Author Archives: Steve

Swing Trading

Buy-and-hold has not been as successful as it used to be. Is swing trading a better way of making money? It is certainly possible to make money with swing trading, even if the market is moving sideways. But before you get started, you must know that successful swing trading requires a lot of discipline and experience.

It is important to understand one significant difference between swing traders and buy-and-hold investors. Swing trading is typically based on technical analysis while buy-and-hold investors rely mainly on fundamental analysis. A swing trader tries to take advantage of the short-term price movements, both upwards and downwards movements. This means that swing traders generally hold a position for just a few days up to a couple of weeks. Buy-and-hold investors on the other hand tend to hold on to their shares for years.

If you are a buy-and-hold investor who wants to try swing trading, it is very important to understand how successful swing traders make their decisions. Apart from the two differences already mentioned, it is also important to be aware of that swing trading requires much more time than standard buy-and-hold investing. Another difference is that buy-and-hold investors generally don’t go short but for a swing trader shorting is an important way of making money in a falling market. What is very important to remember about shorting that is the potential losses from shorting are theoretically unlimited.

Although commissions have become much cheaper, it is still a significant expense for most traders. Most buy-and-hold investors don’t really need to worry much about broker commissions, they don’t make many transactions. Swing traders are much more active, meaning that commissions and fees can add up to significant amounts.

With all these potential drawbacks of swing trading, why would anyone prefer swing trading over buy-and-hold? The answer is simple, the chance of making money even if the stock market does not go upwards. In a bull market which lasts for years, buy-and-hold is an easy and comfortable way of getting rich. But if the market is going sideways or downwards, buy-and-hold investors are not making much progress and may even be losing money.

Needless to say, it is quite possible to lose money on swing trading. A lot of traders lack the discipline that is required to make trading profitable. Virtually every study shows that the majority of traders perform worse than the market average. Plenty of studies have shown that a lot of traders lose money even in a bull market. So before getting started with swing trading, it is very important to consider if it is really the right thing for you.

As mentioned earlier, swing trading requires more time than buy-and-hold investing. For most people it is best to avoid watching the price movements during the day. Instead, decide what trades you are going to do outside the trading hours. This makes swing trading much more relaxed. Studies have shown that traders who watch the market all day long generally overreact to movements and tend to do worse than traders who make their decisions outside the trading hours.

Swing trading should be treated as a business, not as a hobby. And certainly not as gambling. Needless to say, it is best to have other sources of income so if your swing trading is not producing any profits, you can still pay your bills. Desperate traders generally take a lot of risks which will sooner or later backfire badly.

Note that this article has only covered swing trading shares but you can trade almost any security. Currencies and commodities are very popular amongst traders. Whatever you do, make sure to avoid swing trading illiquid securities. Derivatives should also be avoided, you can quickly lose a lot of money due to small unexpected price movements in the underlying security.

Munich Property Market

Munich has been the most expensive city in Germany for a quite some time. A booming economy has meant that the city has grown quickly. The result is a tough real estate market, both for buyers and tenant. Demand has and is still outstripping supply, which has resulted in both higher prices and rents.

A lot of experts were surprised by the sharp increases of property prices in Munich during 2011 and 2012, almost ten percent per year in most parts of the city. Given that prices were already very high and that rental yields were very low, the prices increases were surprising. On the other hand, Munich is still growing and nothing has been done about the chronic shortage of housing. But for investors, the latest price increases have meant that the already low rental yields have become even lower, now about three percent. And we are talking about gross yields, after expenses, the yield will be even lower.

A lot of people see Munich as a safe place for property investments. The city has limited space for growth, new developments are expensive and far between. At the same time, the city has prospered and grown very quickly. And it looks like the growth will continue, at least the next couple of years. Not only have a lot of German property investors pushed up prices in Munich. With the economic problems in many countries in Southern Europe, people worried about the future of the euro have decided that Germany and especially Munich is a safe place for investments. Also people from Eastern Europe and Russia have bought property in Munich.

With the latest price increases, it does not really make sense financially to invest in Munich. Property prices are simply too high at the same time as rents, although by far the highest in Germany, are too low to make the return on investment reasonable. In Germany, rent increases are limited by the law so it will take time to before the rents have increased significantly. As mentioned, the gross yield is about three percent in Munich at the moment. Although interest rates and inflation are low, the yield does not really justify any investments.

So why are property prices still going up in Munich? The answer is that virtually nobody believes that house prices will go down. Most experts believe that prices will continue to increase, albeit at a more moderate pace, around five percent. This is still believed to be higher than what rents will increase, meaning that the poor rental yields will not improve. Munich is the right place for property investors who want safe long-term investments and who are not dependent on short-term cash flow. But most likely you can get better return on your investment in most other places, especially if you want a reasonable cash flow.

As mentioned earlier, there is not much free space left for property developments in Munich. The chronic shortage which has been a problem for more than 20 years, is unlikely to change, at least not for the better. There is not any really bad parts in Munich that must be avoided. But be aware that in many parts of the city, rents are already so high that even households with two incomes have trouble affording the rent. And this even if both have well paid jobs! Like in most other cities, places close to an underground or S-bahn station will always be popular. But don’t waste your time looking for bargains in Munich, there hasn’t been any the last 20 years.

Property Investment in Hamburg

Hamburg used to be almost a little bit of backwater, the economy wasn’t going very well and property prices were going nowhere. But that has changed drastically, now Hamburg is booming. The city is growing and property prices have been increasing strongly and Hamburg is now one of the most expensive cities in Germany.

Hamburg and Berlin have been two of the hottest real estate markets in Germany the last couple of years. The reason for this is that both cities are growing quickly. Hamburg has now the second most expensive real estate in Germany. It is still far behind Munich but has managed to pass all other German cities. It has been an amazing development, given that ten years ago property prices in Hamburg were far behind cities like Dusseldorf and Frankfurt.

Demand is much higher than supply, making it very difficult to find bargains. This is true both for people looking to buy and for those who want to rent. Most experts believe that Hamburg will continue to prosper, at least for the next couple of years. But property investors need to be careful, prices are high compared with the rest of Germany. The common view is that price growth will continue but at a slower pace. At the same time, rents are unlikely to grow as fast as property prices. Tenants in Germany are protected from big rent increases by the law. This means at already low yields are likely to get even lower.

One thing to be aware of is that there is very little free space left for new property developments in the inner parts of Hamburg. New projects are mostly in the outskirts of the city. This should protect the prices in the attractive parts of Hamburg. And it is probably prudent to be careful with buying in the outer parts of Hamburg.

The politicians are well aware that a lot of people (that is, voters) have trouble finding affordable housing. Therefore, new projects are being encouraged and several have been started. But as mentioned, most of the new developments are in the outskirts of Hamburg.

So what does this mean for property investors thinking of buying in Hamburg? Most experts believe that the big price increases are over, prices will continue upwards but at a much more moderate pace. Virtually everyone believes that prices will increase more than rents, which means that yields will get worse. In other words, the party is almost over for property investors.

If you are happy with low yields, below four percent at the moment in the attractive parts of Hamburg, you can find properties which can be labelled as safe but unexciting investments. There is simple not much space left for new developments in inner Hamburg. The lowest yield is in Hafenstadt, 2.7%, which is a newly redeveloped area along the Elbe river. In the outer suburbs, yields are around five percent. Given the relatively poor yield in the outer suburbs and the number of new projects under way, it can be risky to invest in the outer parts of Hamburg. Unless of course you can find a bargain, but finding a bargain in Hamburg has been virtually impossible the last couple of years.

Buying Property In Queensland

The Queensland property market has had both its ups and downs the last five years. Many smaller towns have seen extreme increases in both prices and rents due to the resource boom. But in most of those places, oversupply seems now to be a problem. Central Brisbane, Goldcoast and Sunshine Coast on the other hand have suffered from oversupply for several years.

The Australian property market has been very strong. But there has been a few exceptions, the Goldcoast is the most well known example of oversupply causing prices to fall drastically. Especially buyers of off-the-plan apartments in high-rise buildings have lost a lot of money. Lately, Australian property prices have started to increase again. Foreigners and property investors have become very active while first time buyers are being squeezed out of the market due to the high prices. The low interest rates has not helped first time buyers while investors have become very active despite that in many places yields are only around four percent.

The Brisbane property market has been very slow the last couple of years but many experts believe that prices will start to increase again in Brisbane. But remember that the vacancy rate in central Brisbane, known as postcode 4000, is still very high, about 6%. Property investors are advised to look outside the Brisbane CBD. At the moment, prices in many northern suburbs have started to increase. Like in most other places in Australia, off-the-plan units should be avoided at all cost. They are almost always sold at a premium to foreign investors, who are only allowed to buy off-the-plan properties. And it looks like the premiums are only getting bigger, probably due to increased interest from China.

The Goldcoast is best avoided, oversupply is still a problem and more high-rise buildings are on their way. Houses are not necessarily a bad investment on the Goldcoast but you must know the market inside out. Sunshine Coast has also had problems with oversupply but not as bad as the Goldcoast. Things may start to improve so it may be right time to look for bargains. But keep in mind that developers can quickly flood the market with apartments. It is best to stick to houses or high quality apartments with good views or something else that makes them stand out.

Mining towns are best avoided, the boom seems to be over for now. Many mining towns are suffering from oversupply, and in several places, more properties are on their way. In many towns the spectacular price rises have been replaced with almost as spectacular price drops. But that still don’t make them sound investments.

The Cairns property market has been slow the last couple of years but has lately shown signs of recovery. Many experts believe that the recovery will continue thanks to the tourism industry and strong Asian interest. Quite clearly, Cairns looks like a much better choice for property investments than most other tows in Queensland.

It looks like interest rates will stay low in Australia and population growth is strong. It looks good for property in other words. But it is important to remember that many developers love high-rise projects. They can quickly flood a market with apartments and the oversupply can take very long time to get rid of. Unless you really know what you are doing, avoid off-plan apartments. They are aimed at foreigners and are almost always sold at prices far above market price. Even worse, to keep the prices on new apartments down, they are often ridiculously small.

Berlin Real Estate

The German real estate market has been slow for a long time but lately things have started to changes. Berlin used to be cheap but since 2009 both rents and property prices have increased much more than in other large German cities. Berlin is still far behind Munich, which has the most expensive real estate in Germany, but Berlin is moving closer to the top.

First it is important to point out that Berlin is not like London or Paris. Actually, it used to be a little bit of backwater. But the last couple of years Berlin has started to grow. After that Berlin became the capital of the reunited Germany, developers got ahead of themselves and built far too much. Prices were cheap but few were interested in buying. Things have changed and now Berlin has become a German property hotspot. Due to the oversupply, few property developments were started. At the same time, Berlin started to grow.

It is important to remember that compared with many other countries, the German property market is slow. The boom and bust cycles seen in many other countries haven’t happened in Germany. Even if the Berlin real estate market has become hot, this means increases of ten percent or less. For Germany, this is boiling hot and a lot of people believe that the boom will soon end.

Another important thing is that in Germany, the price of an apartment depends on the size of the apartment, not the number of bedrooms. You often see prices given per square meter. Germans don’t like small apartments. In many cities all over the world, you can find plenty of very small one and two bedroom units. In Germany, such small units will be difficult to rent or sell. It is also good to remember that the legal system in many ways favors tenants.

As mentioned, the Berlin real estate market has become hot. So hot that many old Berlin property investors are staying on the sidelines. But others believe that the boom will last another couple of years. The city is growing and since 2009 property prices have gone up with almost ten percent per year. In Germany, such a growth is almost unbelievable. But the mainstream view is that Berlin will continue to prosper, at least the next few years, and so will the property market.

This does not mean that it is a good idea to buy whatever you can get in Berlin. As usual, some parts of the city have done much better than others. Also, while many believe that prices will continue upwards, most experts believe that price growth will slow down significantly. Politicians have also noticed that Berlin has become much more expensive and they want to keep Berlin affordable. New developments are being started which will boost the supply. In other words, Berlin is still a good place for real estate investments but now you need to make sure that you buy the right property, in the right location at the right price.

The old West Berlin is still more expensive than the parts that belonged to East Berlin. The exception is the city center with Berlin Mitte and Prenzlauer Berg. Most experts believe that this pattern will not change. The safe bets are central Berlin and the western parts of the city. It is also worth pointing out that there is still plenty of free space in Berlin. So buying in a cheap part, waiting for prices to go up can be a risky strategy. As mentioned, developers in Berlin have started to build again. Previously, due the low property prices and rents in Berlin it didn’t make sense financially to build. But that has changed, now developers can make handsome profits and they want to take advantage of this opportunity.

Share Trading For Beginners

You may have noticed that the buy-and-hold strategy has not been as successful as it used to be. Trading is another way of making money on the stock markets but does it really work?

The term trading can be used for a wide range of activities, day trading and Forex trading have become very popular topics on the Internet. Nowadays, small investors can trade in almost anything. But in many ways, share trading is the safest for beginners.

Day trading has been popular for a long time but study after study have shown that most day traders lose money. This even if the market is moving upwards. Profitable day trading requires quick decisions, an extraordinary discipline and a deep understanding of how markets move. But the main problem with day trading is that the gains made on winning trades are very small. This means that day traders need a high ratio of profitable trades in order to make money. Although broker commissions have decreased, you still have to pay commissions regardless if the trade was profitable or not. The commissions are another reason why day trading is very difficult to make profitable.

A long-term investor on the other hand can often make 50% or more on a successful investment. As long as such a investor makes sure to cut his losses, it is possible to make handsome money even the investor picks a winner less than every second time. Also a trader improves his chances of success by holding on to his winners as long as possible. In other words, cut your losses and let your profits run. The longer time horizon has another advantage, you can make your trades once a day, in the morning before the stock market opens or in the evening after it has closed. This way you don’t need to worry about the daily volatile and don’t need to watch the prices all day long as a day trader has to.

But even with a longer time horizon, profitable trading is far from easy. If you are a beginner, it is highly recommended that you start with paper trading, meaning that you are not investing any real money. It may not be very exciting but it is very important to learn how the markets move. Once you have worked out a strategy which is profitable, you can start trading with real money. But note that it is important that your strategy is profitable over a longer period of time, not just a few weeks. Trading is not a fast way to riches, you should at least paper trade for six months before you start trading with your own money. Note that you must include the broker commissions also when paper trading. You are not paying any commissions of course but you will once you do real trading.

During the paper trade time, you should also make sure that you have the best tools you need for successful trading. You don’t really need much, just one program which keeps track of your profits and losses as well as trading software. Be careful with magic trading software that is supposed to automatically pick winners for you. Such programs don’t exist. All you need is a program that automatically downloads the market data and displays the data in a way you like.

As a trader, you should always use a discount broker. Even if you are not a day trader, you need to minimize your broker commissions. Trading requires frequent buying and selling so low commissions are essential. One last thing to remember is that it is impossible to always make money on the stock markets. If your trading is going badly, take a break and reconsider your strategy before you start trading again.

The Schwarzenegger Success Formula

Arnold Schwarzenegger is a well known success story and he has explained his formula for success many times. In his autobiography, Total Recall, is not only his life but also his success formula explained.

Total Recall is an entertaining book and it is easy to read. But the most important message in the book is that anyone can become successful. The Schwarzenegger success formula can be summarized in a few simple sentences.

First create a vision of who you want to be. Then you start living into the vision as if it were already true. Note that it should be a big goal, something that is so exciting that you jump out of bed in the morning in order to start working on getting closer to your goal.

There are two important things you need to know as well. First, you need mentors who can tell you what is the best way of reaching your goal. If you have to find out everything yourself, it will take too much time and you will get started on the wrong path far too often. Secondly, you need to take massive action or to use one of Schwarzenegger’s expressions, work your ass off. Make sure that you do something every day that gets you closer to your goal.

Regardless of what you want to achieve in life, one skill is always required, selling. Schwarzenegger was very well aware of this already when he was into bodybuilding. He become the man who changed bodybuilding from being perceived as an activity for men with psychological problems to a mainstream activity. He was quite clearly not the best actor from technical point of view. But he knew his strengths and weaknesses as an actor and focused on his strengths. He had the right body for action movies and could deliver witty one-liners. His films had very basic stories but plenty of action with some jokes thrown in. He spent a lot of time on promoting his films, both in the US and abroad. The films may not have been especially sophisticated but he had built up a fan club that made the films commercially successful. Needless to say, if you are in politics, you have to be able to sell your views and visions.

Note that as actor Schwarzenegger focused on his strengths and did not worry about his weaknesses, an important strategy for all high achievers. It simply takes far too long time to try to get rid of your weaknesses and typically you only become average anyway. For success, you need to be extraordinary, not average. Thus, know your strengths and weaknesses, make the most of your strengths and find solutions for your weaknesses.

In his autobiography, Schwarzenegger also lists ten principles that are necessary for success. Three of the most important are:

  • Forget plan B
  • The day has 24 hours
  • Reps, reps, reps

If you want to become successful, you have to look forward and not worry about all that can go wrong. It is not easy to become a success, there will be plenty of setbacks. If you have a plan B, you will most likely take the easy way out after a few setbacks. Stay focused on your goal, persistence is always needed if you want to achieve something worth mentioning.

Everyone has 24 hours a day, how you use those 24 hours will determine your success. You need to spend as much time as possible every day working on getting closer to your goal. Success seldom depends on talent or luck, instead hard work (reps, reps, reps) is a much more likely to make you successful. You simply have to be prepared to put in much more work than the average person.

For more about Schwarzenegger’s success formula, read his autobiography, Total Recall.

Technical Analysis versus Fundamental Analysis

Technical analysis and fundamental analysis are the two main methods for selecting shares. Which one is the better method is often hotly discussed. Technical analysis forecasts future price movements based on past price movements. Fundamental analysis on the other hand, looks at the financial figures, not just of the individual companies but also of the competitors, the customers and the whole economy. The goal is to find companies that are valued below their intrinsic value. A technical analyst on the other hand studies charts, trying to find buy or sell signals.

As can been seen already from the short introduction, the two methods don’t have much in common. The technical analyst is looking at historic prices, without even worrying about the underlying company. Actually, technical analysis can be used for anything that is traded, for example commodities and currencies, not just shares. Fundamental analysis is performed on historical and present data, as well as trying to estimate future figures.

Both methods have plenty of devoted followers, and hot debates are common about which school is the best. Especially some of the technical analysts defend their methods aggressively. This may have to do with that some people are looking down of technical analysis and ridicule it and its followers.

Technical analysis has become much easier thanks to cheap computers and Internet. With suitable software, it is possible to automatically download the latest information and display graphs on the screen. It is even possible to let the program do the buying and selling decisions automatically. In the good old days, technical analysts spent a lot of time collecting data and drawing graphs.

But does technical analysis (TA) work? There are plenty of stories about the efficiency of TA, both negative and positive. But it is difficult to find any studies that confirm that TA can be used to produce better returns than the market average. Every now and then a report pops about a new TA method that can be used to make money. But generally it turns out that someone has gone through an enormous amount of data, looking for patterns and found a way that would have produced a handsome profit. The problem is just that there is no guarantee that the specific pattern will repeat itself. By going through a lot of a data, looking at it from different angles, it is always possible to find some interesting patterns. This is true regardless if the data examined is just randomly generated or historic share prices.

Maybe the biggest concern about TA comes the fact that it is very difficult to find rich technical analysts. Given that thanks to computers and Internet, TA is very simple, shouldn’t plenty of people be making big profits? Apart from times when stock markets are going only upwards or downwards, it looks like technical analysts have trouble making money.

But wait a minute! Don’t hedge funds use technical analysis for some of their short term trading? Yes, hedge funds and other financial institutions often use TA for their short term trading. But they typically place huge money on relatively safe bets. The profit margins are extremely small, but with big money, even trades with razor thin profit margins add up to significant amounts after a while. Very few individual traders have such amounts of money and the trading fees are higher for individuals than for financial institutions. Even small fees will quickly wipe out any such small profits. Not to mention that hedge funds have invested enormous amounts of money to get the most efficient trading systems. A laptop with trading software for $100 is unlikely to outsmart such competition.

In theory, fundamental analysis seems to be almost foolproof. You buy something below its real value and wait until the market realizes the true value. Unfortunately, while TA is very simple thanks to computers, fundamental analysis is far from easy. First, there are a lot of different ways to estimate the intrinsic value of a company. Additionally, a number of forecasts about the future is necessary. Furthermore, a fundamental analyst must be able not only to read financial reports but also to understand what the figures are really saying. Even worse, a good understanding of the market is also necessary, as well as be able to judge the strength of competitors. In other words, in order to become a good fundamental analyst a lot of experience is necessary.

Does fundamental analysis work? Difficult question! There are certainly plenty of successful fundamental analysts. Unfortunately, since fundamental analysis can be done in many different ways and it requires a lot of training, it is far from guaranteed that fundamental analysts will be successful.

If you are going to become a trader, TA is the easiest method. But be careful, most traders seem to be losing money. For long term investments, thorough fundamental analysis is the best solution. Unfortunately, while TA just requires a computer with relatively cheap trading software and an Internet connection, fundamental analysis requires much more of the investor. Maybe cheap index funds are not that bad after all!

Two Common Scams That Must Be Avoided

No one likes to get fooled but sometimes it can alao become very painful financially. Two of the most common scams can unfortunately turn out to be very expensive. First, be very careful when someone offers you tax effective investments or in any way suggest you play around with your tax. Second, be very careful if you attend property seminars, buying an off-the-plan property can turn out to be much more expensive than initially thought.

Poor investments or scams are annoying and can be expensive. But at least your losses are generally limited to your initial investment. Unfortunately, there are two big exceptions to this rule. Getting into various schemes that are supposed to lower your tax can backfire badly. The same goes for off-the-plan properties, often bought with a relatively small initial deposit. But if you read the contract carefully, you will find out that you promised to buy the property at the given price. You risk much more than just your initial deposit.

No one likes paying tax and tax laws are complicated. In most countries, tax laws include plenty of various exceptions and tax effective investments which can be used to lower your tax. Unfortunately, scammers have realized that they have good chances of making easy money by setting up a scheme that lowers tax. Especially in the English speaking world, the tax system is very friendly towards such tax schemes, at least the first few years. All the time, people get persuaded to join a scheme that artificially lowers their tax. Things work out fine, until the taxman takes a closer look at the scheme.

The really bad thing about these tax schemes is that they often turn out to be very expensive for the victims. First, they have invested into something that turns out to be worthless. In other words, they have thrown away their money. It does not look like a loss, the artificial tax scheme meant that the money which went into the useless investment would have been paid as tax. But once the taxman has had a look at the scheme, things typically turn nasty. The scheme is not accepted as tax effective and the investors are required to pay the outstanding tax, possible with fines and interest as well.

Since it can take years before the tax authorities take a look at a specific scheme, victims could have invested in a scheme for years. Needless to say, this often is a financial disaster for the victims. It is of course possible to challenge the decision, but that just generally makes it more expensive and prolongs the pain. Never ever get into any tax arrangements without consulting an independent tax adviser. Amazingly, some people accept advice from a salesman who makes a commission from everyone who signs up. Probably very few realize how expensive it can turn out to be.

Property seminars are not as common as they used to be but off-the-plan promotions are far from dead. In theory, off-plan is a good idea. You are getting a property in 18 months or so at today’s price. Unfortunately, virtually all off-the-plan properties are overpriced. Be especially careful at property seminars, often poor investments are disguised as bargains at such venues.

What the seller seldom tells the customers is that by signing the contract, the customer promises to buy the property at the given price. In other words, the customer may lose much more than the deposit paid at the signing of the contract. Needless to say, if the developer has found suckers who have promised to pay more than the market price for a property, he or she is unlikely to let them off the hook.

You must be very careful when signing any contracts. Never believe what a salesman, who after all will make a commission if you buy, tells you. What they tend to forget to tell you is that you have already bought the property, at the given price. But things can be even worse, often you only get two weeks to arrange the final payment once the project goes live. If you fail to secure a loan within the given time frame, you could lose your deposit. This tends to only happen if the current market price is higher than what you have promised to pay. Something that happens very seldom but you should be aware of the possibility of you losing your deposit. If the current market price is less than what you are paying, the developer generally has some understanding if you need some extra days to get your finances sorted. But the developer is unlikely to let you walk away if you have realized that the off-plan price was far too high. He or she will insist on you buying the property at the inflated price.

CDOs – Financial Weapons of Mass Destruction?

CDO, Collateralized Debt Obligation, became well known term after the global financial crises. The subprime mortgage bubble was created by an enormous amount CDOs. They became financial weapons of mass destruction. But what are collateralized debt obligations really?

CDOs are securities that are made up of bundles of asset-backed bonds, or to put it in simpler terms, portfolios of bonds or credit default swaps. The first CDO was issued in 1987 and until 2002, they were mostly made up of corporate and emerging markets bonds. By keeping the debt in the CDOs diversified, the risk was smaller at the same time as the return was typically better than for normal bonds.

But in 2003 some people started become greedy and things started to go in the wrong direction. Mortgage-backed securities started to increase in the CDOs. According to some estimations, already in 2004 more than half of the of the collateral in CDOs was made up of mortgage-backed securities. In other words, the diversification was decreasing. And the subprime mortgage bubble was just getting worse.

With the diversification getting smaller, the CDOs should really have become riskier. But the creators of CDOs had a way of getting around this problem. CDOs were sliced and diced into tranches. These tranches determine how the cash flow of interest and principal payments are divided. The riskiest tranche paid the highest yield but would also be the first to lose out if any of the assets in the CDO defaulted. In essence, the lower the yield, the more secure the tranche was supposed to be.

In other words, CDOs could be tailored to suit both people who wanted to speculate, high risk but also high return, as well as those who preferred low risk and low return. Not only that but also to suit everyone in between these two extremes.

With the increasing dependence on mortgage-based securities in CDOs, things started to get risky. Unfortunately, most people realized this once it was too late. Despite that risk was concentrated rather than diversified, CDOs and related financial instruments still got the highest rating by the rating agencies.

Things got more complicated by the creation of CDO squared, CDOs made up of CDOs. Unfortunately, it was just a way of hiding the fact that much of the underlying assets were made up of subprime mortgages. Far too many of them were so-called NINJA loans, to people with no income, no job, no assets. Even worse was that many of them had been allowed to borrow 100% of the property price. Add to that often an initial teaser rate was used to keep the monthly payments low, and you have a recipe for disaster. As long as house prices kept on rising, things looked good. But the frenzy just pushed already high house prices through the roof and once the market crashed, so did the value of the CDOs.

If it was not bad enough that CDOs with triple A-rating become either worthless or in best case, impossible to value, a lot of financial institutes had used leverage. They had borrowed money to buy what turned out to be more or less worthless CDOs and many of them could not repay their debts. Even worse, in a global world, almost every financial company was in one way or other involved, either by directly owning CDOs or by having lent money which went into CDO investments.