Synthetic CDO
[3] In 2005, the synthetic CDO market in corporate bonds spread to the mortgage-backed securities market,[4] where the counterparties providing the payment stream were primarily hedge funds or investment banks hedging, or often betting that certain debt the synthetic CDO referenced – usually "tranches" of subprime home mortgages – would default.
They enabled large wagers to be made on the value of mortgage-related securities, which critics argued may have contributed to lower lending standards and fraud.
The actual volume was much higher because synthetic CDO trades are unregulated and "often not reported to any financial exchange or market".
[12] A synthetic CDO is typically negotiated between two or more counterparties that have different viewpoints about what will ultimately happen with respect to the underlying reference securities.
[1] Various financial intermediaries, such as investment banks and hedge funds, may be involved in finding the counterparties and selecting the reference securities on which exposures are to be taken.
Sellers of credit default swaps receive regular payments from the buyers, which are usually banks or hedge funds.
[16] The short investor for the entire deal – "betting it would fail" – was Goldman, which purchased credit default swap protection on the reference securities and paid premiums.
These firms put up a total of $195 million to purchase "mezzanine" tranches of the deal (rated AA to BB) and in return would receive scheduled principal and interest payments if the referenced assets performed.
The seller of the synthetic CDO gets premiums for the component CDS and is taking the "long" position, meaning they are betting the referenced securities (such as mortgage bonds or regular CDOs) will perform.
The buyers of the component CDS are paying premiums and taking the "short" position, meaning they are betting the referenced securities will default.
Synthetic CDO Example: Party A wants to bet that at least some mortgage bonds and CDOs will default from among a specified population of such securities, taking the short position.
One investment bank described a synthetic CDO as having characteristics much like that of a futures contract, requiring two counterparties to take different views on the forward direction of a market or particular financial product, one short and one long.
These securities are packaged and held by a special purpose vehicle (SPV), which issues notes that entitle their holders to payments derived from the underlying assets.
According to New York Times business journalist Joe Nocera, synthetic CDOs expanded the impact of US mortgage defaults.
[10] Zuckerman calls the growth of synthetics, "the secret to why debilitating losses resulted from a market that seemed small to most outsiders".
Krugman wrote in April 2010 that: "What we can say is that the final draft of financial reform ... should block the creation of 'synthetic CDOs,' cocktails of credit default swaps that let investors take big bets on assets without actually owning them.
Author Roger Lowenstein wrote in April 2010: ...the collateralized debt obligations ... sponsored by most every Wall Street firm ... were simply a side bet – like those in a casino – that allowed speculators to increase society’s mortgage wager without financing a single house ... even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard.
[26] Columnist Robert Samuelson wrote in April 2010 that the culture of investment banks has shifted from a focus on the most productive allocation of savings, to a focus on maximizing profit through proprietary trading and arranging casino-like wagers for market participants: "If buyers and sellers can be found, we'll create and trade almost anything, no matter how dubious.
In the housing boom, CDS were sold by firms that failed to put up any reserves or initial collateral or to hedge their exposure.
[30] The New York Times quoted one expert[31] as saying: The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen ...
The role of the intermediary is widely understood by the sophisticated investors that typically enter into complex transactions like synthetic CDOs.
[33][34] However, when an intermediary is trading on its own account and not merely hedging financial exposures created in its market-maker role, potential conflicts of interest arise.
