what is a CDO/synthetic CDO, and why are these instruments seen as being responsible for the 2008 financial crisis?

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I have been reading up on the causes of the 2008 financial crisis, and as far as I can tell these two instruments were responsible for a lot of the damage.

I kinda understand what a mortgage backed CDO is – you bundle up loads of mortgages and sell %s of the cash flow from them, with those buying the highest “tranches” getting paid first and being affected by defaults last. What is a synthetic CDO, though? Why were these seen by many as even worse than regular CDOs?

In: Economics

A synthetic CDO is a bundle of credit default swaps – which are actually the problem and not the synthetic CDO itself.

Credit default swaps are essentially insurance that banks buy or sell on the mortgages they hold. So, if I’m a bank with a risky mortgage I can “eliminate” the risk of a default on that mortgage by buying a credit default swap. The owner of that swap then agrees that in the event of a default, they will pay me the face value of the mortgage in exchange for the property, which is likely worth substantially less. This sounds great in theory, in practice the market for credit default swaps is small enough that they aren’t effective.

Say I’m Lehman Brothers and I have a bunch of risky mortgages. I want to take on more risky loans, but Federal regulations prevent me from doing so because taking on more risky mortgages would put me over the amount of risk I am legally allowed to have.

So I buy credit default swaps from Country Wide. Because my risky mortgages are now insured, they don’t present any legal risk to me. Because my level of risk has dropped, I can make more risky mortgages. I keep doing this until my level of risk is off the charts, but its ok because legally I’m covered – even if all my loans default at once Country Wide will just pay me and my net legal risk is 0.

But Country Wide is also making risky mortgages, and it also wants to buy credit default swaps to insure itself. Given that I, Lehman Brothers, have a large amount of “0 risk” assets I think its time to get into the credit default swap market myself. So I start selling credit default swaps to Country Wide and insuring all of its risky mortgages. I do this until my own level of risk has reached the maximum level that is legally permissible.

In theory, my overall risk is manageable because it just consists of the credit default swaps I sold to Country Wide. I also have all of my own risky mortgages, but its ok because Country Wide is insuring those.

Now the crisis hits and all of my risky loans default. So I go to Country Wide and ask them to bail me out per the credit default swaps that I bought from them. Except Country Wide is in the exact same position that I am, and now they want me to bail out all of the credit default swaps that they bought from me. At the end of the day this ends up being a wash – County Wide pays me and takes on all of my bad debt, but I have to pay Country Wide just as much and take on all of their bad debt in return. All that really ended up happening is that I traded all of my bad debt for all of Country Wide’s bad debt. Because neither Country Wide nor I could afford our bad debt in the first place, we’re both still fucked.

That’s the real problem with the credit default swap market. If the market is too small – and it is – then all it ends up doing is creating a false sense of security and encouraging banks to engage in risky lending behavior. Its also impossible to make the market for them bigger because the only entities with sufficient assets to back credit default swaps are the banks themselves.