Insider's Game

Selected writings by David Fiderer

FCIC Shows That Most Synthetic CDOs Were Designed To Fail

First published in OpEdNews on February 5, 2011

Goldman SachsJohn Paulson and Magnetar may not have been so exceptional.   Those entities created toxic financings, known as synthetic CDOs, which were designed to fail. Step 1 was to select hyper-leveraged slices of dodgy subprime bonds for the CDO; Step 2 was to purchase the tiny sliver of CDO equity in order to signal a vote of confidence to investors who might buy more senior slices of CDO debt; Step 3 was to place a much larger bet that the senior debt would default. The equity was a small loss leader used to get the deal done. The big payoff came from The Big Short on the senior slices, which was kept secret from other investors and from the public.   The  FCIC  indicates that plenty of other hedge funds also made money on the exact same scheme:


Investors, usually hedge funds, often used credit default swaps to take offsetting positions in different tranches of the same CDO security; that way they could make some money as long as the CDOs performed, but they stood to make more money if the entire market crashed. An FCIC survey of more than 170 hedge funds encompassing over $1.1 trillion in assets as of early 2010 found this to be a common strategy among medium-size hedge funds: of all the CDOs issued in the second half of 2006, more than half of the equity tranches were purchased by hedge funds that also shorted other tranches.  The same approach was being used in the mortgage-backed securities market as well. The FCIC’s survey found that by June 2007, the largest hedge funds held $25 billion in equity and other lower-rated tranches of mortgage-backed securities. These were more than offset by $45 billion in short positions.


More specifically, those equity investors were not betting on the crash of an entire market; they were betting against a specific portfolio of mortgage securities, which they might have selected.  Here’s how  Merrill Lynch  characterized the process:


It was also common throughout the industry for the equity investor in a CDO, which had the riskiest investment, to have input during the collateral selection process. As mentioned above, however, the collateral manager made the ultimate decisions regarding portfolio composition. Like investors in any asset class, investors in a CDO’s riskier, more-junior tranches, including the equity, would commonly attempt to hedge those positions either by shorting higher-rated securities in the capital structure or by purchasing credit protection on specific portfolio assets. This “long/short” strategy was well known by traders across the industry.


It’s impossible to respond to that kind of sophistry without belaboring the obvious. Almost every trader pursues a  “long/short” strategy. His net position reveals his true intentions and motivations.  But, as the FCIC revealed, equity investors were not interested in netting out their risk exposures at anything close to zero.   They took net short positions on financings that had no legitimate business purpose.  These synthetic CDOs neither financed nor repackaged financings of home mortgages. Though they were comprised of credit default swaps insuring mortgage bonds, they did not necessarily provide for a reallocation of credit risk. (These CDOs usually provided for financial settlement, meaning that the credit protection buyer never needed to own the asset being insured.) And, because almost everything about CDOs is kept secret, these deals added no liquidity or price discovery to the marketplace.  If your overriding motivation is to make money on a short position, then you want the deal to fail.


As of this writing, the FCIC has not yet published its Hedge Fund Survey, which pulls back the curtain on the conflicted motivations of CDO investors. The FCIC noted that its survey did not include hedge funds that had either liquidated or closed. Those funds might have taken net long positions in mortgage securities.