Bernie Madoff’s fradulent investment scheme may turn out to look like a molehill on the mountain of fraud built around the synthetic collateralized debt obligation market. At the end of 2006, the estimated size of the global CDO market was $2 trillion, according to Celent, a financial research and consulting firm. A conservative estimate of the amount of leverage applied to those CDO’s is 10:1.
More after the flip:
The major problem with the synthetic CDO’s is that unlike regular CDO’s they are not backed by physical debt securities such as mortgages. Instead the synthetic CDO’s are backed by credit-default swaps (CDS) which in turn are a bet on whether a third party will default on its debt. The CDS and CDO contracts are linked with a bank's shell company called a special purpose vehicle (SPV) often fronted as a non-profit organization located in a tax haven such as the Cayman Islands. Usually the third party backing the deal is actually a list of between 50 - 150 entities, of which for example if between 7 and 9 default then the CDO is in turn defaulted to its issuer. If 7 banks go under, then 1/3 of the debt is called in. If 8 are in default, then 2/3 is called. If 9 go down, then the entire amount must be paid out. According to financial journalist Alan Kohler, the CDO reference lists include:
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.
Thus, the CDO’s are teetering on the brink of collapsing in their entirety:
It is now getting very interesting. The three Icelandic banks have defaulted, as has Countrywide, Lehman and Bear Stearns. AIG has been taken over by the US Government, which is counted as a part-default, and Freddie Mac and Fannie Mae are in "conservatorship", which is also a part default – a 'part default' does not count as a 'full default' in calculating the nine that would trigger the CDS liabilities.
There have already been 6 full defaults (Glitner, Landsbanki, Kaupthing, Lehman Brothers, Bear Stearns, and Countrywide). The nationalization of AIG, Freddie Mac and Fannie Mae have saved them from going into full default. Last month Ambac and MBIA were given 71% and 73% chances of defaulting, respectively. PMI, General Motors, Ford, and Homebuilders such as Lennar Corp. and MDC Holdings aren’t doing much better.
The synthetic CDO problem may dwarf what is remaining of the subprime mortgages.
The subprime mortgages that started all the trouble have mostly been written down already and the capital replaced. What’s left on the balance sheets – the problem US Treasury Secretary Timothy Geithner is now trying to grapple with – are the collateralised debt obligations, and especially the synthetic ones.
The investment bankers and financial planners who sold the securities on commission to conservative investors like charities and municipal councils, who thought they were investing in fixed interest "bonds", were able to say at the time that the chance of eight investment grade companies going broke at once was virtually nil. (That is, where they even explained how the CDOs worked – most of the investors have absolutely no idea what they invested in).
However 12 months into the US recession, very few of the entities are still investment grade. Most are now junk; the chances of eight of them collapsing is material.