The Audacity Of Synthetics

DeepCapture has picked up something I’ve written about before, but none of these folks seem to put together the "big picture", as I outlined yesterday on my Blogtalk show.

As Fiderer explains, Paulson asked the banks to create those CDOs “so that they could be sold to some suckers at close to par. That way, Paulson’s hedge fund could approach some other sucker who would sell an insurance policy, or credit default swap, on the newly minted CDOs. Bear, Deutsche and Goldman knew perfectly well what Paulson’s motivation was. He made no secret of his belief that the CDOs subordinate claims on the mortgage collateral were close to worthless. By the time others have figured out the fatal flaws in these securities which had been ignored by the rating agencies, Paulson could collect up to $5 billion.

Let’s step back a second.

A "CDO", or "Collateralized Debt Obligation", is in theory a very simple instrument.  It is, at it’s core, a collection of income-producing "assets" that have a cash flow that can be diced up paid to people who have purchased components of the CDO.

The usual thought process when someone says "CDO" is that some bank bought a bunch of bonds, compiled them into a CDO and then sold off the tranches.

The CDO itself is typically held off-balance sheet in a SIV/SPV, lest the bank be forced to recognize it as part of it’s "assets."  This is permissible because the bank doesn’t own the assets, the legal entity does, and it got the money to buy them from the people who bought the tranches that were issued.  The banks do this because they get a nice fee for filing the papers to establish the entity along with a management fee to act as the servicer – that is, the "guy in the middle" who takes the money that comes in from the debt instruments and slices it up, paying out those funds to the buyers of the CDO’s tranches.

So you can think of a CDO, in it’s simplest form, as a way of taking a bunch of bonds, putting them together, and then deciding by some mathematical formula who gets the lion’s share of the risk in those bonds, along with (of course) the larger set of the rewards.

But of course in "structured finance" nothing is ever as simple as it seems.

Remember what I said up above?

A "CDO", or "Collateralized Debt Obligation", is in theory a very simple instrument.  It is, at it’s core, a collection of income-producing "assets" that have a cash flow that can be diced up paid to people who have purchased components of the CDO.

Who said that the "assets" had to be actual bonds?

A synthetic CDO is, as the name implies, not made up of actual bonds.  Instead, the issuer writes a naked credit-default swap on the underlying reference(s) they use.

The buyer of that CDS pays a premium, usually in the form of an annual payment (and sometimes something up front too.)

BINGO!  We have "a thing" that throws off an income stream and thus can, and does, form the basis for a CDO!

The "CDOs" that are at issue here were synthetics.

That is, they did not own actual bonds, they were comprised of credit-default swaps that Goldman wrote against subprime mortgage bonds.

This would have left Goldman exposed (as the writer of the swaps) for the potential losses.  Goldman, in turn, bought a CDS from AIG against the "portfolio" in the CDO, thereby laying off the risk on AIG.

Goldman is thus now "net neutral" (provided AIG can pay!) and happy as a pig in slop, as they made money on the origination fees for the CDO and in addition get to skim a nice little bit off the servicing. 

What could possibly go wrong?

More than a few things.

Let’s start with how this CDO got funded.  Remember, it got originated by Goldman writing a bunch of credit-default swaps.  Who bought them?  Someone had to think subprime was going to detonate, because they paid good money for "protection" that would go up dramatically in value if it did, but for which they were going to pay the CDO investors good money if it did not.

It appears that the buyer of those credit-default swaps was, perhaps, John Paulson:

“Paulson not only initiated these transactions, he also specified the terms he wanted, identifying which mortgages would be stuffed into the CDOs, and how the CDOs should be structured. Within the overall framework set by Paulson’s team, banks and investors were allowed to do some minor tweaking.”

Ah, so the allegation contained here is that John Paulson (of hedge fund fame, not to be confused with Hank Paulson the ex-treasury secretary) combed through the pile of subprime mortgage bonds that were out there and handed Goldman a list of "what I want in there", then offered to buy the Credit Default Swaps that would pay out at a huge multiple if and only if those underlying bonds failed to perform.

In other words Paulson combed through the data available on these subprime mortgage deals and picked out the crappiest of the garbage – the most-rotting of the dead fish, all of which allegedly were "AAA" at the time one would presume but which he was quite sure would soon be either downgraded – or default outright – and then asked Goldman to use those as the references against which it would write the swaps that Paulson wanted to buy.

But remember – Goldman didn’t buy the bonds to set up the CDO – they just issued a credit-default swap, which, it appears, Paulson’s hedge fund bought.

Goldman then went out and solicited people to buy the tranches of the CDOs, selling what was alleged to be a cash-flow stream that Mr. Hedgie had offered (out of the goodness of his heart, no doubt – ed: yes, that’s sarcasm) to fund!

Here’s the question:

Did Goldman disclose to the potential buyers in the offering circular that John Paulson had come to them with a laundry list of characteristics he wanted in the CDO and offered to fund the credit-default swaps which would only make him money if those reference bonds blew up, and that he would take large, material losses IF THE SECURITIES – AND THE CDO – PERFORMED AND ACTUALLY GENERATED THE CASH FLOWS PROMISED?

I don’t have a copy of the offering circulars for these CDOs.  Perhaps someone does and can forward them to me. 

But somehow I find it hard to believe that it was made clear to the buyers of these tranches before they plunked down their money that they came into existence because a wise guy came to the bank and asked for them to create a synthetic CDO with specific characteristics and that they would provide the cash flow to be paid to their investors – but that the essence of their desire in setting this up was that they believed the reference instruments would default and in doing so they would become rich while the tranche buyers would be left with little or nothing!

You can say that the buyers of the CDOs should have done their due diligence.  Ok, I’ll grant you that.  You can also say that the ratings agencies had no business granting "AAA" ratings on underlying securities with such shaky repayment prospects, and I’ll agree with that too.

But this leaves open the question of whether it is fair, just, or even legal to create a synthetic security that at it’s core comes into existence because someone believes that the reference is going to detonate, and then sell off pieces of that security to investors without prominently disclosing the source of the funding of the cash flow, that they proffered the criteria for inclusion in the reference and that the INTENT of their funding was to profit from an EXPECTED detonation of the reference securities.

It also leaves open the question of laying off that risk on an insurance company (whether in a regulated subsidiary or not) without similarly disclosing the above to them up front!  That is, is it fair, just (or even legal) to buy fire insurance on a property when you have been told that someone expects a fire in that structure based on what they believe is credible analysis (e.g. a look at the wiring plan), without telling the insurance company about what you were told?

I don’t have answers to the questions about the propriety or legality of these actions.  But I can opine on my view of the ethics involved in such a set of transactions by a bank, and that’s easy: this, in my opinion, is nothing more or less than intentionally screwing people.  That is, this is not about "intermediation" or any such claptrap – it was, in my opinion, a pure act of financial rape-for-profit.

These sorts of "naked" positions – whether in the form of a raw naked Credit Default Swap or in the form of a "synthetic" CDO – must be barred for creation, trading, management and handling in all of their forms by any entity subject to any form of federal or state regulation or backstop, including but not limited to banks, insurance companies, pension funds and similar entities.

If hedge funds wish to bet amongst themselves on the life (or death) prospects for a given reference security, let them do so.  I don’t care one whit if John Paulson is right or wrong – he’s entitled to place his bets and make (or lose) money as fate and skill dictate.

But he should not be entitled to solicit a bank, investment or otherwise, to peddle off securities to others and obtain what amounts to insurance on their performance, while not fully disclosing to everyone involved that THE VERY REASON THIS SECURITY EXISTS is that he wanted to place a bet that the reference on which this security was based would detonate, and that if he is correct in his analysis THOSE WHO BUY AND INSURE THIS "SECURITY" WILL FIND THEMSELVES HOLDING A PILE OF USED TOILET PAPER.