A recent Wall Street Journal article points to the potential problems with synthetic CDOs. Trillions of dollars are invested in these obscure instruments and some are heavily leveraged. One theory that could explain the decision of Treasury Secretary Paulson to back away from the proposal to buy the troubled assets of financial institutions may be linked to the CDO problem.

Here’s why:

CDO’s are “collateralized debt obligations.” While the real world has many variations, for our purposes assume there are two types of CDO’s: cash based and “reference” based.  A “cash based” CDO pulls together hundreds or thousands of loans such as home mortgages and sells them to an off balance sheet vehicle called a “Special Purpose Vehicle.”  That SPV, in turn, issues new securities to investors in “tranches” – or layers, from more secure (and thus paying a lower yield) to less secure (and thus paying a higher yield).  The yield paid to investors in the SPV’s securities is generated by the interest rates paid by homeowners on their mortgages. 

But these cash based CDO’s can be difficult to arrange since the transfer of loans is complex. In addition, you can only do that once.

But with a synthetic CDO the originating bank can keep the mortgages or other loans on its books and, instead, transfer just the risk associated with the loans by buying a form of protection known as a credit default swap, or CDS, on the loan(s).

A synthetic CDO is set up in an SPV to sell financial institutions CDS protection on a portfolio of its loans. The financial institution pays a monthly fee to the SPV and the SPV uses those fees to pay a yield to investors in new securities that it issues to investors. In case the original loans still held by the originating financial institution have a default event, the SPV collects cash from the investors and pools it in risk free securities and taps into that pool to pay off on the CDS as necessary.

In theory any number of such synthetic CDOs could be set up with “reference” to the loan portfolio held by the originating financial institution.  Also, many such synthetic CDOs are set up using leverage.  Thus, investors only put in a small percentage of the cash needed to guard against possible defaults that would trigger the need to pay off the originator on the CDS sold to it by the SPV.  

Now, the problem that I think may have emerged in the last few weeks is that Paulson & co. realized that entering the market to buy troubled assets of financial assets would be problematic because of the large number (trillions of dollars worth) of synthetic CDOs out there as opposed to actual CDOs. 

Paulson wanted to buy up mortgage loans, setting a floor on prices. If the world were made up only of cash based CDOs that might have been possible. After all, underlying the SPV of a cash CDO are the actual houses owned by troubled borrowers.  If the Treasury owned their mortgages after buying up the CDOs they could renegotiate the loans allowing the borrowers to stretch out their payments until the market stabilized.  The federal government, of course, could afford – in a manner unlike any other player in the markets – to go “long” on the housing market.

But if the Treasury paid current market prices for those cash based CDOs – even if it paid slightly higher than market prices – it would have the effect of forcing investors to write down the value of synthetic CDOs to current market prices.  Since there is no telling when the cash based CDOs would pay off their loan principle (and the federal government could afford to wait a long time) the reference, or synthetic, CDOs are essentially worthless.  In fact, depending on the terms many of them might even be forced to pay out their cash pools to meet CDS payment obligations.

And there would be no point in the Treasury attempting to intervene in the synthetic market because, first, it is much larger (I think) than the sub prime market that is starting point of the problem; and, two, buying up synthetic CDOs is kind of like buying up yesterday’s losing lottery ticket – there is no way they can recover their value, particularly after the loans that they are based on (sub prime mortgages) are now taken off the balance sheets of the banks by the Treasury!

In other words, it is entirely possible that the United States Treasury had to cry “Uncle” this past week and admit defeat in the face of the massive explosion of complex, and largely fictitious, financial instruments in today’s world economy.