An inverted Ponzi scheme?

The WSJ has a wonderful piece on a particular type of CDOs and how they concentrated the risk which is creating problems for the US economy. Remember the lesson of diversification? Well, if you follow their graphic, you'll see that these CDOs actually served to concentrate risk that was diversified in the Mortgage Backed Securities (which purchase individual mortgages and pools them into one instrument). You see, the CDOs would buy pieces of these securities that were all subject to similar default risks, thereby eliminating the advantage of diversification. Geniuses!

The reasons they were doing this was to generate transaction fees, and with the sorry state of the rating agency industry, information on the true nature of the risk was lacking. As these instruments were repackaged and resold, all based on the same underlying securities, you can start to see a analogy to a classic Ponzi scheme, where incoming investors pay the returns of existing investors, without any growth in the underlying security. Kinda like a bubble...

So the current crisis smells of a "reverse" Ponzi, where new investment instruments are created and sold based on existing instruments, all of which share the same underlying asset, and the same risk. The incoming instruments are paying for the returns of the previous instruments (not strictly though).

If it smells fishy, it probably is a big, rotten fish, or a big pile of shit!