Brooksley Born Raises an Important Question, But Answers are Weak [View All]

Have you ever wondered what a synthetic CDO is, or whether it contributed to the housing bubble? At a recent hearing held by the Financial Crisis Investigation Commission, Brooksley Born asked questions designed to get answers for you. A complete answer would lead to a fuller understanding of the role of credit default swaps in the housing bubble.

The panelists are from Citibank: Murray Barnes, was involved in risk management, and Nestor Dominguez, who worked in CDOs are the speakers. There is a brief description of CDOs at the end of this post. A synthetic CDO issues credit default swaps on other entities, including CDOs and real estate mortgage backed securities. A hybrid CDO issues credit default swaps and holds other debt instruments, such as securities of other CDOs and subprime mortgages.

Born is trying to find out if the issuance of synthetic and hybrid CDOs made the housing bubble last longer and cost more. Watching the panelists answer, you’d think they had never thought of that question. Eventually, Dominguez says it didn’t extend the housing bubble because “it didn’t require any origination.” Yves Smith explains why that is wrong in her excellent book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. She thinks the housing bubble was significantly affected by synthetic CDOs.

A number of firms, including Goldman Sachs, are known to have bet against the securities they were selling to investors. Whoops, sorry, Goldman Sachs says it was just a market maker, and denies that they were betting against their investors.
Smith gives a detailed description of Wall Street strategies. The explanations are complex, and what follows is only a sketch. Interested readers should read Chapter 9 of ECONned closely.Smith explains that synthetic CDOs were first formed in mid-2005, when the International Swaps and Derivatives Association formalized the procedures for issuing CDSs on tranches of CDO securities. Before then, investors could buy insurance from the monoline insurance companies, like AMBAC. Suddenly anyone could write protection, or buy protection on just about any tranche of a CDO.

That led to this strategy called credit arbitrage. The hedge fund buys a low tranche of a CDO, and buys protection on the next higher tranche. For example, the hedge fund buys the BBB tranche of a mezz CDO, and buys a CDS on the A tranche. While the CDO is functioning, the BBB tranche throws off cash to the hedge fund. If the CDO fails, the hedge fund makes a big profit by collecting on the CDS if the A tranche goes down along with the BBB tranche. Mezz CDOs are full of the worst of the securities of other CDOs so that seems likely.

http://firedoglake.com/2010/04/09/brooksley-born-raises-an-important-question-but-answers-are-weak/