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.

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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.