Today's WSJ: Insurance Deals Spread Pain of U.S. Defaults World-Wide

To better understand how investors found themselves in their predicament, it helps to take a look at a synthetic CDO called Torquay — named after a small town in Australia’s Victoria state, famed for its surfing. Torquay was born during the credit boom in 2006.

Torquay belongs to the most popular type of synthetic CDO, known as a mezzanine deal. Morgan Stanley estimates as much as $400 billion in mezzanine securities are outstanding. Bankers engineered them to provide the highest possible return while still garnering gold-standard credit ratings. But one feature made them a lot riskier than a similar portfolio of corporate bonds: If losses to defaults rose above a certain threshold — typically between 3% and 6% of the underlying pool of debt — investors would lose all their money.

An arm of J.P. Morgan Chase & Co. won a mandate from an Australian bank called Grange Securities to put together Torquay. J.P. Morgan pioneered the use of credit derivatives in the early 1990s. People close to the bank say J.P. Morgan had revenues of $400 million to $500 million from synthetic CDOs in 2006.

J.P. Morgan and other investment banks typically paired with local financial institutions to market synthetic CDOs in Australia, where small investors such as the town of Parkes make up a large part of the market.

The mind boggles. A town in Australia bought a higher yielding instrument with their money, which, if certain conditions were met, would result in them losing all their money. The collateral damage of these pernicious CDO’s and CDS’s continues apace worldwide. Read it all–KSH.