CDS and Synthetic CDO: 2008, the other side of the bet

The global economic boom of the early 2000’s saw the explosion of the use of various financial products, these products were utilised by investors to profit from the high growth and optimism characterising the global economy in the early 2000’s. On the back of this positive sentiment in the global economy, products such as Collateralized Debt Obligations (CDO) came to be widely used by investors to profit from the boom in the US housing market.

But, not everyone was taken in by this euphoria, investment managers such as John Paulson and Micheal Burry foresaw a crash in the US housing market, and wanted to profit from the coming downfall. While most of us have heard of the products used to profit from the surge of an economy, few have heard of products used to profit from the downfall of an economy. A Credit Default Swap (CDS) was the product which gave these investment managers an opportunity to profit their research work.

With most people disagreeing with the views of these investment managers, only a few bought these products, thus, far from profiting from this downfall, most people lost large personal fortunes.
So what are CDS’s?

 

Credit Default Swap

Invented in 1997 by JP Morgan, a Credit Default Swap (CDS) is an instrument used by investors in financial markets to protect themselves from the risk of default of assets such as bonds and CDO’s. A CDS functions in essentially the same way as a conventional insurance such as home or car insurance. The primary difference between a CDS and a conventional insurance lies in the difference of the characteristics and motives of buyers and sellers.

Difference between buyers and seller of CDS’s and Conventional Insurance:

Buyers:
Buyers of a conventional insurance generally own the asset under consideration and the motive of a buyer of this insurance is to protect personal wealth. For example, a buyer of Home insurance would own the house and the contents within the house, and look to protect her/his personal wealth in case of an unforeseen tragedy such as fire.
On the other hand, the financial asset for which a CDS has been bought doesn’t necessarily need to be owned by the buyer of the CDS, and the motive of a buyer of a CDS is to make a profit by correctly predicting the default of an asset. Michael Burry’s strategy of betting against CDO’s prior to the financial crisis of 2008 is an example of this.

 

Sellers:
The sellers of a CDS aim to make a profit by correctly predicting the stability of an asset (i.e. the asset doesn’t default) and hence pocket the entire premium amount as profit. Sellers of this product are generally investment banks, but they can also be hedge funds, pension funds or even high net worth individuals.
The sellers of home insurance are primarily specialised insurance firms. They also look to pocket the premium as profit, provided there is no claim from buyer of the insurance incase of damage to the asset (For e.g. fire damage of a house), just like sellers of a CDS.

 

Thus, CDS’s provided investment managers with the perfect product to bet against the housing bubble in 2008.

With popular opinion pointing in a different direction and people looking to profit from what they thought was “stupidity” of the above people, another product came to be widely used, the Synthetic Collateralized Debt Obligation (Synthetic CDO). This was a product used in an attempt to profit from the premiums paid out by the above investors.
So what is a Synthetic CDO?

 

Synthetic CDO

A Synthetic CDO is a financial instrument which collates multiple CDS’s into one security. A Synthetic CDO generally holds the sellers side of the bet i.e. it receives the premium from buyers and pays out incase the Synthetic CDO defaults. A Synthetic CDO uses the same principle as a normal CDO, the only difference is that a Synthetic CDO is backed by the cash flow of multiple CDS’s while a normal CDO is backed by the cash flow of multiple loans and bonds.

Once collated, the cash flow of the Synthetic CDO is broken up into tranches and sold to investors depending on their risk profile, i.e. the low risk investor will generally receive the least amount of premium, but will also pay the least incase of a default. On the other hand, the high risk investor will receive the highest amount of premium, but, will pay the most incase of a default.

 

As we all know the buyers of the CDS’s made windfall profits on their bets against the housing market while the buyers of Synthetic CDO’s made huge losses. Firms such as American International Group (AIG) suffered huge losses and nearly went bankrupt due to the large obligations it had to the buyers of CDS’s.

Investors who used CDS’s have often been questioned and viewed with contempt for profiting out of the downfall of the global economy. But, for markets to be fairly valued, products such as CDS’s must exist to ensure that markets don’t get ahead of themselves. Thus, instead of questioning the morality and calling for the ban products such, the markets for these products must be expanded to ensure that every individual has the opportunity to profit from such credit events.

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