A zero-sum game with mortgages as the dice

D. MURALI | Updated on June 11, 2011


Synthetic CDOs (collateralised debt obligations) were Wall Street's version of a lab experiment gone mad, write Bethany McLean and Joe Nocera in All the Devils Are Here: The hidden history of the financial crisis ( www.landmarkonthenet.com). Unlike a corporate bond, backed by the assets of a corporation — or even a mortgage-backed security, backed by actual mortgages — these CDOs existed solely to make complex bets on securities that existed somewhere else in the system (which, as often as not, were themselves bets on securities that existed somewhere else in the system), the authors explain. “They were called synthetic CDOs because the CDOs didn't contain ‘real' collateral; rather they were based on the performance of existing bonds held by someone else. In Street parlance, they ‘referenced' the real bonds.”

Risky tranches cloned again and again

It may seem weird, but with a synthetic CDO, it did not matter anymore if the originators could make new mortgages, or even if they went out of business entirely, as the book elaborates. Because synthetic CDOs made of credit default swaps referenced mortgage bonds that already existed, you did not need any more bonds, the authors reason. “You could clone the same risky tranches again and again — five, ten, twenty times if you wanted. And you could do this quickly, without waiting around to buy real securities. Even if there wasn't a single new mortgage bond created, the supply of securities was now infinite and immediate, thanks to credit default swaps and synthetic CDOs.”

A pertinent question that perhaps got overlooked during the period of exuberance was the rationale of a synthetic CDO, something which did not fund a home, or make the mortgage market any better. Alas, as the authors acknowledge, it was a zero-sum game in which the dice were mortgages. More dangerously, as they note, the synthetic CDOs magnified the bubble because it was possible to bet on the same bad mortgages many times over.

Plenty of dumb smart money

There was plenty of dumb smart money, reads a quote cited in a chapter titled ‘The smart guys.' And there were some smart people to whom it was evident that all was not well. The chapter makes a reference, for instance, to a January 2007 email of a young Goldman Sachs salesman, Fabrice Tourre, desperately describing to his girlfriend how his work is laborious, and also bizarre because he has the sensation of coming each day to work and reliving the same agony, a little like a bad dream that repeats itself.

“When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: ‘Well, what if we created a ‘thing,' which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows the price?')” Continues Tourre that it sickens the heart to see the product shot down in mid-flight, like Frankenstein turning against its own inventor!

Of course, the one thing that was neither conceptual nor theoretical was the losses, the authors add. “They were all too real, and in 2007, as winter turned to spring, they were coming.” Chronicles of a collapse, of epic proportions.

Published on June 11, 2011

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