Synthetic CDOs: I Punch You In the Face

This is where my tortured analogy of spicy soup dies: the synthetic CDO. Let us recall:

• Tranched bonds (like mortgage backed securities): spicy soup that has been allowed to settle. Some people buy spicier soup for less money.
• CDOs: let the soup settle again so we can divide it up yet again - a way to try to recover a little more value from the spicy soup.

Now here's where we have to break from reality. In real life if you buy that really spicy bowl of soup and drink it, your mouth is going to be on fire. No one else's. You drink it, you burn. We can't get away from that.

But in the world of finance, pain comes in the form of losing money. This means...pain can be transferred. It's not impossible to set up a deal where you drink the spicy soup and someone else's mouth feels like an inferno.

(Hrm...that might be a really good deal. Remember, the spicier the soup, the cheaper. So you could get cheap soup and someone else hurts like hell...hrm...)

That is the synthetic CDO. You get paid a little bit, and your mouth hurts like hell when someone else drinks the soup. It's as if we have a side agreement that if I drink the soup and it is too spicy, I can punch you in the face.

To get more technical:

• Normally I get paid interest by taking a little bit of risk. I get more interest for more risk.*
  
• Normally the way I take this risk is by loaning someone money. The risk is I don't get paid back.
• For a CDO, the whole thing has been through a blender. (Hard to spot those Wall Street bankers taking fees with all of that blending!)
• For a synthetic CDO, you've got my back! I loan some money out, and you take the risk of me not getting paid back. If I don't get paid back, you pay me. I give you a bit of my interest to convince you that this isn't the worst idea ever.

For me, the synthetic CDO lowers my risk (I will get paid back no matter what) and it lowers my return (since some of my interest money has be used to pay you to take this insane gamble).

For you, you get paid a little bit now and you might have to pay me later. If this looks a lot like an insurance policy, that's because it is. You're insuring me against the loss of my loan. In real life, a synthetic CDO might be built out of Credit Default Swaps (CDS), which are just that - insurance on a loan or bond.

With a synthetic CDO, we've separated the party drinking the soup from the party getting burned. What are the implications of this?

1. I still get some interest, even though you took the risk of not getting repaid. Wha? Well, not getting repaid is not the only risk of a loan. I could make a loan at a low interest rate, then interest rates shoot up. I lose out on the chance to make a loan at a higher rate. This is "interest rate risk" and I still am exposed to it even though you insure me against a total loss. So by selling you this synthetic CDO, I got rid of some of my problems, but not all, and I got rid of some of my return (interest) but not all.
2. Since I get repaid no matter what, I can now loan money to just about anyone I want. Uncle Joe likes to place bets down at the track, but I don't care. If he can't repay, you've got my back.
3. I can only loan uncle Joe as much money as I have. But you, you've got a very different situation. If you have my back, you don't have to put up any money right now! You only owe me money if Uncle Joe doesn't make book. So you could insure me against a bunch of loans without actually having the money!** This would be profoundly stupid of you, because I'll have to break your knee caps (and me, because how are you going to make good on the loan if you have no money and no knee caps) but not impossible.

Of course, item 3 is precisely what AIG did - they told Goldman Sachs they'd make good on loans Goldman had made if the debtors went under. AIG didn't have enough money on hand to actually pay off all of the loans. How did this play out?

1. AIG goes bankrupt.
2. We (the taxpayers) bail them out, giving them lots of cash.
3. They use the cash to pay back Goldman, whose original loans have not paid off.

Well, that worked out well, didn't it.

The astounding thing is that AIG wasn't required (and still isn't) required to record in their financials that "in the event of a bad day, we will owe Goldman Sachs a crap-load of money."

If it seems astounding stupid that you could possibly owe someone a gajillion dollars and go around pretending that you don't have a burden on you, well, it is. A good start to financial reform would be to require such obligations to be recorded on balance sheet.

* This is a little bit surprising to normal people because the most basic savings vehicle, the bank savings account, has no credit risk because the FDIC has your back if the bankgoes under. But then that savings account isn't paying much interest is it?

** To be clear: you can sell a credit default swap without having the full amount of money to cover the loss. That's the AIG case. When the insurance is packaged up in the form of a synthetic CDO, in theory the principle of the synthetic CDO should be equal to the amount we might lose. Thus the worst case is losing all of the synthetic CDO. That's why it's called a synthetic CDO - it looks just like a CDO in that it earns a little bit of "interest" and in the event of a bankruptcy loses all of its principle - just like a regular loan.