The silver lining to synthetic CDOs

By Felix Salmon
April 11, 2010
Shleifer paper on financial innovation is this part of the model:

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One of the more thought-provoking bits of the Shleifer paper on financial innovation is this part of the model:

Optimism about the profitability of the new claim at t = 0 encourages the intermediary to over-invest in an unproductive activity, eventually triggering a loss… Investment in A occurs only if new securities can be engineered, so financial innovation bears sole responsibility for unproductive investment. It can be argued that the expansion in the supply of housing in the last decade was an example of such inefficient investment needed to meet the growing demand for securitization of mortgages.

To put it another way, it was the excessive and irrational demand for collateralized debt obligations which caused all those Miami condos and Phoenix tract homes to be built in the first place.

That makes sense to me, but it raises an interesting question about the damage caused by synthetic CDOs. Here’s Jesse Eisinger and Jake Bernstein, from their investigation of Magnetar:

By helping create investments it also bet against, the hedge fund was actually fueling the market. Magnetar wasn’t alone in that: A few other hedge funds also created CDOs they bet against. And, as the New York Times has reported, Goldman Sachs did too. But Magnetar industrialized the process, creating more and bigger CDOs.

Several journalists have alluded to the Magnetar Trade in recent years, but until now none has assembled a full narrative. Yves Smith, a prominent financial blogger who has reported on aspects of the Magnetar Trade, writes in her new book, “Econned,” that “Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”

Certainly the banks and investors who ended up on the long side of the synthetic CDO trade ended up losing lots of money to people like Magnetar and John Paulson who were on the short side of the trade. But in some ways the Magnetar-driven boom in synthetic CDOs was actually preferable to the boom in RMBS-based non-synthetic CDOs which preceded it.

Think about it this way: both CDOs and synthetic CDOs resulted in losses for investors on the long side. But In the world of CDOs, demand for paper ended up creating a disastrous building boom which diverted resources from more productive activity, skewed local tax revenues, and created the precondition for the wave of foreclosures which is likely to continue for the foreseeable future.

In the world of synthetic CDOs, by contrast, demand for paper just ended up making a bunch of shorts extremely rich: all the other real-world repercussions of the CDO market were actually avoided.

I’m not saying that the world of synthetic CDOs was a good thing. In fact, I’ve explained why I think that it was harmful. But the point that investors started moving from CDOs to synthetic CDOs marked the point at which the housing bubble stopped growing: the move played a significant role in ending the real-world housing insanity. If banks could create synthetic CDOs out of thin air, they no longer needed to encourage subprime originators in the Inland Empire to give $600,000 mortgages to itinerant strawberry pickers, just to keep their channels full.

When talking about credit default swaps, the material out of which synthetic CDOs are made, people often get very upset that you can have more CDS outstanding on a certain name than there is of the underlying instrument. But just think how much better off we would be if the amount of real-money subprime lending had never boomed at all, and if all the financial speculation on subprime mortgages had been confined to synthetic CDOs, all of which referenced a relatively small handful of subprime deals. We wouldn’t have had nearly as much of a housing boom, we wouldn’t be stuck with crumbling suburbs, we wouldn’t have a foreclosure crisis, and we would have invested our money in much more productive things than real estate for most of the last decade.

Of course, it would have been much harder to find people like John Paulson to take the short side of those trades: you needed a bubble to attract the hedge funds who fueled the synthetic CDO boom. But I still think it’s reasonable to consider synthetic CDOs to be less harmful, at the margin, than their real-money counterparts.

All that said, synthetic CDOs did make it much easier for banks, in particular, to take on enormous amounts of highly-leveraged exposure to the subprime market, by holding on to unfunded super-senior tranches. That was a particular problem in the case of Citigroup. When the likes of Citi and Merrill Lynch got out of the moving business and started going into the storage business, they were creating a lot of systemic risk where none had previously existed — and the rise of synthetic CDOs made it much easier for them to do so. As I say, synthetic CDOs were indeed harmful. But were they more harmful than normal CDOs? I’m far from convinced.

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