Financial alchemy is the process of transforming something of little value into something worth much more. The unfolding crisis in global financial markets is a result of the unpaid price of that financial alchemy.

How does this medieval-sounding madness apply to today's financial markets? As this letter suggests, the financial alchemy took subprime mortgages, leveraged buyout loans, and other financial assets and turned them into Collateralized Debt Obligations (CDOs), many of which received AAA ratings from agencies such as Moody's Corp. (NYSE: MCO) and McGraw Hill Companies' (NYSE: MHP) Standard & Poor's (S&P), in a process of shopping for ratings which I described here.

The upshot is that investors in Asia and Europe -- eager for higher returns (estimated at 22 basis points above treasury yields) and comforted by the AAA rating -- recycled the cash generated from record energy prices and trade surpluses with the U.S. into these CDOs. There are roughly $2 trillion such CDOs outstanding against which those investors borrowed as much as 13 times the amount they raised in equity from investors, up from nine to 10 times as recently as late 2005 -- let's say $20 trillion -- to amplify the returns on the CDOs.

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The $18 trillion unpaid price of financial alchemy originally appeared on BloggingStocks on Sat, 18 Aug 2007 10:05:00 EST. Please see our terms for use of feeds.