Goldman Case: Indictment of Synthetic CDO Market?

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Includes: AIG, GS
by: Charles A. Smith

Why does the market for synthetic CDOs exist? Is it because we ran out of deadbeat borrowers in early 2007? In other words, were the bears (Paulson, Magnetar, etc.) in the same position as an equity short determined to press a winning trade - unable to borrow any more shares - so they decided to create more out of the whole cloth of credit default swaps? It sure looks like it.

Synthetic CDOs have no mortgages directly backing them, a fact which (as the Wall Street Journal pointed out today in its lead editorial) the SEC seems blithely unaware. Instead, from the perspective of the buyer of a synthetic CDO, they're exactly like writing an insurance contract. They're a bet that the purchasers of the insurance (in this case the hedge funds), will continue to pay their premiums, and that the mortgages underlying the swaps won't default.

Let's think about the motivations of the underwriter of such an instrument. First and foremost is yield. Crappy credit costs more to insure, so the premiums for a stack of dicey mortgages provide a juicy yield for the insurer. If Moodys (NYSE:MCO) or S&P tells you the odds of default on the senior tranches are miniscule, all the better. So greed undoubtedly played a role.

But there are a couple of other things going on here. First is the issue of transparency. Goldman Sachs (NYSE:GS) obviously had no obligation to reveal who was buying the contracts, but what if the writers of these contracts knew the trends in the prices of the policies they were writing? If, instead of being transacted in the recesses of the investment banks, these swaps were homogenized and traded on public exchanges, the sellers might have been better able to recognize the risks they were taking. Goldman will argue that as Rule 144 buyers, the banks and pension funds that ended up stuck with this stuff were sophisticated investors, and therefore able to protect themselves. But there is no substitute for sunshine.

Finally, in what ways was the very character of the mortgage mess altered by synthetics? These products really took off in early 2007, well after the peak in home prices. If the majority of CDOs created after January 1, 2007 were simply a bet on the direction in home prices, rather than an investment in bricks and mortar, you could argue that "virtual" mortgages actually truncated the housing boom instead of exacerbating it. But this is a dangerous path. They didn't necessarily truncate the boom as much as divert the money flow. Instead of flowing into the hands of mortgage brokers, builders and contractors, the cash ended up in the hands of hedge fund managers. And when the dominant underwriter of these insurance contracts gave it up (NYSE:AIG), we all paid.

Disclosure: No positions