I’m not a securities guy, but CDOs are not insured to my knowledge in any way.

Forgive me for a somewhat pedestrian stab at explaining my understanding of what is going on, but here goes:

A bank (and hedge funds) makes money by borrowing money and turning around and investing it in hopes of a higher return than they borrowed it at. Interest rates have been so low, that the mortgage CDOs offered a little boost over the standard rates of return on safer investments. Perhaps an important sidenote I have been reading about is the fact that a lot of these investments were rated higher than they should have been. So some CDOs that were rated in the A’s weren’t really all that safe.

So the bank borrowed short term at low rates from conservative investors looking for a quick place to park cash and turn around and used the money to buy POS CDOs and get rich. Then…

from today’s WSJ:

“short term borrowings had to be renewed frequently. And when investors realized that their collateral for the borrowings included U.S. subprime mortgages, they shut off the spigot”

So what is happening is that the people with cash to loan to their banks (and banks to the hedge funds) right now HAVE NO IDEA what has been done with their money. For all they know, it’s ALL invested in subprime crap. So they are “shutting off the spigot”. It’s a credit crunch. Money is there. Just nobody wants to lend it because they think something stupid might be done with it.

A simplified example: If I thought there was a chance that my Credit Union had been taking my 2.5% savings account money and used it to buy POS CDOs, I’d pull it out until I knew they had their act together again. If I don’t know what they did with it, right now I’m going to play it safe and pull it anyway (that’s the fear factor).

I’m just using my credit union and and my own little savings account as a highly simplified example but this all plays out at the institutional level and these people are dealing with sums well beyond discussion of any insurance.

So until it all gets sorted out and everybody is satisfied that all of the holders of these POS CDOs have been identified, it affects everybody, not just the mortgage market. They are afraid the person they have been loaning money to won’t be able to pay them back. Also, there seems to be an entire reevaluation of risk at all levels now as well. If some of the crappy mortgage securities are turning out to be not as safe as they were rated to be, what could be hiding in non-mortgage related securities too? This is all going to take a long time to sort out.

Front page story on the Wall Street Journal today about the little German bank that just got bailed out is a good soup-to-nuts story of how things go wrong.