Have you ever wondered what a synthetic CDO is, or whether it contributed to the housing bubble? At a recent hearing held by the Financial Crisis Investigation Commission, Brooksley Born asked questions designed to get answers for you. A complete answer would lead to a fuller understanding of the role of credit default swaps in the housing bubble.
The panelists are from Citibank: Murray Barnes, was involved in risk management, and Nestor Dominguez, who worked in CDOs are the speakers. There is a brief description of CDOs at the end of this post. A synthetic CDO issues credit default swaps on other entities, including CDOs and real estate mortgage backed securities. A hybrid CDO issues credit default swaps and holds other debt instruments, such as securities of other CDOs and subprime mortgages.
Born is trying to find out if the issuance of synthetic and hybrid CDOs made the housing bubble last longer and cost more. Watching the panelists answer, you’d think they had never thought of that question. Eventually, Dominguez says it didn’t extend the housing bubble because “it didn’t require any origination.” Yves Smith explains why that is wrong in her excellent book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. She thinks the housing bubble was significantly affected by synthetic CDOs.
A number of firms, including Goldman Sachs, are known to have bet against the securities they were selling to investors. Whoops, sorry, Goldman Sachs says it was just a market maker, and denies that they were betting against their investors.
Smith gives a detailed description of Wall Street strategies. The explanations are complex, and what follows is only a sketch. Interested readers should read Chapter 9 of ECONned closely.Smith explains that synthetic CDOs were first formed in mid-2005, when the International Swaps and Derivatives Association formalized the procedures for issuing CDSs on tranches of CDO securities. Before then, investors could buy insurance from the monoline insurance companies, like AMBAC. Suddenly anyone could write protection, or buy protection on just about any tranche of a CDO.
That led to this strategy called credit arbitrage. The hedge fund buys a low tranche of a CDO, and buys protection on the next higher tranche. For example, the hedge fund buys the BBB tranche of a mezz CDO, and buys a CDS on the A tranche. While the CDO is functioning, the BBB tranche throws off cash to the hedge fund. If the CDO fails, the hedge fund makes a big profit by collecting on the CDS if the A tranche goes down along with the BBB tranche. Mezz CDOs are full of the worst of the securities of other CDOs so that seems likely.
Magnetar took this one step further. It arranged for the organization of new CDOs. It agreed to buy the equity, the lowest tranche, of the CDO, which basically gave it a veto over the assets of the new CDO. The equity tranche gets a lot of income in the first months of the CDO. Magnetar used the money to buy CDSs on the higher tranches, betting against securities that wouldn’t have existed if it hadn’t been willing to put up the equity. Essentially, its goal was to collect on the CDS when the CDO tanked. In fact, if the CDO didn’t tank, it wouldn’t make money. Smith emphasizes that this is perfectly legal.
In order to keep this going, it was necessary for there to be more and more subprime loans. The perverse effect of credit default swaps was to encourage lending to people who absolutely would fail, so that the CDO would fail and the hedge fund organizer would profit on the CDS. Smith says it is “entirely possible that Magnetar deals account for 35% of the 2006 subprime issuance” of CDOs, which totaled $448 billion.
If Smith is right, there is no doubt that synthetic CDOs and credit default swaps extended the life of the housing bubble.
* * *
CDO is a general term for collateralized debt obligation. It is a debt security issued by an entity like a trust or an LLC. The entity holds a large group of debt obligations of third parties, such as credit cards, car loans, student loans or residential real estate mortgages. A pool consisting solely of residential real estate mortgages might be called a CDO, or it might be called a RMBS, for residential real estate mortgage backed security.
CDOs can have all kinds of securities in them. A single CDO might hold debt obligations issued by other CDOs, say a group of RMBSs. It might also hold subprime mortgages, or notes secured by commercial real estate, or notes issued by corporations for general purposes or any combination.
In each case, the CDO issues debt securities in tranches. Higher tranches are paid in full before lower tranches get any money. The tranches are rated differently, from AAA to BBB or lower or Not Rated. Generally people refer to the tranches by their rating. There might be 5 different tranches: AAA, AA, A, BBB, Not Rated.
The CDO might own a pool of mortgages itself. Or, it might buy a group of securities of other CDOs with different ratings. Yves Smith calls these mezzanine or “mezz” CDOs. The mezz CDOs buy a bunch of the lower rated paper from other CDOs. Even so, it issues a good sized tranche of AAA rated debt as well as the lower tranches.



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Gotta be crazy to bet the tranche on a setup like that ;).
Thanks for knuckling under yet again to the wingnuts, Obama. Fucking asshole.
the hedge fund buys the BBB tranche of a mezz CDO, and buys a CDS on the A tranche. While the CDO is functioning, the BBB tranche throws off cash to the hedge fund. If the CDO fails, the hedge fund makes a big profit by collecting on the CDS if the A tranche goes down along with the BBB tranche.
Talk about a pyramid scam. Anyone with an ounce of brains could see that such a structure was bound to fail at some point.
Wait. Real estate will go up forever. Never mind.
They were betting on it to fail, and they wanted it to fail.
Good point. The house always wins, eh?
I’ll see Blankfein’s letter, and raise him a Bill Lockyer letter
http://www.treasurer.ca.gov/cds/goldman.pdf
More here
Control fraud, conspiracy to defraud, breach of fiduciary responsibility, suborning fraud, misrepresentation, gross negligence, and they are probably guilty of being ugly too.
That’s it in a nutshell, succinctly put
oops, and what has been changed?
Not sure, but I infer from the explanation that the reason to buy the higher tranche CDS was because it would be less expensive to hold insurance on the higher quality tranche of a given CDO. And if the CDO defaulted, it would be likely that all the tranches would go down together, but the payout on the higher quality CDS would also be more assured.
It’s arbitrage with a bias towards fail. What’s not covered here is whether the CDS holders could have been short selling the lower tranche CDO to create a run that could lead to default and a payout. That would seem like a natural play and would be clear proof that the speculators were purposely driving fails to profit from defaults. Easy enough to check out by looking at their trading history.
In any case, when trading volume for CDS insurance went up, that would also be a signal to the general market that fail was around the corner and it would become a self fulfilling prophecy. Financial engineering at its worst. No value to anyone except the greedy engineers, at the expense of homeowners, pensions, savings, endowments, government accounts, on and on.
Shorter: the whole things stinks like last week’s fish.
Excellent point. The buying of CDS on the higher tranches gives the scam away.
I was going to read more comments before I replied to the thread at hand, but your comment was just so spot on I have to reply to you and massaccio at the same time!
Two great links, there John, BTW, thanks for sharing them!!!
In regards to the post, and your comments, I find incredible parallels and patterns of operational behavior as is found in the lengthy, detailed and REMARKABLE expose of Deep Capture.
Bundling and selling inflated values of useless debt obligations without holding any VALUE in reserve, insuring against their success, ‘betting’ for and against those packages, creating phantom stock to DEVALUE the debt obligations even more . . . all standard operating procedures at the major trading houses for Deep Capture, with names and collusions all detailed out, and incredibly similar procedures and processes as what happened to the home ownership market . . . .
Add in healthcare insurance companies who hold ‘overvalued’ worth on their books thru consolidations (over inflated goodwill values, just like in radio and tv and print ownership) that basically renders the worth of the insurance companies as ZERO (think too big to fail, like finance/banking institutions) and you have yet another continuing piece or ‘arm’ of the financial world that’s shifting taxpayer money, personal investments and every dime of we the people to the 1%.
Heck of a post, massaccio, and thanks John for your comments, and all the other comments.
It’s a mass looting of the public, across the board, legalized and aided and abetted by our elected offals.
It’s impossible not to see that big picture, anymore.
And the sheeple graze on, as the pastures shrink.
Mods, looks like I missed a close tag in my #12, if ya get a chance, sorry I know yer busy!!!
MODNOTE: fixed
You folks are FAST!!! Thanks, sorry for the mistake . . .
The process as exactly described in Deep Capture, to a T.
Thanks for your whole comment, great insight.
I’m halfway thru part two. There’s all kinds of crap these vultures are doing to our governments (especially California mainly because of Prop 13) that people don’t know about – here’s a post I did Wednesday about Lehman, UBS, and JPMorgan’s Muni bond bid-rigging conspiracy
And if I get time tomorrow I’m going to do a post on Lehman’s Repo 105s
I find it helpful to remember that under the common law, which was approved by the US Supreme Court in a number of decisions, any agreement based upon the happening of a future event was an illegal wager unless it involved the actual delivery of a commodity. In light of this, how is any contract, labeled a “credit default swap” or anything else, e.g. “agreement for the future delivery of bullshit” not an illegal wager? Boiled to its basics with all the mathematical bullshit stripped away, all Congress needs to know is that if there is no law which specificaly says they are legal, they must be presumed illegal and show it to be so and then let the machinery of justice do its magic on these frauds, thieves and liars.
john in s– if you have not yet viewed the video clips (about 10 min each) at the makemarketsbemarkets.org website, they’d probably be really helpful for your research.
As I’ve been able to connect the dots, it’s not ‘if’ the CDO defaulted, but ‘when’.
And the lower tranches, being of poorer quality, had less chance of paying out — but if/when they did pay out, they would bring a far higher return (based on the premise that more risk = more profit).
Which is why we absolutely have to have the AIG emails made public,and also why we need to see exactly what Goldman Sachs was doing.
Now obviously, Goldman Sachs thinks they own the US government (along with other governments), and so far there is good reason to believe that may be the case. It really does come down to politics in a lot of ways, and to education: we still have Congresscritters who have less grasp on the fundamental processes than the knowledge exhibited on this thread alone.
It’s clear to those of us connecting the dots that this is rampant criminal behavior –at many levels (realtors, appraisers, mortgage brokers, Wall Street firms) and that the system itself was designed to minimize accountability, and also to almost ensure that people would engage in anti-social (i.e., ‘criminal’) behavior.
The culture of the corruption really is breathtaking, as described in the FCIC videos that I’ve been able to view of this week’s proceedings. And clearly Robert Rubin doesn’t yet grasp that a whole lot of us view it as sociopathic and unsustainable.
Brookesley Bourne, OTOH, seems to see the pathology quite clearly.
Aren’t pyramid schemes illegal? She is a smart woman and I hope she gets somewhere for our sake.
Indeed. Why not call the FBI?
Boy does it ever, holy crap. There’s not even any plausible deniability in such an arrangement. You’re taking in payments off the riskiest tranche while buying insurance on the safest? If one weren’t specifically trying to game the system, that situation would be exactly reverse.
If you didn’t think the higher tranche would go down, you wouldn’t buy a CDS. The cost of the premiums would dramatically reduce your take on the lower tranche. The purpose of buying the lower tranche in many cases was to make sure the deal closed.
Gack!!
I have an error somewhere in my understanding of this process… I’ll do a quick review and hope to check your Sunday post for clarification.
Meanwhile, thanks for the correction ;-))