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By Root 3652 0

out of business entirely. Because synthetic CDOs made of credit default swaps referenced mortgage bonds that already existed, you didn’t need any more bonds. You could clone the same risky tranches again and again—five, ten, twenty times if you wanted. And you could do this quickly, without waiting around to buy real securities. Even if there wasn’t a single new mortgage bond created, the supply of securities was now infinite and immediate, thanks to credit default swaps and synthetic CDOs. But that also meant that as subprime mortgages continued to default—and those losses eventually began to erode the value of the CDOs—those losses were going to be greatly amplified because so many side bets had been made so quickly through the purchase of synthetic CDOs.

The gains were amplified, too, because synthetic CDOs are a zero-sum game: someone has to lose and someone has to win. Even after all the damage had been done, some would make the argument that there was nothing wrong with this. In a free market, shouldn’t all participants be able to “express their views”—a euphemism for placing a bet—on the direction of mortgage-backed securities? Maybe so. But if the ability to short a mortgage-backed security, and maybe even the construction of the index, brought a kind of transparency to the market, then the synthetic CDO took it away. That’s because the synthetic CDO allowed Wall Street to take all of Mike Burry’s and Andy Redleaf’s bets, and instead of holding the other side of those bets—or finding investors who actually wanted to be long a tranche of triple-B-rated mortgage-backed securities backed by New Century loans—it could instead reassemble those bets into triple-A-rated securities. (And, yes, the rating agencies put those triple-A ratings on large chunks of synthetic CDOs.) That way, the other side of the bet wasn’t someone who had investigated the mortgage-backed security—like Burry and Redleaf did—and thought he was betting on its performance. It was someone who was buying a rating and thought he couldn’t lose money.

“Negative news on housing nags the market,” Burry wrote in an early 2006 letter to his investors. “Yet mortgage spreads in the cash market fell substantially.” What he meant by that was that the market was acting as if there was less risk instead of more. This development, Burry wrote, is “indicative of ramping synthetic CDO activity.”

18

The Smart Guys

“We’re not trying to outsmart the smart guys. We’re trying to sell bonds to the dumb guys.”

So said a big time Kidder Peabody trader named Mike Vranos back in 1994, according to colleagues who talked about him to the Wall Street Journal on May 20, 1994

“This list [of potential buyers] may be a little skewed toward sophisticated hedge funds with which we should not expect to make too much money since (a) most of the time they will be on the same side of the trade as we will, and (b) they know exactly how things work... vs. buy-and-hold ratings buyers who we should be focused on a lot more to make incremental $$$ next year....”

So wrote a young Goldman Sachs salesman named Fabrice Tourre in an internal e-mail on December 28, 2006

On one level, the creation of synthetic CDOs was the apotheosis of the previous twenty-five years of modern finance. They were stuffed with risk, yet, thanks to the complex probabilistic risk models developed by Wall Street’s quants, large chunks of them were considered as safe as Treasury bonds. They were Wall Street’s version of a lab experiment gone mad. Unlike a corporate bond, backed by the assets of a corporation—or even a mortgage-backed security, backed by actual mortgages—they existed solely to make complex bets on securities that existed somewhere else in the system (which, as often as not, were themselves bets on securities that existed somewhere else in the system). They had the imprimatur of the rating agencies, whose profits depended on stamping these complex bets with triple-A ratings. They massively increased leverage in the system. They were made possible by the invention of the credit derivative,