Over the past few days, two very smart people have asked me about a passage in Michael Lewis’s cover story for Portfolio in which he talks about synthetic CDOs without actually using the term. They said that they didn’t quite understand it, so I’m going to try to explain what a synthetic bond is. Once I’ve done that, the Lewis passage should be a lot more comprehensible.
Let’s start with a simple single-credit synthetic bond. You’re an investor, and looking at the credit markets, you see that IBM debt is trading at attractive levels, especially around the 5-year mark, where they yield about 150bp over Treasuries. You’d really like to buy $100 million of IBM bonds maturing in five years, but IBM isn’t returning your calls (they have no desire to borrow money at these spreads), and there aren’t any IBM bonds with exactly the maturity you want. What’s more, even the bonds with maturities nearby are illiquid, and closely held: there’s no way you can just blunder into the market and buy up that many bonds without massively skewing the market, since the overwhelming majority of the bonds are just not for sale.
So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market. Essentially, you take the $100 million that you were going to spend on IBM bonds, and you put it into a special-purpose entity called, say, Fred. (In reality, it’ll be called something really boring like Synthetic Technology Invetments Cayman III Limited, but Fred is easier to remember.) First, Fred takes the $100 million and invests it in 5-year Treasury bonds.
Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral. The buyer of protection will pay $1.5 million per year (150 basis points) to Fred, and in return Fred promises to pay $100 million to the buyer in the event IBM defaults, less the value of IBM’s bonds at the time. The buyer knows that Fred is good for the money, because it’s already there, tied up in Treasury bonds.
So long as IBM doesn’t default, you get not only the $1.5 million per year from the buyer of protection, but also the interest on the Treasury bonds. You wanted to buy IBM bonds yielding 150bp over Treasuries, and that’s exactly what you’re getting: the 150bp from the CDS counterparty, and the Treasury interest from the Treasury bonds. At maturity, assuming IBM still hasn’t defaulted, you get your $100 million back, the CDS contract has expired, and Fred has no contingent liability any more.
The effect is identical to holding an IBM bond — and you can even sell your interest in Fred, just like you could sell an IBM bond. If IBM defaults, you lose your $100 million, but you get back the value of an IBM bond — which again is the same outcome as if you’d bought an IBM bond for $100 million and IBM defaulted.
But the key thing to note is that IBM itself is not involved in the transaction at all. It doesn’t matter how few bonds IBM has issued, there can be many times that amount in synthetic IBM bonds, just so long as there are enough people out there willing to buy and sell credit protection on IBM.
And just as you can create a synthetic IBM bond, you can create a synthetic bond portfolio, made up of credit default swaps on any number of corporate names or even mortgage-backed securities. The special purpose vehicles in those cases sometimes sell protection on a lot of different names; sometimes they just sell protection on a liquid CDS index. Either way, the returns that those vehicles offer are basically the same as the returns on buying the underlying securities — if those securities were easily available.
Now that we’ve understood all that, we can return to Michael Lewis’s piece, where he’s talking about a chap called Steve Eisman, who was buying protection in the CDS market, and is sat at dinner next to one of his counterparties, who was selling protection.
Whatever rising anger Eisman felt was offset by the man’s genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.’s; he saw it as a basis for friendship. “Then he said something that blew my mind,” Eisman tells me. “He says, ‘I love guys like you who short my market. Without you, I don’t have anything to buy.’ßø”
That’s when Eisman finally got it. Here he’d been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren’t enough Americans with shitty credit taking out loans to satisfy investors’ appetite for the end product. The firms used Eisman’s bet to synthesize more of them. 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?”
What Eisman is saying is that there were mortgage-backed securities, and then there were synthetic mortgage-backed securities; when the banks ran out of actual MBS to sell to investors, they sold them synthetic MBS instead. And yes, that was allowed.
There is some hyperbole here, though. While there were undoubtedly a lot of synthetic MBS issued, they weren’t a large multiple of the real MBS issued, as the "one hundred times over" quote would suggest. Which is quite obvious, if you think about it: there weren’t a lot of people like Steve Eisman willing to short the MBS market — and you need them, to take the other side of the trade.
In fact, most of the synthetic MBS issued were issued by banks which kept the underlying mortgages on their own balance sheet. Rather than put the mortgages directly into a CDO and sell that to investors, they kept the mortgages themselves and bought protection from the CDO on them — creating a synthetic CDO which mirrored (and which they could sell to hedge) their own holdings. Why did they do that? That’s the story of the super-senior tranche, and will have to wait for another day.