Synthetic CDOs

What the hell is a synthetic CDO you ask? Well, you’re probably not asking, but it’s one of the most unbelievable, interesting and boarder line criminal vehicles that financial engineering has come up with, and one that made the subprime mortgage crisis that much worse. As such, you should at least try to wrap your head around a synthetic CDO. If nothing else, you’ll get an excellent taste of what the evil geniuses on Wall Street really put their minds to.
Before getting into synthetic CDOs, it’s probably best to explain normal CDOs. CDO, which stands for Collateralized Debt Obligation is an investment vehicle composed of bonds which are in turn composed of subprime mortgages. Let’s 10 million Joe Blows want mortgages to buy themselves and their Joe Blow families a house to watch TV in. Typically, they would find themselves eagerly welcomed by local firms that specialize not only in originating mortgages to Joe Blow, but turning around and selling that debt and its interest payments to someone else. At ground zero, things are already skewed; the originator isn’t really concerned whether Joe Blow can pay up, only making it look like he can in order to sell it off.
As one man’s debt in another man’s investment (although in the case of subprime borrowers, the adage seems tentative; it’s more like this particular kind of man’s debt is the stupidest place another man can put his money) the mortgage is quickly sold off to a more sophisticated institution. The originator pockets the difference and starts looking for another J.B. The financial firm now holding the mortgage adds it the millions of other subprime mortgages it owns and starts cutting them up, rearranging and assembling them into bonds for sale. As will remain constant, the coupon payments on these bonds are coming out Joe Blow’s pay check, if he has a job.
Next, the firm will either sell off its new patchwork bonds to another, even slicker financial institution for yet another, more complex layer of remodelling, or if they’re sophisticated enough do it themselves. Regardless, the bonds are next assembled with thousands of other subprime bonds for another round of cutting up and rearranging. Frankenstein rises and the CDO is born coupon payments and risk ratings based on mind boggling complexity and opaqueness Ready for sale, its pitched to institutional investors around the world, typically finding its home in pension funds, hedge funds and mutual funds hungry for safe investments with high returns.
What’s the point of this elaborate Wall Street paper mache project? Ideally, by combining millions of mortgages into different tranches and arrangements, the risk of the underlying assets is mitigated. Until 2007, it was thought that financial engineering was now able to turn Joe Blow, who was otherwise inaccessible and too risky for institutional investors into a AAA rated asset fit for the world.
Obviously it work didn’t quite work out. The CDO machine was a dysfunction circle jerk so systemically flawed it led to a near financial meltdown and one of the worst recessions in history. There’s a lot of different reason and factors as to why it all happened; why so many loans were given to so many Joe Blows only to have them mainlined into a addicted global banking system. But remember, we’re trying to get to synthetic CDOs, not explain the origins of the crash. Plus, synthetic CDOs are best part of the story, which is continued tomorrow.

Synthetic CDOs arose during the very peak of the subprime mortgage market, when things were getting too good to be true. With more and more institutional investors wanting CDOs in their portfolios, the companies on the front line, the ones finding Joe Blows and handing them money, where miraculously having trouble finding Joe Blows. Wall Street had used up its subprime fuel.
They’d find more in the most unlikely of places.
Not everyone was mainlining Subprime Crank. Since the mid 2000s, a variety of prescient investors had seen the light and were busy figuring out how to as make as much money as possible off its inevitable collapse. The instrument they found was a Credit Default Swap or CDS.
A CDS is essentially an insurance agreement on a debt repayment. If I loan $1 million to a Greek entrepreneur, I could buy a CDS for a small monthly of someone like AIG and if the loan goes bust, AIG covers it. In finance, everything can be securitized and traded, so buyers of Credit Default Swaps don’t have to actually own the underlying assets the instrument insures. If and when the mortgage market collapsed, those short with CDSs would make a fortune selling them off.
However, they had to wait for the crash to come, and continuously make monthly payments while they did. Enter irony and the synthetic CDO. The quicker Wall Street ran out of Joe Blows to fill institutional investors demand, the more speculators began shorting the market; but as the payments from Credit Default Swaps on CDOs grew to increasingly high numbers, Wall Street saw them not as a warning to stop selling dangerous mortgage debt but as solution to sell more securities related to the subprime market. Wall Street started assembling the revenue streams from the millions of payments from credit default swaps into packages that mirrored the coupon payments from subprime CDOS. Ignorant investors who couldn’t find a CDO to invest in could now get the same high payments from a synthetic CDO composed not of mortgages but of insurance payments against mortgages. They didn’t even need to put money down to collect the payments, all they had to do was agree to back the real CDO in the event of a default . From 2005 to 2007 over $108 billion dollars worth of synthetic CDOs were issued.
There you have it, financial engineering at its best/worst.