Have I got a preposition for you!

They aren't much mentioned any more, but long ago, Guambat remembers when "genuine synthetic pearls" were all the rage.

Not so benign but hidden in plain sight by equally dissonant language are "synthetic CDOs", which are now all the rage. At least, they are now causing a great number of people to rage about them.

To look at synthetic CDOs, first consider what a CDO is:

A CDO, most broadly, is a device that repackages the income from a pool of bonds, derivatives or other investments. A mortgage CDO might own pieces of a hundred or more bonds, each of which contains thousands of individual mortgages. Ideally, this diversification makes investors in the CDO less vulnerable to the problems of a single borrower or security.

Guambat recently had a post that touched on the current problems with synthetic CDOs, which were described as:

As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against debt defaults, typically on a pool of a hundred or so companies or individual bonds.

banks, hedge funds and insurance firms around the world, used synthetic CDOs as a way to invest in diversified portfolios of companies without actually buying those companies' bonds.

Alan Kohler is an Australian financial commentator often mentioned in these posts. He describes how synthetic CDOs may restore banks around the world to their wealth and health, which would be a good thing.

But because for every winner there is a loser, this could be a very bad thing for people who bought these things for the yield they offered without regard to the risk they posed. Actually, the "without regard" part is only part right because in a great many cases they had no idea whatsoever what the synthetic part of the CDO was, if even they had any notion of a CDO to begin with, and to the extent that they understood anything at all, it was the non-synthetic AAA rating placed on things by ratings agencies run amok.

Let Alan tell us how this might all play out:

CDOs were invented by Michael Milken’s Drexel Burnham Lambert in the late 1980s as a way to bundle asset backed securities into tranches with the same rating, so that investors [code for fund managers playing with someone else's money, yours for instance] could focus simply on the rating [code for neglecting their own due diligence and relying blindly and purposefully ignorantly on ratings agencies] rather than the issuer of the bond [code for who gave a damn about what was in the stuff and if it was in any way credible?].

[In other words, CDOs were created to draw attention away from any thought about a return of capital, and mesmerize the market buyers (who usually got paid based on yields) with dreams of returns on capital.]

About a decade later, a team working within JP Morgan Chase invented credit default swaps, which are contractual bets between two parties about whether a third party will default on its debt.

In 2000 these were made legal [code for this stuff used to be illegal but somehow became not so], and at the same time were prevented from being regulated [code for free markets], by the Commodity Futures Modernization Act, which specifies that products offered by banking institutions could not be regulated as futures contracts.

This bill, by the way, was 11,000 pages long, was never debated by Congress and was signed into law by President Clinton a week after it was passed. It lies at the root of America’s failure to regulate the debt derivatives that are now threatening the global economy.

Anyway, moving right along – some time after that an unknown bright spark within one of the investment banks came up with the idea of putting CDOs and CDSs together to create the synthetic CDO.

Here’s how it works: a bank will set up a shelf company in Cayman Islands or somewhere with $2 of capital and shareholders other than the bank itself. They are usually charities that could use a little cash, and when some nice banker in a suit shows up and offers them money to sign some documents, they do.

That allows the so-called special purpose vehicle (SPV) to have “deniability”, as in “it’s nothing to do with us” – an idea the banks would have picked up from the Godfather movies.

The bank then creates a CDS between itself and the SPV. Usually credit default swaps reference a single third party, but for the purpose of the synthetic CDOs, they reference at least 100 companies.

They have a variety of twists and turns, but it usually goes something like this: if seven of the 100 reference entities default, the SPV has to pay the bank a third of the money; if eight default, it’s two-thirds; and if nine default, the whole amount is repayable.

For this, the bank agrees to pay the SPV 1 or 2 per cent per annum of the contracted sum.

Finally the SPV is taken along to Moody’s, Standard and Poor’s and Fitch’s and the ratings agencies sprinkle AAA magic dust upon it, and transform it from a pumpkin into a splendid coach.

The bank’s sales people then hit the road to sell this SPV to investors. It’s presented as the bank’s product, and the sales staff pretend that the bank is fully behind it, but of course it’s actually a $2 Cayman Islands company with one or two unknowing charities as shareholders.

It offers a highly-rated, investment-grade, fixed-interest product paying a 1 or 2 per cent premium. Those investors who bother to read the fine print will see that they will lose some or all of their money if seven, eight or nine of a long list of apparently strong global corporations go broke. In 2004-2006 it seemed money for jam. The companies listed would never go broke – it was unthinkable.

Here are some of the companies that are on all of the synthetic CDO reference lists: the three Icelandic banks, Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae, American Insurance Group, Ambac, MBIA, Countrywide Financial, Countrywide Home Loans, PMI, General Motors, Ford and a pretty full retinue of US home builders.

In other words, the bankers who created the synthetic CDOs knew exactly what they were doing.

As one part of the bank was furiously selling loans to these companies, another part was furiously selling insurance contracts against them defaulting, to unsuspecting investors [code for spreading the risk via information arbitrage]

nobody has any idea how many were sold, or with what total face value.

It is known that some $2 billion was sold to charities and municipal councils in Australia, but that is just the tip of the iceberg in this country. And Australia, of course, is the tiniest tip of the global iceberg of synthetic CDOs. The total undoubtedly runs into trillions of dollars.

All the banks did it, not just Lehman Brothers which had the largest market share, and many of them seem to have invested in the things as well (a bit like a dog eating its own vomit) [code for greed makes you do silly things].

It is now getting very interesting. The three Icelandic banks have defaulted, as has Countrywide, Lehman and Bear Stearns. AIG has been taken over by the US Government, which is counted as a part-default, and Freddie Mac and Fannie Mae are in “conservatorship”, which is also a part default.

Ambac, MBIA, PMI, General Motors, Ford [code for, "are you sure you want to bankrupt the auto companies?"] and a lot of US home builders are teetering.

If the list of defaults – full and partial – gets to nine, then a mass transfer of money will take place from unsuspecting investors around the world into the banking system. How much? Nobody knows, but it’s many trillions.

The distress among those who lose their money will be immense. It will be a real loss, not a theoretical paper loss. Cash will be transferred from their own bank accounts into the issuing bank, via these Cayman Islands special purpose vehicles.

The repercussions on the losers and the economies in which they live, will be unpredictable but definitely huge. Councils will have to put up rates to continue operating. Charities will go to the wall and be unable to continue helping those in need. Individual investors will lose everything.

But for the banks, it’s happy days. Suddenly, when the ninth reference entity tips over, they will be flooded with capital. It’s possible they will have so much new capital, they won’t know what to do with it.

This is entirely uncharted territory so it’s impossible to know what will happen ....

If this scenario plays out, given the momentous consolidation in the banking industry, they will have to re-write the definition of "big bank".

But, at least the banks will be in the position of being able to lend again, and there will be no shortage of borrowers. As Ben Franklin didn't say, "ever a lender or a borrower be".