On synthetics in Maiden Lane III

Calculating the exposure of a CDO to synthetic assets is complicated for two reasons:  (i) first because, not only can the CDO itself use swaps to generate synthetic exposure, but also the CDO and RMBS tranches in which the CDO invests may include synthetics; and (ii) secondly, because the tranche structure of CDOs complicates things.

Because it is easier to create synthetic exposure to an asset than to originate an actual loan (remember creating a synthetic asset involves selling protection on an asset, not buying it — thus you just need to find counterparties willing to pay small premia for protection), I will generally assume that the synthetic exposure of a CDO or RMBS is close to the limits permitted in the deal documents.  This is an assumption and therefore subject to correction if the actual data is ever made public.

The collateral underlying the Broderick I CDO is 20% CDO, 80% RMBS.  20% of this collateral may be in the form of synthetic assets.  Since the industry (and undoubtedly Merill Lynch in particular as a major CDO issuer) had a great need to place junior CDO tranches most likely it was the RMBS that was referenced synthetically, not the CDOs.  So as a working assumption lets consider that the Broderick I CDO is 20% CDO, 20% synthetic referencing RMBS and 60% RMBS.

The thing to remember is that the 20% CDO collateral is likely to also be 20% synthetic.  I’m not going to make any assumptions about the synthetic exposure in the RMBS, because I haven’t found reliable information on the issue, but there is no question that some synthetic RMBS were issued.  Thus Broderick I could easily be backed by 24% synthetic assets — and possibly more.

But it’s important to understand that 24% would be a low estimate of Broderick’s exposure to synthetic assets.  This is because the structure of a CDO is designed to concentrate risk by increasing the exposure of the junior investors to losses..

To explain, consider a simple tranched securitization of five $1 million mortgages with one junior $1 million investor and one senior $4 million investor.  It should be obvious that the junior investor — because he absorbs losses first — has 100% exposure to each of the five mortgages.  If one of those mortgages is synthetic, then the junior investor has 100% exposure to the synthetic mortgage.  In short, in a CDO you must always remember that only the first priority investor is guaranteed to benefit from diversification of assets.

For this reason when calculating the exposure of subordinate CDO tranches to synthetic assets, what is important is whether the detachment point of the tranche (that is the point at which it stops absorbing losses because it is worth nothing) is lower than the fraction of synthetic assets in the CDO.  If the CDO has 20% synthetic assets and the tranche in question detaches at 10%, then the tranche can be wiped out twice over by losses on synthetic assets alone.  Thus it doesn’t really make sense to claim that the tranche has less than 100% exposure to synthetic assets.

Since the subordinate tranches in Broderick (as a group) detach at 16%, every one of them probably has 100% exposure to synthetic assets.  If the CDOs included in Broderick are similarly structured (and if I am right that these CDOs made maximal use of synthetic assets), then it is fair to say that Maiden Lane’s exposure to synthetic assets via Broderick I is $400 million or 40% of the CDO.

Why does this matter?  Because as I asked in my first post on Maiden Lane III as taxpayers we need to consider these issues:

Are we okay with the fact that financiers who saw how dysfunctional our debt markets were didn’t go off and raise hell at the Fed and SEC, but instead expressed their views via the market?  Are we okay with the fact that when one of their counterparties to the expression of these views couldn’t honor it’s obligations, the taxpayer stepped to validate the existence of this market?  Is there a difference between bailing out banks that were financing real economic activity and grossly underestimated the risks of that activity and bailing out traders who used derivative markets to express their views on the dysfunctionality of the debt markets?

I think we need public disclosure on each of the Maiden Lane vehicle’s exposure to synthetic assets.  So we can have a robust public discussion about the role of government in underwriting synthetic assets.


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