Wednesday, Nov 26, 2008
The tsunami is getting ever closer
Business Spectator: A tsunami of hope or terror?
As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm that could actually save the global banking system.
It is a truly great irony that the world’s banks could end up being saved not by governments, but by the synthetic CDO time bomb that they set ticking with their own questionable practices during the credit boom.
Alternatively, the triggering of default on the trillions of dollars worth of synthetic CDOs that were sold before 2007 could be a disaster that tips the world from recession into depression. Nobody knows, but it won’t be a small event.
Posted by gardeniadotnet @ 02:54 PM (956 views) Add Comment
18 Comments
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1. seanb303 said...
i'm gobsmacked
2. denzil said...
I don't doubt the accuracy of the article but the thing smells like a bunch of stoned bankers who got together one night to see what ludicrous schemes they could concoct. I can just picture it. One banker says to other, "I have an idea called a SPV". Assembled crew roar with laughter because it sounds like spiv. "And what about this", says another his eyes still moist at the thought of spiv, "a synthetic CDO". The ensemble collapse onto the floor, their sides splitting with laughter.
Synthetic CDO maybe but the bullsh1t smells and looks pretty real to me, that's for sure.
3. mountain goat said...
"This is entirely uncharted territory so it’s impossible to know what will happen, but it is possible that the credit crunch will come to sudden and complete end, like the passing of a tornado that has left devastation in its wake, along with an eerie silence."
An eerie silence of wealth destruction. I bet our pension funds are up to their necks in these "investments".
4. fjcruiser said...
Great article. AIG in 1997-1998 was already one of the largest buyers of japanese structured products (all the repackaged japanese bad loans of the 90s).Back then, all they were interested in was the triple A rating so I cannot even imagine how much they could have accumulated on their balance sheet in the last 10 years.All it cost the banks was a good dinner with the rating agencies to obtain the triple A ratings they needed in odere to conduct business.
Yes the whole process was as simple as this article described it. It shows the extent of greed and how banks really stuffed investors.
5. bystander said...
Why is nine the magic number????
6. renting2 said...
Can't believe that stuff as devious as this actually exists.
7. plato said...
You have got say "Wow" to this. Is this really possible or a possibility? Could the whole scenario be turned on its head as far as the banks are concerned and is this why governments are doing everything in their power to rescue the banks? Knowing that the big pay day is only a matter of time and the banks will be flooded with capital.
Great Post, good reading and quite a revelation, but I need some expert views on this!
8. gardeniadotnet said...
5. bystander said... Why is nine the magic number????
Wondering that myself. Is it a tipping point or critical mass thing?
The article says...
"Those investors who bother to read the fine print will see that they will lose some or all of their money if seven, eight or nine of a long list of apparently strong global corporations go broke."
9. mountain goat said...
The banks didnt get off so lightly when mortgage CDOs exploded. I recon they won't escape lightly when company CDOs explode either when the insolvencies kick in. Martin Weiss feels the same Citigroup collapses! Banking Shutdown Possible.
10. 51ck-6-51x said...
Interesting article on the surface but...
A synthetic CDO has CDS in the SPV's collateral pool, not struck between the bank and the SPV:
Bank buys CDS contracts (sells protection)
Bank sells CDSs to SPV
SPV issues tranched Notes, such that the first hit from prospective defaults is taken by the equity tranche, then by mezzanine tranches and finally by the most senior tranche.
This can be seen as follows: when an underlying default occurs the SPV's waterfall (the cash flowing down towards the equity trache) gets shorter (does not reach the lowest traches to the same amount).
Since the SPV has protected against default it must then honour the contract and pay out the notional to the CDS counterparty (that is where the lost cash flow, above, goes!)
The article suggests that either this is not the case or that banks have then, separately, bought protection from the same SPVs on a kth to default basis*, however if the CDO manager had decided to do that the ratings of their notes would have been damaged - even using rating agencies old models.
* and for some reason the author seems to know this is k = 9 and that this is the case across the board - I am sceptical - they already offloaded their risk, but now they want to take on some counterparty risk which they know will not hold? I seriously doubt it! I think it's more likely that this guy has misunderstood what a synthetic CDO is.
The REAL problems with CDOs are:
1) That they are difficult* to model without making some very sweeping assumptions. * by difficult I mean thousands of dimensions.
2) The buyers of the notes seemed to blindly trust rating agencies. These agencies had publicly available models and are paid by issuers. It's like trusting an estate agent when he tells you the foundations of a house are solid!
11. gardeniadotnet said...
10. 51ck-6-51x said... I think it's more likely that this guy has misunderstood what a synthetic CDO is.
Unlikely, looking at his pedigree.
http://en.wikipedia.org/wiki/Alan_Kohler
12. Orcusmaximus said...
"the bank agrees to pay the SPV 1 or 2 per cent per annum of the contracted sum."
This doesn't sound like much of an investment. What am I missing?
13. last_days_of_disco said...
"Commodity Futures Modernization Act, which specifies that products offered by banking institutions could not be regulated as futures contracts.
This bill, by the way, was 11,000 pages long, was never debated by Congress and was signed into law by President Clinton a week after it was passed. It lies at the root of America’s failure to regulate the debt derivatives that are now threatening the global economy.
Anyway, moving right along – "
The humour here, really made me chuckle. However, it really is unacceptable that JP Morgan can just bypass any oversight on the part of the representatives of the people and its a huge problem. It makes a farce of American democracy. So the important decisions are not made by the people. I am really going to rub every American I meet's nose in this when they prate on about democracy.
14. davecrash said...
Sounds like yet another pyramid selling scheme that’s about to come tumbling down.
It looks like the world has gone more stark raving bonkers over the past decade than I thought. As soon as NASA find another planet with a breathable atmosphere I'm off.
15. stillthinking said...
Amazing. Really rolling back the deceit.
The article doesn't explain how the magic pixy dust got sprinkled though? A bit too skimpy on that point which seems kind of crucial. The liabilities offloaded to the SPV but the beneficiary of default being the bank?
16. amjidk said...
wtf?
17. malct said...
very subtlely subversive mg - nice one
18. 51ck-6-51x said...
gardeniadotnet:
He is a journalist, I am in quantitative finance (you know the people who design all this crazy stuff - yeah yeah - it's all my fault...).
The idea is correct in that a bank could, in theory, purchase protection from the SPV - but a synthetic CDO is not constructed in that way - it would be a secondary deal which would impact the CDO's issued notes.
So the article makes it sound far more dodgy than reality. CDO's are not bad instruments in themselves - they are misunderstood instruments (or rather the model risks are misunderstood).
Orcusmaximus:
A CDS is a contract made between two parties, kind of like insurance.
One pays the other a premium (eg 1% of notional every year, usually quarterly) in order to purchase protection on that notional in an entity.
For example a CDS on the UK Government is currently around 1% (very high for a government, reflecting the perceived likelyhood of their [technical] default)
Unlike normal insurance, however, one may enter the contract without underlying exposure - kind of like me taking out life insurance on you... I don't think you'd be happy if I did that would you? Which can make the contracts pure bets.
A synthetic CDO is a CDO where the collateral pool is made up of CDS contracts.
(compared to a normal CDO, where the collateral pool is real assets)
For more information see wikipedia