'Out of thin air': Synthetic CDOs, inflated the credit bubble

From Marketwatch:
http://www.marketwatch.com/story/out-of-thin-air-synthetic-cdos-pumped-bubble-2010-04-26,

SAN FRANCISCO (MarketWatch) -- The securities at the crux of the Securities and Exchange Commission's case against Goldman Sachs Group Inc. inflated the credit bubble, leaving even more losses when it popped, structured-finance experts and investors said in the wake of the recent civil-fraud charge against the investment bank.

"Derivatives and synthetic securities have been used to create imaginary value out of thin air," George Soros, chairman of $27 billion hedge-fund firm Soros Fund Management, wrote in a column posted on his Web site last week.

"More triple-A CDOs were created than there were underlying triple-A assets. This was done on a large scale in spite of the fact that all of the parties involved were sophisticated investors," he added. "The process went on for years, and culminated in a crash that caused wealth destruction amounting to trillions of dollars. It cannot be allowed to continue."

"Synthetic CDOs should be abolished," Janet Tavakoli, a structured-finance specialist who wrote a book about CDOs in 2003, said in a recent interview. "They're too complex and provide no real benefit. They only existed to game the system or hide losses."

The SEC alleged that Goldman Sachs (GS 147.20, +5.23, +3.68%) didn't tell investors in a synthetic CDO called Abacus 2007-AC1 that hedge-fund firm Paulson & Co. helped structure the deal, and also was betting against it. Goldman and Paulson have denied wrongdoing.

Because they weren't based on real assets, such investments were tricky to value. When the housing market collapsed, the existence of such hard-to-value securities in the financial system caused havoc as counterparties struggled to find out who had lost money.

Fabrice Tourre, the Goldman banker named in the SEC's case, described such problems in a January 2007 email, just as the subprime-mortgage meltdown was gaining steam.

"I'm trading a product which a month ago was worth $100 and which today is worth $93 and which on average is losing 25 cents a day," Tourre wrote, according to recent Goldman disclosures.

"When I think that I had some input into the creation of this product (which by the way is a product of pure intellectual masturbation, the type of thing which you invent telling yourself: 'Well, what if we created a 'thing', which has no purpose, which is absolutely conceptual and highly theoretical and which nobody knows how to price?') it sickens the heart to see it shot down in mid-flight," Tourre added in the email.

Packaging

Synthetic CDOs sat at the end of a long chain of boom-time transactions that began with the origination of mortgages and other loans. These assets were packaged up by investment banks and sold as asset-based securities, including residential mortgage-backed securities, or RMBS.

CDOs were created by taking pieces of RMBS and other securities, packaging them up again and reselling them.

Demand for such investments was so strong during the credit boom that there weren't enough underlying assets to build new ones. So Wall Street came up with a way of creating CDOs that didn't need actual assets.

The result was synthetic CDOs. These are formed by writing credit-default swaps on bits of RMBS and other asset-backed securities. (These swaps pay out in the event of default.) Once enough of these derivatives contracts were written, investment banks bundled them up into new CDOs and sold them.

More than $110 billion worth of synthetic CDOs were sold in 2006 and 2007, according to Thomson Reuters data.

Raynes, who used to work at Moody's Investors Service (MCO 22.29, +0.53, +2.44%) and co-authored a book on structured finance, said the rating agency put AAA ratings on many parts of CDOs, giving investors the confidence they needed to buy the products.

"You needed a third party to analyze the structures," he added. "That's what provided the value for these deals."