What are synthetic CDOs?

Felix Salmon has written an excellent post on synthetic CDOs. It explains how they are created and how it could easily turnaround from a cool return to a hot hot loss. Thanks to Baseline Scenario for the pointer.

Actually Salmon post reminded me of a paper by Dean Foster and Peyton Young which was based on the same idea but had a different implication. The paper explains how the hedge fund manager can structure the derivative contracts which will make him appear as a skilled fund manager but in reality he is unskilled or even an ‘outright con artist’.

In another entry, Baseline Scenario explains a particular dealbetween five Schools in Wisconsin and Royal Bank of Canada involving synthetic CDOs. The Schools have lost a lot of money in the transaction. James Kwak, writer of the post says:

Now, structured financial products can play a role in reducing your risk. In general, derivative trades have a “safe” side and a “risky” side. For example, if you buy a call option, you are on the safe side: you are paying a fixed amount, and you may enjoy an unlimited gain. However, if you sell a call option, you are on the risky side: you are gaining a fixed amount, but you may face an unlimited loss. Credit default swaps are similar in that one side gets a guaranteed but small stream of payments, but faces a very large but unlikely loss. So it makes sense for a local government to use derivatives to hedge some other exposure it has – but not to basically write call options or credit default swaps for other people

The question that comes to my mind is why should someone be selling/writing these options then? One could understand the need to take the risks if the extreme events in financial markets are very rare. This is clearly not the case and most of the time the crisis strikes unexpectedly and very close to good times. This derivatives writing  lead to a collapse of AIG and similar concerns are felt for other forms as well. And if there is a risk in writing/selling options and gets limited in time to come, whom will you buy these options from? Would we see a decline in derivative volumes in future?

Another thing which always interested me (and pointed by Tyler Cowen in his blog, I can’t locate the exact post) is the swap transactions. We are taught in text books that swaps help change the nature of inflows/outflows. Say you are receiving (or paying) fixed rate on a loan and want to change it to floating. Instead of asking the bank to change the loan you can swap it with someone who needs a fixed income loan. Likewise, if you are receiving in dollars and want to change it to Swiss Franc you can swap it with someone.

Now, there are 2 questions- 1) The change to floating or swiss franc should be based on some logic (say floating rates are lower or swiss franc is more stable). So, doesn’t that apply to all and wouldn’t most want to do the same? 2) I can understand if the swaps are done after some sudden changes in say interest rate outlook and currency outlook. Why sudden? Because one swaps after taking into account the most likely future developments. And sudden changes are rare but the swap markets are fairly large. Why would one take a loan in USD and swap it with Swiss Franc immediately when he can take the loan in Swiss Franc rightaway? Another thing is this market is largely institutional (with banks doing swaps with each other) and people are paid to have some futuristic outlook. IF the outlook changes suddenly fine swap it. But why this constant swapping of inflows and outflows?

Again, I don’t mean to say swap/derivative markets are useless. I just don’t understand the huge volumes in these markets.

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