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This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loa

This is not a regular CDO - this is a synthetic CDO. The 'synthetic' means that the issuer may not (and most likely does not) hold the risk being tranched (loans in your example). Instead it generates return by selling CDS protection on certain market defined risks (hence the word synthetic, in the sense of being a derivative exposure). This makes a big difference: 1. Since individual tranches can be created on demand (unlike a regular CDO, where the full capital structure has to be placed), banks can create bespoke standalone tranches which are then hedged based on a correlation model. Thus there is much lesser market feedback to put a brake on unbridled issuance. A (very) loose analogy would be insuring your house (i.e. needing to own the loan under the CDO) and betting that your neighbour's house will burn down (where you have no skin in the actual asset). You can clearly do much larger sizes of the latter contract, for the first one, you need to buy a house each time you want to put the trade on. 2. The CDO invests in collateral to back the protection sold. One of the issues during the crisis was that this collateral itself was other CDO tranches (either synthetic or physical). When the market melted down, these assets became unpriceable given the opacity of the collateral. Result = even higher illiquidity Of course the issued size is nowhere near becoming a systemic problem similar to 2007, but it does seem that those who do not learn from history are condemned to repeat their errors. In this context Raghuram Rajan's speech at the 2005 Jackson Hole symposium is especially prescient: https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp082705 https://www.imf.org/en/News/Articles/2015/09/28/04/53/sp0827... Edit: misread JumpCrissCross's reference to payment processors as protection buyers, deleted this part.

coliveira 7y ago
I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth until it is again too late.
- kangnkodos 7y ago
  One of the key problems back in 2008 was that AIG was issuing something equivalent to insurance to everyone. Different investment banks were helping their customers to make big bets, and if things went south, they had "insurance" from AIG. In hindsight, AIG wasn't charging enough for this "insurance", and didn't have sufficient reserves to cover their losses if real estate prices across the whole country went down at the same time. Almost no one seriously considered that as a possible scenario at the time. So the important questions are: - Who is providing "insurance" this time around? - Is the company providing "insurance" charging enough? - Does the company providing "insurance" have enough reserves to cover losses if we have another situation where everything goes south at the same time?
  - BoiledCabbage 7y ago
    That's again missing for forest for the trees. The whole point is that those questions above cannot be answered ahead of time. The synthetic securities are so complex and intertwined that the risk cannot be safely calculated w.r.t. the amount of money being invested in them until after the fact. Nobody can say if anyone is charging enough for insurance because nobody can quantify the risk accurately. Noone can say if the company has enough reserves because they we don't know how correlated that risk is or how large it is. If I'm shorting a stock I know exactly how much is at risk (within a reasonable margin of error), because these are complex contracts meant to balance out other complex contracts all with extremely high leverage any imbalance can spiral out of control. And any unexpected large change can destroy the entire financial system. There are more degrees of freedom than can be well quantified in way something can go wrong. It's not that people didn't think to ask and answer those questions above, it's that with the complexity of the system and the scale of money involved and leverage used they can't be answered with confidence. Only the appearance of confidence.
    - kangnkodos 7y ago
      I much more agree with you than disagree with you! Almost everything you're saying is true. You make very good points! I agree that pricing and setting reserves for this insurance is extremely difficult. I disagree that it is impossible. I agree that there are very few people capable of doing this. I disagree that there is no one. I agree that there may currently be no one at the regulatory agencies capable of doing this correctly. I disagree that they cannot hire someone from the industry who is capable of doing this. BECAUSE it is so difficult and complex to price this insurance and to have sufficient reserves, it's important to not throw up our hands and say that it's impossible. Instead it's important to bring the issue into the open. If regulators are not currently up to the task again this time around, then THAT should be the headline of the articles... "REGULATORS CURRENTLY UNABLE TO PRICE SYNTHETIC INSURANCE AND SET RESERVE LEVELS WHICH COULD LEAD TO THE NEXT FINANCIAL CRISIS"
kangnkodos 7y ago
Yes. Most people missed the importance of the word synthetic. In order to explain it, let me make an analogy. You think IBM is going to go up in price. (It should with the new CEO from Red Hat!) You can send $100 to investment bank A which turns around and buys a regular share of IBM. Or you can send it to investment bank B which offers a synthetic share of IBM. Investment bank B doesn't actually buy a share of IBM but collects bets from different people who think the price of IBM is going to go up, and other people who think the price of IBM is going to go down. With investment bank A, your money may go up or down a little, but there's not much chance that investment bank A will go out of business. On the other hand, with investment bank B, there are several different ways the investment bank could go out of business. It might not balance out it's up and down bets correctly because it's confident that IBM is going up. Or many of the other customers may be unable to pay up. Or maybe investment bank B made a deal with AIG to make sure that investment bank B would not lose money on the deal, but AIG was unable to pay. With synthetics, there are additional risks which are more difficult to quantify.

coliveira 7y ago

I see people repeating the mantra that CDOs are Ok, because they're theoretically sound and the only problem was with the regulatory issues until 2008. Given this and the apetite for risk in an environment of low returns, I wouldn't discard the possibility that these assets have once again risen to unsustainable levels. After all, the opacity of such arrangements is one of their problems. We may not learn the truth until it is again too late.

kangnkodos 7y ago
One of the key problems back in 2008 was that AIG was issuing something equivalent to insurance to everyone. Different investment banks were helping their customers to make big bets, and if things went south, they had "insurance" from AIG. In hindsight, AIG wasn't charging enough for this "insurance", and didn't have sufficient reserves to cover their losses if real estate prices across the whole country went down at the same time. Almost no one seriously considered that as a possible scenario at the time. So the important questions are: - Who is providing "insurance" this time around? - Is the company providing "insurance" charging enough? - Does the company providing "insurance" have enough reserves to cover losses if we have another situation where everything goes south at the same time?
- BoiledCabbage 7y ago
  That's again missing for forest for the trees. The whole point is that those questions above cannot be answered ahead of time. The synthetic securities are so complex and intertwined that the risk cannot be safely calculated w.r.t. the amount of money being invested in them until after the fact. Nobody can say if anyone is charging enough for insurance because nobody can quantify the risk accurately. Noone can say if the company has enough reserves because they we don't know how correlated that risk is or how large it is. If I'm shorting a stock I know exactly how much is at risk (within a reasonable margin of error), because these are complex contracts meant to balance out other complex contracts all with extremely high leverage any imbalance can spiral out of control. And any unexpected large change can destroy the entire financial system. There are more degrees of freedom than can be well quantified in way something can go wrong. It's not that people didn't think to ask and answer those questions above, it's that with the complexity of the system and the scale of money involved and leverage used they can't be answered with confidence. Only the appearance of confidence.
  - kangnkodos 7y ago
    I much more agree with you than disagree with you! Almost everything you're saying is true. You make very good points! I agree that pricing and setting reserves for this insurance is extremely difficult. I disagree that it is impossible. I agree that there are very few people capable of doing this. I disagree that there is no one. I agree that there may currently be no one at the regulatory agencies capable of doing this correctly. I disagree that they cannot hire someone from the industry who is capable of doing this. BECAUSE it is so difficult and complex to price this insurance and to have sufficient reserves, it's important to not throw up our hands and say that it's impossible. Instead it's important to bring the issue into the open. If regulators are not currently up to the task again this time around, then THAT should be the headline of the articles... "REGULATORS CURRENTLY UNABLE TO PRICE SYNTHETIC INSURANCE AND SET RESERVE LEVELS WHICH COULD LEAD TO THE NEXT FINANCIAL CRISIS"

kangnkodos 7y ago

Yes. Most people missed the importance of the word synthetic. In order to explain it, let me make an analogy. You think IBM is going to go up in price. (It should with the new CEO from Red Hat!) You can send $100 to investment bank A which turns around and buys a regular share of IBM. Or you can send it to investment bank B which offers a synthetic share of IBM. Investment bank B doesn't actually buy a share of IBM but collects bets from different people who think the price of IBM is going to go up, and other people who think the price of IBM is going to go down. With investment bank A, your money may go up or down a little, but there's not much chance that investment bank A will go out of business. On the other hand, with investment bank B, there are several different ways the investment bank could go out of business. It might not balance out it's up and down bets correctly because it's confident that IBM is going up. Or many of the other customers may be unable to pay up. Or maybe investment bank B made a deal with AIG to make sure that investment bank B would not lose money on the deal, but AIG was unable to pay. With synthetics, there are additional risks which are more difficult to quantify.