No nation should know what goes into its laws, its sausages or its CDO's. Indeed, most of the time, the contents are of no interest to anyone. But once in a while, a little curiosity pays off. Here, we poke around in the innards of the mortgage derivatives market, just to see what we can find.

Collateralized Debt Obligations, CDO's, and Mortgage-Backed Securities, MBS's, are as much a mystery as andouille to the typical investor. But they might be of greater importance. For on top of these capital letters, associated swaps, synthetics and various elaborations delicately rests a derivative market of as much as $500 trillion in nominal value.

Readers who really want to know how these instruments work are advised to consult a financial engineer who knows what he is talking about. What we have learned about them is little more than hearsay and conjecture. Not admissible in court, it nevertheless tells a remarkable tale.

Down on the sultry bayous of Louisiana or out on the windy prairies of Nebraska, homeowners are feeling the pinch of a peaked-out housing market. Prices are falling. Sales are slow. And many householders have seen their adjustable rate mortgage payments ratcheted upwards massively. Local sheriffs are said to be working overtime, padlocking houses whose owners can no longer afford to pay for them. As foreclosures rise, so does the inventory of unsold, unloved, uncared-for houses. Occasionally, one is auctioned off on the courthouse steps. That is when Mr. Market speaks clearly…and when we find out what it is really worth - often, as little as 50 cents on the dollar.

America's subprime market includes approximately six million abodes mortgaged to nearly 100% of their value. When these houses begin to sell at big discounts, the whole mortgage industry - from the Bayou's Best Mortgage Deals to Wall Street's Enhanced Leverage CDO Funds - begins to stink.

Usually, a local mortgage lender gets rid of his mortgages as soon as he is able. He makes money by writing mortgages, not by holding them. So he sells them on and uses the proceeds to write more of them. The buyers of these mortgages, usually large investment banks, package them into mortgage-backed securities. These are divided into tranches, based on credit quality, and sold to other institutional investors as collateralized debt obligations. The best tranches are easily marketed to solid investors - pension and insurance funds, for example. Less credit-worthy parts - Wall Street's equivalent of double-wide trailers and paycheck lenders - pose a problem. They are not as safe, and not as easily swallowed by the financial industry. A little extra grease is needed to get them down.

Often, a big financial house will create its own hedge funds, specifically for the purpose of digesting risky tranches of mortgage debt. The hedge fund raises some capital…and then typically borrows additional money in order to leverage its returns. One of Bear Stearn's funds, for example - the High-Grade Structured Credit Strategies Enhanced Leverage Fund - borrowed nearly 20 times its investment capital, controlling $12 billion worth of mortgage assets with just $699 million in actual cash.

Anyone who would lend money to something called the High-Grade Structured Credit Strategies Enhanced Leverage Fund deserves the indigestion he gets. But given the huge size and ubiquitous grasp of the derivatives market, it could be that even the rest of us will soon get a taste of it. The whole worldwide boom depends on low lending rates. And lending rates are low because so many people are so eager to lend in so many different ways - with much of the lending stuffed in the derivatives market like corn down a goose's gullet. When Merrill Lynch lends to Bear's hedge funds, it enables the funds to buy Bear's portfolio of slippery mortgage loans, which permits Bear to buy more subprime loans from sweaty mortgage lenders, who in turn, now have more money to spread all over the levees and plains.

Each link in the food chain has its own delusions. Bear Stearns has merely brought them to light. When its Enhanced Leverage hedge fund lost 23% of its value from January to April of this year, creditors started eyeing the furniture, wondering what they could haul off and what they could get for it. Then, when they saw what houses were going for when they put them on the auction block, they panicked. Creditors, notably Merrill Lynch, wanted their money in the worst possible way, but it simply wasn't there. The Financial Times reported this week that when vulture funds began to bid on the Bear's holdings the highest bid was only five cents per dollar of face value. Meanwhile, investors in the funds were offering their positions at 11 cents on the dollar - with no takers.

"That is the big ugly secret of this market," said a hedge fund manager quoted in the FT, the market clearing price is far below the price people are willing to accept.

Whether you are a desperate homeowner…or a desperate hedge fund…when you are in a jam, the price of your assets usually goes down fast. At least with a house, potential buyers can drive by before the auction and see what they are getting. Every house has some value; buyers can even imagine living in them. The value of the High-Grade Structured Credit Strategies Enhanced Leverage portfolio, on the other hand, may be zero. You can list the ingredients in these wieners on the side of the package or report them on a 10-Q form, but what they were worth is anyone's guess. And Bear Stearns didn't want to guess at all. In an open auction, Wall Street would discover what they were really worth. But that is exactly what Wall Street doesn't want to know. At least, not now. Bear Stearns is not the only outfit with billions invested in these hot dogs. None of the big investment houses want to discover that their assets and their collateral are worth a lot less than they thought. So there will be no auction. The mess will be cleaned up in private. Mr. Market will have to hold his tongue.

Complex derivatives have been one of the biggest hits of 21st century finance. The math geniuses who create them probably won't get Oscars or their names on any public monuments, but they deserve some recognition. They didn't merely package gristly lumps of dodgy loans. Their great breakthrough was to separate the mortgage income stream from the risk of loss. A "credit default swap" - CDS - is, in effect, an insurance plan. Holders of CDO's can off-load their risk to a third party, paying a premium, just as though it were an insurance policy. So, with the risks supposedly controlled, the way was cleared to sell some of the foulest securities as if they were Treasury debt. Spreads narrowed, because the danger had been swapped out of the risky credits - at least, in theory.

Then, the quants at Goldman, Bear, and elsewhere, went a step further. They took the stream of insurance income itself - the swap payments - and created yet another derivative - a "synthetic CDO." Those are sold to hedge funds too. And now we have a whole alphabet of derivative sausages…all cross-insured, counter-partied, tranched and retranched…spliced and diced…and all desperately counting on some Cajun yahoo down on the bayou to pay more for his house than it is really worth.

What are all these mortgage-backed securities really worth? We don't know. We doubt anyone knows. The whiz kids on Wall Street have their formulae. But we want to hear what Mr. Market says when he finally gets to speak.


Regards,

Bill Bonner
The Daily Reckoning

Bill Bonner [send him mail] is the founder and president of Agora Publishing, one of the world's most successful consumer newsletter publishing companies, and the author of the free daily e-mail The Daily Reckoning. He is the author, with Addison Wiggin, of New York Times Business best sellers "Financial Reckoning Day: Surviving the Soft Depression of The 21st Century" and "Empire of Debt: The Rise Of An Epic Financial Crisis". Copyright © 2007 Bill Bonner