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Europe’s Financial Alchemy

It is universally recognized that a key factor behind the financial crisis was the diffusion of collateralized debt obligations, which transformed lower-rated debt into highly rated debt. And now Europe has embraced this egregious financial alchemy, in the form of the European Financial Stability Facility.

CHICAGO – It is universally recognized that a key factor underlying the 2007-2008 financial crisis was the diffusion of collateralized debt obligations (CDOs), the infamous special-purpose vehicles that transformed lower-rated debt into highly rated debt. As these structures lost popularity on Wall Street, however, they gained popularity on the other side of the Atlantic.

After all, the European Financial Stability Facility (EFSF), created by the eurozone countries last May, is the largest CDO ever created. As with CDOs, the EFSF was marketed as a way to reduce risk. Unfortunately, the outcome could be similar: the entire banking system sent into a tailspin.

CDOs are a form of financial alchemy: special-purpose vehicles that buy the financial equivalent of lead (low-rated mortgaged-backed securities) and finance themselves mostly with the financial equivalent of gold (highly sought-after AAA bonds). This transformation is based on one sound principle and two shaky ones.

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