Joined Nov 11, 2007
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Time to Celebrate: Synthetic CDOs Return to Wall St.

“Japan swore off nuclear weapons for generations after the bombings of Hiroshima and Nagasaki. Wall Street’s memory vis-a-vis weapons of mass destruction is just a bit shorter.

Ladies and gentlemen, whether you like it or not, the synthetic collateralized debt obligation (CDO) is making a comeback, Bloomberg reports. The numbers are small so far, and the bets being made with them appear to be sober. But that’s always how these things start out.

What on earth is a synthetic CDO, you likely ask? It is a side bet on a bunch of side bets on somebody else’s debt. First you take a bunch of corporate bonds. Then you write insurance protection on those bonds, in the form of derivatives called credit default swaps. And then you jam a bunch of those credit default swaps together into a toxic meatball called a synthetic CDO, on which you can also bet as much money as you like, assuming you have any money, considering you are the kind of doofus who bets money on toxic meatballs.

These have absolutely no economic value, aside from enriching the bankers that sell them and maybe giving investors a way to make an extra buck. And they are potentially disastrous, depending on how they’re filled: These were among the derivatives that helped nearly bring down American International Group and the financial system less than four years ago. Now, with investors hungry for anything that offers the slightest bit of yield, these derivatives are making a comeback, which I’m sure is totally fine, because Wall Street has of course learned its lesson.

So far these things are only being sold to hedge funds; they’re not getting credit ratings or being sold to investors the way synthetic CDOs were during the crisis. The filler in the meatballs so far are corporate bonds, not subprime mortgages. And we’re not talking about a bunch of money here, yet. Synthetic CDOs on about $2 billion in debt were sold last year, Bloomberg writes, citing Citigroup data, and CDOs on another $1 billion have been sold so far this year.

And those totals overstate the total amounts actually being wagered on CDOs, Felix Salmon points out — they’re what’s known as “notional” amounts, or the total of the underlying debt on which investors are betting.

If you’re betting on the default of $100 million in bonds, for example, you don’t have to bet $100 million. You can just bet $1 million. So far, the amounts being bet in the synthetic CDO market are pretty tiny….”

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