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.

Why JP Morgan wants Detroit to Die

The Big Three automakers (Ford, General Motors, Chrysler) are begging for a bailout. Although we haven't seen the CEOs of the companies on bended knee, we assume their pleas are strident and whiney. Nevertheless, we are certain that a token bailout is being rammed through Congress as we clatter away at the keyboard. $15 billion may sound like a lot of money, but it's a drop in the bucket for these behemoths. They are hemorrhaging capital, disbursing money like Ebeneezer Scrooge doesn't.

Despite this, there is no way in Mordor that the Big Three will live to see Christmas 2009. The obvious reasons: they're unprofitable; they're not competitive, either domestically or globally; their cars are crappy, ugly, out-of-date energy hogs that cost too much and are difficult to repair. Please, don't get us started, it will make us rant loudly.

Like we said, however, those were the obvious reasons. But there is something else - a Sword of Damocles - hanging invisibly over Detroit as we type: synthetic collateralised debt obligations (SCDO), which are soon to become massive windfalls to big banks, like JP Morgan. These SCDOs are very complicated, so please bear with us as we use the Business Spectator to explain:

"A synthetic CDO is a collateralised debt obligation that is based on credit default swaps [CDS] rather than physical debt securities... Here’s how it works: a bank will set up a shelf company in Cayman Islands or somewhere with $2 of capital and shareholders other than the bank itself... That allows the so-called special purpose vehicle (SPV) to have “deniability”, as in “it’s nothing to do with us” – an idea the banks would have picked up from the Godfather movies.

The bank then creates a CDS between itself and the SPV. Usually credit default swaps reference a single third party, but for the purpose of the synthetic CDOs, they reference at least 100 companies.

The CDS contracts between the SPV can be $US500 million to $US1 billion, or sometimes more. They have a variety of twists and turns, but it usually goes something like this: if seven of the 100 reference entities default, the SPV has to pay the bank a third of the money; if eight default, it’s two-thirds; and if nine default, the whole amount is repayable...

Finally the SPV is taken along to Moody’s, Standard and Poor’s and Fitch’s and the ratings agencies sprinkle AAA magic dust upon it, and transform it from a pumpkin into a splendid coach.

The bank’s sales people then hit the road to sell this SPV to investors. It’s presented as the bank’s product, and the sales staff pretend that the bank is fully behind it, but of course it’s actually a $2 Cayman Islands company with one or two unknowing charities as shareholders.

It offers a highly-rated, investment-grade, fixed-interest product paying a 1 or 2 per cent premium. Those investors who bother to read the fine print will see that they will lose some or all of their money if seven, eight or nine of a long list of apparently strong global corporations go broke. In 2004-2006 it seemed money for jam. The companies listed would never go broke – it was unthinkable.

Here are some of the companies that are on all of the synthetic CDO reference lists: the three Icelandic banks, Lehman Brothers, Bear Stearns, Freddie Mac, Fannie Mae, American Insurance Group, Ambac, MBIA, Countrywide Financial, Countrywide Home Loans, PMI, General Motors, Ford and a pretty full retinue of US home builders." [emphasis added]

Please, read this article from the Business Spectator. It is an excellent discussion of the swindle that are SCDOs. It is an epic financial bomb with an uncertain fuse, but will certainly go off with the Big Three dead and buried. And that, dear Reader, is why JP Morgan wants Detroit to die. While JP Morgan may or may not have invented SCDOs, they are certainly at the top of the guest list at this reportedly $50 trillion jamboree (yes, dear Reader, that's trillion).

Put simply, there is an unbelievably huge pie out there, somewhere, and JP Morgan is getting hungry. A little thing like the Big Three, or any of the other companies on SCDOs lists, will not stand in the way of their slice.

Ingredients for the 2008 Depression

'Why is this happening?' is a question that will defy a rational explanation. Our previous post suggested because the Depression is an unstoppable force, but that is hardly satisfying to the inquiring intellect. What are the ingredients that were thrown into the economic pot that triggered this Depression? There has been a bit of speculation on this subject, and as the Depression becomes increasingly self-evident, the attempts to rationalise it will become abundant, and politically motivated. One can never know for sure, but we shall offer our opinion of what the ingredients have been, both in this post and future ones.

Here is today's list: falling real median wages in the USA; too much debt just about everywhere; a speculative mania in housing in most countries; a speculative mania in housing -related investment securities; a speculative mania in securities backed by consumer debt; a speculative mania in exotic investment vehicles such as bond insurance and credit default swaps; a speculative mania in companies which separate speculators from their money such as mutual funds and hedge funds; corruption and mismanagement in financial institutions, their auditors, and their regulators. To this we could add some factors that are probably be at work: fiat (i.e. "paper") money; resource depletion issues; consumption of previously-formed capital, including social capital.

Every item in this list has quite a story behind it, and though they may seem abstract, their effects are most definitely present in your life. In future posts we will touch upon all these ingredients (and more). If you deem any to require expedited discussion, please leave a comment.