Creditflux Newsletter

From the tone of the Senate panel and the wailing on editorial pages, to the pointed questions from my mother, it is pretty obvious that structured credit is losing hearts and minds. Some criticism is justified, but much is not. Take for example the misconceptions around this month’s whipping boy, synthetic CDOs.

Like any product, a synthetic CDO is only as good as the materials used to make it. Most synthetics exposed investors to investment grade corporate debt and resulted in light credit losses. Goldman Sachs’s ABACUS exposed investors to subprime mortgages. Structured credit has long claimed the ability to put risk into appropriate hands. It has never claimed the ability to turn lead into gold.

Managing the risk might be complicated, but to an investor these instruments are pretty simple and completely transparent. Investors are paid to take exposure to the debt of a fully disclosed list of corporations. Viewed as a stand-alone business, a synthetic CDO is like a rust belt manufacturer: the CDO buys something; modifies it to increase its value; and sells it for more than it cost.

On the question of whether synthetic CDOs serve a “social purpose”, the answer is that they benefited Main Street. They contributed to the pre-crisis, low risk premium environment, which reduced the cost of capital for corporate America and allowed it to create jobs.

The full value of synthetics was realised through the development of the correlation market. Single tranche transactions were a boon for all market participants.

For investors, their investment selections were no longer limited to products designed for a broad audience. Customisation became standard. Investors could select a portfolio of corporate exposures, the maturity of the transaction, tranche size and attachment point. As with any product, the more customised the transaction, the more the investor paid. Still, synthetics offered investors better returns than most similarly rated alternatives. 

For dealers, the single tranche market generated tremendous flows in both the single name and index markets, each with an opportunity to profit. There were a few pre-crisis hiccups, but the correlation books managing the risk generally performed well.

For Main Street, the exact impact of synthetics is difficult to isolate, but during the relevant period, spreads largely stayed within a narrow range. When spreads on single names widened even slightly, synthetics could move considerably because they were leveraged. The wider spreads attracted investors. A new synthetic would be announced by b-wic. As with “real” products, the law of supply and demand held. When the b-wic announced an increase in the supply of credit protection, the cost of credit protection fell. For a corporation, the resulting tighter spreads made return hurdles more achievable and issuance more attractive.

As we now know, it ended badly for some. It certainly did for the dealers. Those managing correlation books mistook precision for accuracy. In a stressed environment the finely calibrated models were precisely wrong.

For investors the end was a mixed bag. On a mark-to-market basis, they learned that leverage is like a US marine. They’d had no better friend. They now had no worse enemy. However, because most tranches had substantial subordination and corporate credit did not collapse, the realised losses from the transactions have been modest. For Main Street, it has only ended badly because it has ended.

Despite their value, synthetic CDOs will not return to former levels of issuance. Dealers will not devote the capital. Investors will not forget the volatility.

More generally, the damage to the securitisation market will result in more balance sheet financing, making bank balance sheet management more important and more difficult. But the best tools for managing that risk will be those developed in the synthetic CDO market.

Joe Carroll is the founder and managing principal of asset management firm FCG|Foundry Capital. He previously worked in structured credit structuring and marketing roles at a number of banks, most recently serving as US head of synthetic credit structuring at Barclays Capital. He can be reached at jcarroll@fcgfoundry.com.