Let me editorialize this story that was in the WSJ today:
PARKES, Australia -- In this town of 10,000 in what Australians call "the bush," administrator Alan McCormack has a headache. The county council is poised to lose millions of dollars if more U.S. companies succumb to a deepening recession.
Ten thousand miles away, at New York investment firm ICP Capital, hedge-fund manager William Gahan is reaping big gains on Mr. McCormack's predicament.
The fortunes of the two men are connected through an investment known as a "synthetic collateralized debt obligation." Between 2005 and 2007, the Parkes local council put more than A$13.5 million ($9.3 million) of its savings into synthetic CDOs. The investments offered an attractive income and a gold-standard credit rating -- in return for providing a sort of insurance on the debt of hundreds of mostly U.S. companies
Now, though, if even a handful of those companies renege on their debts, Parkes will have to cough up as much as A$12 million to honor the insurance commitments it made. That's been a boon for Mr. Gahan, who used financial products to place bets against many of the same companies.
The linkage between Messrs. McCormack and Gahan demonstrates how far a vast superstructure of credit derivatives such as synthetic CDOs, built up over the past decade, has spread the risk of lending to U.S. companies -- and how far the pain is likely to reach. They're called derivatives in part because they don't entail any direct investment into companies. Instead, they're more like side bets on the companies' fortunes.
Global investors have already lost billions of dollars on derivative investments tied to U.S. subprime mortgages, but many more -- including towns, charities, school districts, pension funds, insurance companies and regional banks -- put money into synthetic CDOs that insure the equivalent of trillions of dollars in mostly U.S. corporate debt.
Who was buying these synthetic CDO's anyway? Does anyone think that these investors dreamed up these securities? No it was JP Morgan. Milken at Drexel conjured up CDO's. Then JPM Morgan conjured up credit default swaps (CDS) in 2000, but they were created so they couldn't be regulated. You can read about them in the link below, but let me help you with just a couple parts:
A fundamental premise of the CDS market is that CDS are not insurance contracts. The conclusion that CDS are not insurance contracts is based upon the fact that the buyer of credit protection under a CDS need not suffer any loss nor provide any evidence of any loss with respect to the relevant reference entity or obligation to receive payment from seller....
The Commodity Futures Modernization Act of 2000 (CFMA), signed into law by President Clinton on December 21, 2000, generally excludes CDS from regulation as “futures” under the Commodity Exchange Act. Furthermore, the CFMA provides that CDS are “swap agreements” that do not constitute “securities” for purposes of the 1933 Act or the 1934 Act.
Now merge CDO's with CDS's and you have synthetic CDO's! And you can sell something that then, isn't regulated, by sophisticated banks that craft these deals, and sell these products to unsuspected and unsophisticated investors in the outback of Australia or the farming communities of Wisconsin! But to make the scam kosher, the Investment bank would hook up with another bank in the community of which it wanted to fleece. The con needed a front man, and they needed to throw in fees to get it juiced!
As synthetic CDOs run into trouble, investors are popping up in unexpected places. In Singapore, hundreds of individuals, including retirees, who bought these notes were recently told they were unlikely to get any of their money back. In Wisconsin, five school districts that put a combined $200 million into synthetic CDOs in 2006 now face budget shortfalls due to write-downs on those investments. Belgian bank KBC recently took a €1.6 billion ($2.23 billion) write-down on synthetic-CDO investments. Australian town councils invested nearly A$600 million in synthetic CDOs, according to a government report.
And why would the banks create these synthetic CDO's? Because they needed to hedge their exposure to the companies that were going bust. Why else was Fannie Mae, Freddie Mac, Countrywide, AIG, Lehman, Bear Stearns, AIG, MBIA, PMI, the banks in Iceland that went bust, and a whole slew of homebuilders in this paper?
The deal was that they would sprinkle in the bad names, with a bunch of good names, but if you had 9 bad names out of a 100 go bust, then the buyer of this synthetic CDO was on the hook for the banks problem. Why 100 names? Because a bank that creates this synthetic CDO, with a Cayman Island off balance sheet Special Purpose Vehicle (SPV) needs at least that many names in it. And the fees are cheap! And investors won't understand what they are buying, but the banks know exactly what they are selling!
See the bank was dealing with leveraged loans to these companies, while the bank, was hedging their same risk to these companies, by creating a synthetic CDO that looked good on paper, that would implode. And by creating this insurance product, (of which by definition it wasn't, though it was) and by having the rating agencies rate what they didn't understand, the bank offloaded the stuff they created to those that didn't know what the bank was peddling.
Bankers engineered them to provide the highest possible return while still garnering gold-standard credit ratings. But one feature made them a lot riskier than a similar portfolio of corporate bonds: If losses to defaults rose above a certain threshold -- typically between 3% and 6% of the underlying pool of debt -- investors would lose all their money.
Look at the fees in one of these deals.
Torquay was a huge success for its creators, selling some A$95 million in notes to Australian investors. J.P. Morgan's expected revenue over the life of the seven-year deal would have been worth more than A$6 million, compared with less than a million for a typical bond issue of similar size, according to people familiar with such transactions.
About A$2 million of that would go to Grange for acting as the underwriter and distributor. About A$100,000 would go to Standard & Poor's for rating the deal. Lion Capital Management, the firm appointed to manage the portfolio, would get close to A$1 million. Meanwhile, the investors, who took on almost all the risk, would receive payments worth a total of about A$7.5 million.
Who was hit in Torquay's portfolio?
Torquay was hit by five of the seven major defaults that have occurred in 2008: Lehman, Washington Mutual, Freddie Mac and Icelandic banks Kaupthing and Glitnir.
Now the world understand that these synthetic-CDO's are completely toxic.
Meanwhile, the price of default insurance on companies widely used in synthetic CDOs suggests cumulative losses to defaults could rise to more than 10% over the next five years. That would wipe out almost all of Parkes's investments in various synthetic CDOs, as well as a large portion of all the synthetic CDO deals currently outstanding globally.
Once again, it's just theft. But this time, the banks created the product, and then offloaded it unto those who didn't understand it. In the WSJ piece JP Morgan said the purchaser was a "sophisticated client that specified what it wanted in an investment product."
Yeh right. Farmers want a off balance sheet, Cayman Island SPV structured synthetic CDO's from a NY bank gnome!
The WSJ's conclusion:
As a result, synthetic-CDO deals are poised to trigger a massive transfer of wealth from investors such as Parkes to hedge funds and the trading units of big U.S. investment banks. By various estimates, the amount of money set to change hands could be anywhere from tens of billions to hundreds of billions of dollars.
Was all of Wall Street suddenly just so prescient that they could make tens and tens of billions of dollars, by farmers glamoring to buy these structured products? We have outrage from Bernie Madoff? Where's the outrage on JP Morgan?
It's just another bank putting lipstick on a pig.
And another case of Wall Street stealing money from the unsophisticated.
Until the lawyers get involved!