Saturday, December 26, 2009

Synthetic CDO's: weapons of mass destruction

There is a good Christmas piece over at the NYT. It goes into the role Goldman had in creating these opaque securities, designing them knowing they would blow up and then shorting them, for fun and gain, making a killing when the markets tanked. One of the problems was that the damage got multiplied. The article mentions a 6x on these instruments (naked to non?)

Synthetic CDO's
Regular CDO's are a just a way to package debt securities and market them in tranches. The senior tranches will carry a AAA rating, by design. Synthetic CDO's are CDO made of exotic "assets". Such asset can be the BBB tranche left from a previous CDO deal or a naked CDS. A CDS is an insurance against default, it will pay a yearly premium to the holder of the contract and oblige him to pay out the notional value of the bond on default. A naked CDS is when you buy the protection without owning the underlying asset, effectively speculating on its default.

By packaging these contracts in CDO, the banks were able to find buyers to the long end of its exposure, while it, itself was short. It effectively marketed its long risk as AAA securities. The demand was strong.

Liquidity drain
One aspect should be regulated which is the amount of notional these instruments effectively emitted. When debt default it is the notional that must materialize, most of the time in cash reserves. This was a massive liquidity hold-up and a source of systemic instability. It spread and mutated the disease in the financial system.

Tarnished reputation
Clearly setting up securities to blow up, knowing they will blow up, marketing and selling them, no matter how transparently, while holding onto the short end, represents a huge conflict of interest. GS had privileged information it used first to offload the risk it had and then to speculate against markets. Clearly their clients interest was second to greed. This in and on itself is not illegal, but should be, in a Glass Steagal way. A business that willingly screws its own customers is a dead business anyway, no? The GS CEO gets lionized.

Broken models, broken markets
At a pure analytical level this also says that pricing in these securities got ahead of everyone. These securities were in fact impossible to price and the underlying default models (gaussian distributions) proved wrong. There will be models with fat distribution used in pricing these derivatives etc but I believe trust is gone from these markets and until it returns, securitization is effectively dead. This is a deflationary force.

AIG connection
For sure, AIG is worth mentioning in this context as most of the long exposure ended up there. At this stage, as it came to pass, it was the US Taxpayer that was on the hook for the liquidity needs of AIG. All these shenanigans allowed a few smart desks to speculate and unload risk on the US Taxpayer.


Anonymous said...

Nice analysis. GS always takes a piece from both sides. These financial instruments have served no productive purpose for the economy or the community--except for enriching a privileged few.

On another note, tell us where you might put your capital and where you might see risks over next 1-3 years?

Marcf said...

1-3 years? I navigate at 1-3 mo visibility max :) So my only advise is to stay liquid or as liquid as you can. I do that with options.

Anonymous said...

hey le marco, comment va?
Ici Salin: t as pas recu mes mails?
Bonne annee a la famille