Explaining CDO’s and synthetic CDO’s

[from NPR]

…[I]magine there is a house by the ocean and you want to bet that it’s going to get hit by a hurricane. One way to do that would be to take out an insurance policy on the house, even though you don’t own it. So every month you pay a small premium for the insurance, maybe $200. This goes on for a couple years.  Then the house gets hit. And the insurance policy pays off, for say $1,000,000.  You’ve lost a couple thousand, but made close to a million.

The reason the CDO expert was happy that Eisman was buying insurance, was that the expert had clients that were dying to sell that insurance. These were people who wanted to buy up mortgages, but there just weren’t enough around. So they sold insurance instead. In a sense it was the same thing, owning mortgages and selling insurance. If you own someone’s mortgage, then you get steady interest payments. If you sell insurance on someone’s house, then you get paid steady insurance premiums. The two are similar on the downside also.  In each case, if things go bad, you could lose an amount equal to the total value of the house.

There was a whole industry build up around this similarity. In a regular CDO (collateralized debt obligation) you actually own some mortgages in a pool. In a synthetic CDO you’re selling insurance on a slice of mortgages in a pool. They’re similar instruments, but constructed from different pieces. In one you own the mortgages. In another you’re selling insurance on them.

Michael Lewis puts it nicely:

Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn’t create a second Peyton Manning to inflate the league’s stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. “They weren’t satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn’t afford,” Eisman says. “They were creating them out of whole cloth. One hundred times over! That’s why the losses are so much greater than the loans. But that’s when I realized they needed us to keep the machine running. I was like, This is allowed?”

So in this sense Eisman and his colleagues were propping up the housing bubble, taking the other side of what turned out to be very unwise bets.

“It was like feeding the monster,” Eisman says of the market for subprime bonds. “We fed the monster until it blew up.”

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