Synthetic CDO's are Beginning to Bloom

One of our many interests in the unfolding calamity in the financial world are the hell-spawn known as Synthetic Collateralised Debt Obligation, or SCDO. For an indepth refresher on exactly what these monsters are, please read our first post on the nature of SCDOs. We'll include a brief definition here, but we recommend brushing up on your SCDOs... we needed to do so, as well, since they're impressively complicated.

Put simply, SCDOs are issued by American super-huge banks, and are composed of credit default swaps taken out against a list of about 100 or so major companies, called the reference entities. The investors who buy these SCDOs (under the impression that the instruments are 'bonds') become, in effect, a pool of 'names' - the people who pony up the money when insurance needs to be paid out. In this case, the credit default swap is the insurance for the issuing bank against the reference entities going bankrupt. When a small number of the reference entities - about seven or so - go bankrupt, the SCDO is triggered and the investors' money is immediately and irreversibly transferred to the issuing bank.

As an aside, reference entities typically include such fine companies as: AIG, Fannie Mae, Freddie Mac, Bear Stearns, Merrill Lynch, Chrysler, General Motors, et cetera. All are, as we are sure you noticed, not in the best of shape.

When that slew of reference entities bit the dust, we wondered when the SCDOs' 'trigger' would be tripped; which company or companies were going to start the flood of wealth? Ever heard of Syncora Guarantee Inc? According to Asia One, the Pinnacle Series 1 notes out of Morgan Stanley have wiped out every last cent of those who invested in the notes. Pinnacle Series 1 is a SCDOs, and it has been triggered by a Syncora default. The article also reports that Pinnacle Series 2, 3, 4, 5, 6, and 7 are careening toward being triggered.

As the 2007 Depression puts the screws to the world's economy, Morgan Stanley has tasted some of the first blood in the SCDO arena. When General Motors enters bankruptcy, we strongly suspect that many more SCDOs will be triggered, and thus what will likely be the single greatest transfer of wealth in world history will continue. As the action on the SCDO front is heating up, we will be reporting much more regularly on the topic. You can likely expect another update soon after GM enters bankruptcy.