Chickens, eggs and CDOs

After a turkey, successful construction of a 1100 piece K’nex rocket rollercoaster, many turkey sandwiches, several 10 person games of farkle, too many goodbyes and two “could have been much worse” flights, I can get back to the question of whether the causality in the CDO market ran from the “dumb” money to the low spreads or not.

What is missing from the argument that “dumb” money caused low spreads is an analysis of how synthetic assets (e.g. CDS on MBS and CDOs) affected the market.  By definition a CDS has a short and a long side, so from a purely theoretic perspective it should have no effect on the price of the underlying — but this theoretic argument is based on a world without asymmetric information, so it is likely to be misleading (since one thing that’s pretty clear at this point is that the buyers and sellers of CDOs (and CDS via CDOs) definitely did not have similar information — the buyers were “dumb” because they relied on credit ratings).

Most participants in the market argue that the CDO market “needed” synthetic assets in order to meet the demand of the “dumb” money.  But what this implies is that, in the absence of synthetics, spreads would have fallen even further and that, in the absence of synthetics, the demand would have extinguished itself as spreads fell to the level of treasuries and there was literally no point in buying CDOs because the yield advantage was completely gone.  In other words, in the absence of synthetics, market forces would have worked to eliminate the “dumb” money demand for CDOs by eliminating the spread differential between Treasuries and CDOs entirely.

In other words, the role of synthetics was to artificially sustain the yield spread over Treasuries (small as it was) offered by CDOs.  By keeping the yield spread up and delaying the function of market forces, synthetics kept the “dumb” money in the market and helped create a situation where the market collapsed abruptly (rather than slowly having the air pushed out of it by yield spreads that fell steadily to zero, discouraging demand in a natural manner).

In short, I think the “dumb” demand for CDOs was sustained for months and years, because synthetic assets created an artificial supply of CDO assets that kept yields at an artificially high level — in order to attract and sustain that demand.

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