It should have read:

I doubt the agencies knew that BSAM — which was acting as Portfolio Manager for the syn CDO — actually owned the Reference Portfolio in one of its HG hedge funds. (Even CSFB’s lawyers didn’t know until an email accident spilled the beans a few days before closing.)

Re your argument that the very nature of the CDO tranche structure nearly determines its use for speculation, I refer (again) to the third example here …

http://www.newcombat.net/article_whats_a_cdo.html

… (headed in bold “A More Interesting Problem”) — where ALL the tranches of a syn CDO were bought by Bear Stearns Asset Management — to hedge the entire portfolio of one of its High Grade hedge funds — which HG portfolio precisely matched the notional reference pool.

Thus: No speculators. Indeed: No third-party investors of any sort.

The economic reality of the deal was BSAM hedging its hedge fund, with the investment bank (CSFB) that did the CDO acting as protection seller thru a subsidiary.

As to why BSAM didn’t choose to use a thousand CDS instead of the syn CDO, I can only guess:

– Because it would have been more costly?

– Because counterparties could not be found to write the protection on some of the (arcane?) securities in the HG portfolio?

Re the latter case:

– the BROADNESS of the CDO approach might have been attractive to the protection seller.

However that may be, take note that the tranche structure of the approach chosen was rather irrelevant, given that BSAM was buying every dime of every tranche.

That is: The tranche structure was merely an effect of the form of the chosen instrument and — crucial to note — of rating agency involvement in blessing the deal.

That is: It’s the rating agency’s chief function as risk evaluator (once it tweaks the detail mechanics of the deal) to assign the $$$ amount of each tranche (revising shortly before closing the estimates that the bank made early on as the deal was being crafted).

Is that point clear? (I fear perhaps not.)

In the example at hand, the fact that the solution to BSAM’s problem took the form of a tranched CDO was somewhat sumbebekos — “accidental.”

BSAM wanted to hedge a huge arcane portfolio. CSFB offered (I imagine) to sell that protection using the pooled form (ie, a CDO rather than a zillion CDS) — and this meant the rating agencies would, as usual, be divvying up the pie into tranches AS THE MEANS toward the end of rating the pool’s risk.

I doubt the agencies knew that BSAM was the only “investor” in the tranches. (Even CSFB’s lawyers didn’t know until an email accident spilled the beans a few days before closing.)

The tranched form of the CDO, then, was convenient and familiar — easy to do — but accidental to the economic reality of the deal.

And all the syn CDOs in our shop were similarly motivated.

Perhaps there were other shops out there using the same form to place speculative bets for Big Rollers (willing to pay several millions in fees for the pleasure). But I’ve never had my hands on such a deal.

Perhaps large portions of the synthetic CDOs were constructed to meet specific demands, as you indicate, but that raises the question of why the purchasers didn’t simply buy direct CDSs. It is the tranche nature of the CDO, synthetic or otherwise, that reveals its inherent purpose: the tranches apportion the risk, and hence the returns, among the purchasers. But an entity looking for protection will simply buy straight protection; only a speculator or an investor is interested in the risk versus return.

While the secondary market for synthetic CDOs may be weak, the very existence of the tranche structure argues for the presence of speculators and investors; and if speculators and investors are involved, then the result of the CDS triggers may be more than simple payouts, but may have dramatic effects on the balance sheets of entities who, it will be discovered, had no actual exposure to the reference securities.

1A. The issuing trust/spv of a cash CDO physically OWNS the pool of underlying assets, the cashflow of which gets pressed thru the tranches to produce stratified returns.

1B. But in a synthetic CDO the pool never gets bought. Instead it’s a “notional” (imaginary) pool. It exists only as a list of instruments stapled to the back of your offering memo: the so-called “reference portfolio.”

A synthetic deal then proceeds thru time with an eye on the actual performance and mishaps of the instruments in the “reference portfolio.” But without ever owning them.

(It’s something like Rotisserie Baseball — where the actual performances of real baseball players get translated into the imaginary world of the Rotisserie league, and there produce results.)

Synthetic CDOs, then, are “naked” in the sense of (x) a Credit Default Swap where the subject security has not been warehoused — or (y) a short stock sale where the shares have not been properly borrowed.

For a richer picture of a synthetic cdo at work, see the third example here:

http://www.newcombat.net/article_whats_a_cdo.html

The example was taken from life — one of the Bear Stearns High Grade hedge funds.

1C. All the synthetic CDOs I worked on were — like the Bear example — entered into to hedge a specific securities portfolio. They were problem solvers for the owner of that specific portfolio.

Ie, they were NOT huge complex “naked” bets against a pie-in-the-sky reference portfolio by a third-party gambler.

It’s POSSIBLE synthetic CDOs might be used to place a wide-ranging “naked” bet — as so many CDS were used to bet nakedly against a single corporate issuer.

But my imagination protests that it would be an odd circumstance that would lead a client to pay a bank and the rating agencies millions in fees to concoct and close such a CDO — unless (again) that client has a bigger problem that the CDO helps to solve.

It sounds from the Bloomy piece that the synthetic CDOs were (again like the Bear example) hedges for somebody holding a lot of the Iceland bank bonds.

Ie the reference portfolio was the universe of CDS on the Iceland banks. The synthetic CDO then would be just a super CDS.

Thus, the Issuer of those CDOs would be, via a separate complex CDS built into the deal (as in the Bear example), buying protection, and a third party (most likely a “specialty financing” subsidiary of the investment bank that did the deal) would be the protection seller.

The buyer of the CDO tranches would thus be the net protection buyer.

Perhaps the Icelandic banks themselves, or the Treasury or central bank (if they have one).

2. Also au contraire: the type of instrument in the pool has nothing to do with whether the CDO is cash or synthetic.

Corporate bonds, ABS, CDO tranches, CDS, LBO loans — all might or might not be in any given cash or synthetic cdo pool.

3. You touch on secondary market trading.

To be gross to be brief: No secondary market worthy of the name existed for CDO tranches. They could be dumped if needed, dealing thru investment banks, but the dumper would expect to take a haircut.

In good part this is because CDOs were were problem-solvers for a particular client and tended to have idiosyncratic problem-solving mechanics.

In contrast, CMOs — where the pools consisted purely of mortgage bonds or long-term commercial leases — were both voluminous and more generic, more interchangeable, and thus the secondary mkt here was rather healthy.

The Iceland synthetic CDOs in the bloomy piece seem to have been “pure” — referencing the universe of CDS on the Iceland banks. But it’s hard to imagine the volume here worldwide would support active secondary trading. But maybe I’m wrong.

For a discussion of these secondary markets differences, see:

http://newcombat.net/Conversation/credit-crisis-alphabet-soup-phantom-market-value/

Thanks for the reminder that a worldwide CDS/CDO shoe still has to fall and that IT might fall with a bigger thud than the local ones.

-K

I'm not reassured. Synthetic CDOs are pretty dodgy paper. I'm amazed this stuff hasn't been written to zero already, but from what S&P hints at, the Iceland matter is going to have a serious impact on these trades. And size of balance sheet pre-bankruptcy isn't necessarily a reliable guide. Lehman had far fewer CDS per dollar of cash bonds that Delphi when it filed for bankruptcy. I have no idea where Iceland sits on this matter.

And even if true, saying that the Iceland CDS unwind is smaller than Lehman isn't reassuring either. That's like saying pneumonia is less serious than congestive heart failure. But we aren't talking one versus another, we are talking one AFTER another. And pneumonia after congestive heart failure is a completely different kettle of fish than pneumonia in an otherwise healthy person.

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