Here’s an argument you rarely see ventured forth nowadays:
Synthetic CDOs were good for everybody…
…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.
That’s Joe Carroll, a former — surprise! — US head of synthetic credit structuring at Barclays Capital, in the Creditflux newsletter. (H/T Alea.)
It’s always nice to have a straightforward defence of synthetic CDOs.
Well, someone has to argue their corner, we guess — it’s still unclear if Goldman Sachs will go and fight the SEC’s case against it over ABACUS 2007-AC1.
That would perhaps be rather a shame, as it could well be a landmark ruling on information disclosure and asymmetry in CDOs — which is indeed the issue here.
After all, as Carroll continues:
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.
Of course, one can take the Abacus counter-argument against this, that investors were in fact denied full disclosure of other investors’ material interests in the selections involved, as is alleged to occurred for ACA and IKB in the face of John Paulson’s big short on subprime.
And there are other possible counter-attacks, though — for instance, the literature on the sheer computational complexity of CDO-tranche investment, which has been a bit underrated, perhaps. As the best paper so far, by Sanjeev Arora et al, notes:
…it may be computationally intractable to price derivatives even when buyers know almost all of the relevant information, and furthermore this is true even in very simple models of asset yields…
…even the most sophisticated investment banks such as Goldman Sachs cannot be fully rational since they do not have unbounded computational power. We show that designers of fi nancial products can rely on computational intractability to disguise their information via suitable “cherry picking.” They can generate extra profi ts from this hidden information, far beyond what would be possible in a fully rational setting. This suggests a revision of the accepted view about the power of derivatives to ameliorate the effects of information asymmetry.
That’s only emboldened attempts to engineer ‘pseudo-random’ derivatives which aren’t lemon-loaded in particular tranches, of course, but it’s still the trillion-dollar problem for reviving synthetic CDO issuance.
It’s not what you’re exposed to, or whether you know each information input or piece of the CDS portfolio going into your product — it’s whether you can assess it in the first place. Ironically for Carroll, it’s always been correlating that information that beat the banks, even for bog-standard ABS CDOs.
Until — if — complex derivatives solve that, we’ll be debating this issue with all the relevance and reality of medieval scholastic theology.
Related links:
Synthetic CDOs: not saving anything – FT Alphaville
On killing the market for complex products – FT Alphaville