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.

A great read into the background of the subprime crisis by Michael Lewis who wrote Liar’s Poker, the classic expose of now defunct Salomon Brothers investment bank in the late 80s.

One of the key points he makes is that Wall Street banks created many synthetic CDOs on top of actual CDOs. This may help explain why the crisis has become so widespread when the percentage of actual subprime loans is small relative to the damage in the wider markets. In essence Wall Street set itself up for this crash by replicating poisonous assets.

The latest stage of the rolling rescue of the US financial system is the plan to buy preferred stock in banks. But apparently the Treasury has no plan to get any of the upside for taxpayers in case of bank recovery since the preferred is straight not convertible. And there is no oversight either since the equity position apparently does not come with either a board seat or voting rights.

Who negotiated this deal?!

Here is my letter to the Financial Times on a similar proposal vetted there today by George Soros:

Sirs,

George Soros in “How to capitalise the banks and save finance” (Oct. 12, 2008) is certainly correct that now is the time to take advantage of the flexibility built into the Paulson/Bernanke rescue plan to re-capitalize the banks through the purchase of convertible preferred shares by the federal government. Convertibility into common stock provides the public with some participation in the possible upside of a turnaround in the fortunes of the banks.

However, Mr. Soros makes no mention of whether these are to be voting shares and no mention of whether they come with a seat on the board of directors of the banks fortunate enough to be the recipient of a rescue at the expense of the wider public.

The real danger in the current situation is that a financial crisis – finally recognized – becomes a legitimation crisis that undermines a deeper faith in our basic political institutions. Thus, accountability and transparency must be the order of the day.

Any preference shares issued by the private sector financial institutions must come with appropriate voting rights and at least one seat on the board of directors of the rescued banks. That is only way that the general public, which after all is footing the bill for this rescue after having been victimized by the de-regulation of the last twenty years, can rest assured that the banks will now turn in a direction that is socially and fiscally responsible.

Such a move will, in and of itself, send a measure of reassurance to the wider public and have an impact on restoring general confidence in our core financial and political institutions.

Sincerely,

Stephen Diamond, JD, PhD
Associate Professor of Law
Santa Clara University School of Law

Valuable analysis from one of the most astute observers of the world of global finance, Doug Noland, of Prudent Bear:

Hoping There’s Hope:

This is the first all-encompassing global dislocation of contemporary finance, impacting virtually all economies, markets and asset classes. The media is now all over the “Wall Street” and “banking” crisis. I am of the view, however, that the collapse of the hedge fund industry has moved to the forefront – that it is now at the epicenter of global market upheaval. To watch silver lose more than 20% of its value today in intraday trading; to see the collapse in energy prices; to see the entire commodities complex absolutely routed; to view global currency markets in complete disarray, with double-digit intraday drops in the Brazilian real and Mexican peso; to witness major currencies such as the Australian and Canadian dollars suffer precipitous declines; for benchmark Fannie Mae MBS yields to surge 62 bps in three days; to see Brazilian dollar bond yields jump almost 200 bps in four sessions; for global equities indices to suffer rapid double-digit drops throughout both the developed and “emerging” markets; to witness a 1,000 point intraday swing in the DJIA. All the favorite trades are blowing up, and the leveraged speculating community is in a panic de-leveraging.

There is no doubt that markets are in the midst of an unprecedented liquidation of positions across virtually all asset classes and a vicious unwind of a multitude of investment and trading strategies. The Massive Pool of Global Speculative Finance is being drained. Investors and speculators alike are desperate to flee risk. Having watched the ballooning of the hedge fund industry over the past few years in absolute awe, I can say today that an industry collapse would entail the sale (voluntary and forced by the margin clerk) and unwind of literally Trillions of positions. It has been history’s most spectacular speculative Bubble and, especially over the past few years, it became very much global in nature and infiltrated virtually all asset classes. This Bubble is in a full-fledged collapse – entailing unprecedented liquidations – and it’s taking global markets down with it.

The situation is dire, as is now commonly recognized. The media is in a tizzy, and Wall Street makes for an easy and generally deserving villain. I fear the rapidly mounting anger. But I guess for this evening there is something about coming home after a distressing week and spending time with my little four month old baby. My wife and I gave our smiling and laughing little guy a bath and I just kissed them goodnight. I just don’t have it in me right now to analyze and to write gloom. I’d rather Hope there is Hope.

Perhaps things will stabilize once the hedge fund liquidations run their course. Treasury (TARP) purchases will commence soon. Fannie and Freddie will be aggressively expanding their market purchases. The Fed is now buying commercial paper, and the Fed and Treasury are working to resolve the dislocation in the “repo” market. Across the globe, governments are in full crisis management mode. There appears universal resolve to bolster financial sectors and stem the collapse. And there were actually some positive indications of stabilization in our Credit system late in the week.

I also hold out Hope that the Trillions of reserves held by global central bankers will provide some buffer to stem financial system collapse. In particular, I am Hoping that China, India, Russia, Brazil and the Middle East have today sufficient reserves to somehow avoid a ‘90s style financial and economic meltdown. I am Hoping that demand from China, India, Asia and Latin America will help offset inevitable economic downturns in the U.S. and Britain and, hopefully to a lesser extent, Europe. I am hoping that the collapse in energy and commodities prices is more a reflection of acute financial market dislocation rather than a harbinger of synchronized global economic upheaval. I am hoping there is more substance to the dollar’s rally than simply an unwind of bearish dollar bets. And I am hoping that with large capital infusions our deeply impaired banking system will retain the capacity to finance a much less robust but at least functioning U.S. economy. I really Hope everything is not as dire as it appears.

GM is on the verge of bankruptcy and yet it was able to shovel billions in health care liabilities onto the backs of its workforce in a sham collective bargaining agreement.

Here is a critique I wrote at the time of the deal and here is a protest letter I wrote on behalf of two UAW GM workers to the Securities and Exchange Commission and here is my draft brief arguing why the UAW violated federal labor law in its conduct of the GM contract ratification vote.

Nouriel Roubini is the only mainstream economist to predict the current financial meltdown so he is worth paying attention to. 

In his words:

(I helped start a discussion list a few years ago called Meltdown to discuss the possibility but never predicted it would actually happen – actually, I was always a bear on the thesis of that group.)

I am a critic of the de-regulation ideology that helped shape the conditions that led to the asset bubble that has now most decidedly burst. We opened up huge holes in the federal securities laws through which both Main Street CEOs and Wall Street financier were more than happy to drive through over the last two decades.

But Sebastian Mallaby is not wrong about the price we have paid to enjoy the China price – the low cost consumer goods produced by horribly abused sweatshop non-union labor kept in line by a strong arm regime favored by so many American CEO’s and, pathetically, labor leaders like Andy Stern and Jimmy Hoffa.

And it is not just mainstream analysts like Mallaby who agree the China issue is a problem. Radical economist Michael Perelman is worth a read as well.

The same free market de-regulation ideology that got us into this financial crisis is now blocking the road to a solution.  As the Wall Street Journal explains House Republicans appeared to be those most responsible for the debacle that unfolded at the White House today.

These Republicans naively think the Paulson plan is a “bail out” of Wall Street with government money.  This is wrong.  The Paulson plan is a revolving line of credit extended to the Department of Treasury by the American taxpayer allowing the Treasury to enter the financial markets to buy assets like mortgage backed securities or MBS’s.  

What Paulson is attempting to do is “make a market” for these securities, much like the service provided by the New York Stock Exchange or the Nasdaq.  Since these securities usually trade in the off exchange environment, what some call dark matter, they are not easily priced even in ordinary times.  But in an environment of great uncertainty only an institution with very substantial resources like the federal government can make a market for such complex instruments.

These MBS’s are now priced well below their long term value because of fear and uncertainty in the markets.  Thus there is room for Treasury to purchase billions in those assets at above current prices yet below their fair value and over time to resell those assets at a profit for the taxpayers.

We did the very same thing in the 1930s when the Reconstruction Finance Corporation entered into the market for mortgages and restarted the frozen market for those bonds.  And we did not take preferred share positions in the companies that sold us those bonds, as some mistakenly argue.  Soon other players followed and prices started to rise off the bottom.

The aversion to federal action by the Republicans is certainly repugnant, but it did not help matters today to see Maxine Waters more worried about cutting in women and minority owned businesses on the action in the Treasury plan than actually making sure that the federal government is first allowed to stop the financial bleeding.

The disadvantages of our atomized political culture are coming into full view as the far right and left attempt to weigh down a triage operation proposed by Bernanke and Paulson with all sorts of politically opportunistic amendments.  One particularly disappointing turn of events: left wing economists like Michael Reich and Jamie Galbraith joining with right wing anti-union and anti-regulatory ideologues from the University of Chicago to oppose the plan.

Take one concern: CEO pay.  Most of the CEOs who got us into this mess are already out of a job.  Those who are left will be earning far less than they did before given the very different economic and regulatory landscape they will be operating in.  

And what prevents us from re-visiting this and a host of other issues once the illiquidity issue is addressed?

It is unfortunate that the broader public does not understand how deep the problems we now face really are.  

Perhaps the collapse today of WaMu, the largest bank failure in US history, will wake people up.

But here is one helpful anecdote from the unfolding crisis:

Goodyear Tire & Rubber was forced today to draw down an expensive $600 million reserve line of credit because it was not allowed to withdraw money from its money market mutual fund. That mutual fund is supposed to be composed of what accountants call “cash equivalents” because they are invested in “commercial paper,” the most secure financial instruments we have next to actual dollars.

But the commercial paper market is now itself being deeply impacted by the unfolding crisis.  Industrial grade companies like Goodyear depend on commercial paper – loans for 30 or 45 days – to finance their working capital.  But of late the interest rate on CP is skyrocketing.  IBM is now facing triple its ordinary interest rate on CP in order to finance its operations. IBM thus applied for, and received, protection against short sales.

In other words, the real economy – Main Street in today’s phony parlance – is being directly impacted by the unfolding crisis.

The right solution is to let Paulson do his job.