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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How does a synthetic CDO actually work? I read that the synthetic CDO is just a bunch of CDS that pay out if the mortgage market fails. So if you buy a synthetic CDO, do you get paid from the underlying CDS when the underlying-underlying bonds drop in value. Does that mean if you are long on a synthetic CDO, you are actually shorting the mortgage market?

Is it possible for the synthetic CDO to contain CDS that people have bought and do not want any more. That would allow the CDS buyers to sell it to some bank who then builds the synthetic CDO and sells the investors. The original CDS buyer no longer has to worry about the CDS. The bank will pay the premium for the CDS (with the money from the investors) and no new CDS will have to be created in the system. but i guess that isn’t financial innovation if nothing new comes out of it :)

Posted by savo | Report as abusive

I’ve written CDS and CDO so many times, it all looks the same.

Posted by savo | Report as abusive

Synthetic CDOs might be less harmful, at the margin, to the average citizen (just as you’ve pointed out). But I think they’re clearly more harmful to the banking system, especially if CDO risks aren’t understood (and clearly they weren’t).

Which means we then have to debate which is directly more harmful — a housing bubble, or a bank run.

Posted by Sprizouse | Report as abusive

Look on the bright side. “[E]xcessive and irrational demand for collateralized debt obligations” provided a market-based rationalization for lowering lending standards, and in so doing solved that pesky “redlining” problem.

Posted by Mega | Report as abusive

CDOs sucked all value out of homebuyers pockets, synthetic CDOs sucked the meaning out of our entire economy. Top marks for staying out of jail, lads.

Interestingly, both sets of culprits blame (via tea-party mouthpieces) the bankers’ plight on overconfident prospective homeowners believing they could actually afford something of value by subscribing to the American Dream on the banks’ apparently stated terms, forcing said humble bankers to fork over loans they really(?) didn’t want to make in the first place…

That dream having turned into a nightmare burning from the top down, the creators of toxic financial instruments, none of whom is above reproach yet all of whom are looking to buy time by editorial revisionism in relativization of their crimes, continue to fiddle.

Like many patient listeners, I’m already bored with the old one, so let’s hear a new tune, shall we? Something like the one you were just humming…

Some might submit, if Bernie Madoff had just kept going, we’d have had a cure for cystic fibrosis by 2011. Um, right. Then again, you might say we didn’t really need those homes that got built because everybody in America already has the best home (no) money can buy, so it’s actually better to have screwed the whole country rancid because absolutely no-one needs one of those, either. Yeah, that one has a nice ring to it, but it might be just a bit too close for comfort to the truth, and it doesn’t let MegaDeth off the hook.

OK then, for the sake of argument, which is better – dying of HIV or AIDS?

Posted by HBC | Report as abusive

When you make the distinction between cash and synthetic CDOs, why don’t you discuss hybrid CDOs? It seems to me that’s where you’d see the action with synthetic assets affecting the cash market.

Posted by csissoko | Report as abusive

You are correct in stating that S-CDO’s were a clear indication from the Banking/Wall Street community that housing was running out of steam. There was simply not enough migrant cherry pickers to pounce on. But the problem for the banks was that they had indeed hundreds of billions of ABS CDO’s on their books that was unaccounted and unhedged. Also, there were many smart hedge fund managers who were starting to buy CDS protection from the banks, and buying them at cheap prices. Wall Street was still drining the cool-aid at this moment in 2006. So what we have here is Wall Street instituions and the supply chain extremely long subprime. When the thought came across their minds that indeed the inmates were running the asylum, S-CDO’s started to be created. But to state that S-CDO’s was an emergency brake for the subprime crisis is patently untrue. The simple reason we had the final spike up in housing was indeed because of S-CDO’s. Most people even at that time had no clue what these things were. The S-CDO is a binary bet on housing with Wall Street dealing the cards. Many investors and speculators saw this as an even more reason to suggest that Housing will never correct. Finally the invention of the S-CDO was the reason we saw so much pain in the credit markets and economy. If S-CDO’s were never created then AIG wouldn’t have had to insure them. The S-CDO is the single worst financial product in the history of financial products as it made all of the counter parties pees in a pod. Credit Default Swaps on the other hand actually work as designed.

Posted by JayTrader | Report as abusive

There is a response to this article that defends cash CDOs at he-silver-lining-to-cash-cdos?source=fee d

Posted by Paulman | Report as abusive

What Sprizouse Said. Without the S-CDO, you have “pier loans,”–or, more accurately, mortgages you were stupid enough to write and/or buy because you thought that you would find The Bigger Fool.

With the S-CDO, you get to multiple that exposure while pretending you’re “managing risk.”

Posted by klhoughton | Report as abusive