those borrowers did OK, the bets were money; if not, investors lost everything. It’s as if our entire financial system went to the racetrack and put a big chunk of its money on a single horse.
What’s more, because most of the bets were dressed up as triple-A investments, the investors didn’t have to do what any gambler would have to do — prove they had the money (ie, capital) to pay up if they lost. That allowed them to make such large bets that the potential losses would leave them more than broke.
The result, as we now know, was losses far greater than the players could afford. In all, dealer banks including Goldman, Deutsche Bank, Citigroup, Merrill Lynch and UBS created some $132 billion in synthetic mezzanine ABS CDOs from 2004-2007, according to data from Citigroup. The value of those CDOs has fallen virtually to zero, so that’s also the best estimate of the losses they generated. It’s actually a conservative estimate, because the Citigroup data don’t capture some specially tailored private CDO deals.
More importantly, the losses were so sudden and so severe that they played a pivotal role in undermining the faith and confidence required for financial markets to function. Remember the days when Merrill Lynch couldn’t figure out how many billions of dollars it had lost, and AIG became a bailout case almost overnight. The loss of faith culminated in a global credit freeze so harsh that many companies couldn’t even do the run-of-the-mill borrowing they needed to maintain inventories and pay workers.
For What It's Worth 