Wednesday, November 19, 2008
synthetic CDO unwind continued
alan kohler of aussie business spectator has some interesting views following an simple explanation of how synthetic CDOs work.
As the world slips into recession, it is also on the brink of a synthetic CDO cataclysm that could actually save the global banking system.
It is a truly great irony that the world’s banks could end up being saved not by governments, but by the synthetic CDO time bomb that they set ticking with their own questionable practices during the credit boom.
Alternatively, the triggering of default on the trillions of dollars worth of synthetic CDOs that were sold before 2007 could be a disaster that tips the world from recession into depression. Nobody knows, but it won’t be a small event.
the upshot is that synthetic CDOs -- soon to trigger as a byproduct of defaults among the reference list -- will result in a massive one-time transfer of trillions in capital to the originating banks from the investors to whom the synthetic CDOs were sold. while kohler notes this could bolster the banking system -- indeed perhaps save the money center banks who sold them -- the loss is likely to devastate the investors, which include insurers, pension funds, money market funds, municipalities, individuals, corporations, and of course other banks.
it may be important to note that most synthetic CDOs are partially-funded -- that is, the notes sold to investors raise an amount of cash (held in the special-purpose structure) insufficient to pay out the entire CDS should it trigger. this means that the originating banks will not receive the entire notional value of the protection but merely the amount held in the structure -- unless, of course, they have contracted a monoline to pay the difference (LOL).