One part of the financial crisis is collateralized debt obligations (CDO's). Another is credit default swaps (CDS's). Suppose Seat of the Pants (PANTS) investment company officers cook up a CDO in which they have assembled $100M in mortgage backed bonds (MBS.) The MBS's had an average credit rating of "B+." Who knows what their real rating should have been, since the issuers paid the rating services to rate them. Pants then uses them as collateral to issue a CDO with 5 tranches, the top being $243M of bonds which they have paid to get rated "AAA." Lower tranches with higher interest rates rank all the way down to $2m in unrated equity. PANTS sold the $243M in bonds to Greater Fool (GRTFUL). GRTFUL eventually got antsy about getting its payments from PANTS' CDO and took out a credit default swap from insurer JERK-U- ROUND (JRKURN). Now PANTS can't pay GRTFUL, nor can GRTFUL collect from undercapitalized JRKURN.
One of the most fundamental principles of contract law is that there must be a meeting of the minds for there to be a genuine contract. But all that really existed was a an IBG - YBG agreement among the individual financial geniuses acting as officers of these companies. "IBG - YBG" is an understanding among the individuals that each of us will earn fees off this grossly over-leveraged "deal," and if, in the fullness of time, it collapses, "I'll be gone and You'll be Gone." So, let's say GRTFUL sues JRKURN. Could not a judge untie the CDS string, at least, by ruling that there was no meeting of minds between GRTFUL and JRKURN. The CDS is nullified. Rather it was, if not fraud or misrepresentation, a mutual mistake? JRKURN must pay back the insurance premiums and both parties must make accounting entries to properly write off fake "values" allegedly represented by the CDS agreement.
I'd rather see this than give - what's it up to now? - the bailout of AIG - $123 Billion?
