Collapse guaranteed thanks to synthetic collateralized debt obligations

Below is a WSJ article. It may be difficult to understand, but it says that a part of the credit market is collapsing and that it will have dire consequences for the economy.

(emphasis mine)

Trouble for Banks, Insurers May Lurk in Synthetic CDOs

LONDON -- A recent rash of bank failures is wreaking havoc on a large but little-known corner of the credit markets, in a development that could mean more write-downs for banks and higher borrowing costs for companies everywhere.

Even as some lending markets begin to recover from last month's demise of Lehman Brothers Holdings Inc., the securities firm's default -- together with those of other U.S. and European banks -- is causing new dislocations in the multitrillion-dollar market for complex investments known as synthetic collateralized debt obligations.

That could mean trouble for banks, hedge funds and insurance firms around the world, which used synthetic CDOs as a way to invest in diversified portfolios of companies without actually buying those companies' bonds. Many synthetic CDOs contain a heavy dose of exposure to financial companies, including Lehman, U.S. thrift Washington Mutual Inc. and recently nationalized Icelandic banks Glitnir Bank hf, Kaupthing Bank hf and Landsbanki Islands hf.

As a result, the users of synthetic CDOs are facing a wave of credit-rating downgrades and outright losses, which are coming to light gradually as ratings firms pore over hundreds of individual synthetic-CDO deals. In one early sign of the potential impact, Belgian bank KBC last week announced a —‚¬1.6 billion ($2.15 billion) write-down on its —‚¬9 billion synthetic-CDO portfolio after Moody's Investors Service downgraded some of the deals it held.

Meanwhile, hedge funds and other investors are heading for the exits amid worries about how bad the losses and downgrades will be, causing the market value of synthetic CDOs to slide. Dealers are offering about 50 cents on the dollar or less for some pieces of synthetic CDOs that used to be rated triple-A, according to one trader. That is down from about 60 cents on the dollar only three weeks ago.

"We've seen some hedge funds trying to get out of positions, and that's rattling credit markets," said Laurent Gueunier, head of structured corporate credit at AXA Investment Managers in Paris.

As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against debt defaults, typically on a pool of a hundred or so companies or individual bonds. Given the size of the market, synthetic CDOs can have a large impact: By various estimates, they have sold insurance on the equivalent of between $1.25 trillion and $6 trillion in bonds.

When investors attempt to get out of synthetic CDOs, they push up the cost of default insurance. That, in turn, raises the cost of borrowing for companies, which use the cost of default insurance as a guide when deciding what interest rate they must pay on new bonds.

As of Monday, the average cost of $10 million in default insurance on highly rated North American companies stood at $191,000 annually, up from $128,500 at the end of September, according to the Markit CDX index. For European companies, the cost has risen to —‚¬144,000 from —‚¬121,000 to insure —‚¬10 million in debt, according to the Markit iTraxx index.

Ratings firms Standard & Poor's and Moody's have already downgraded several synthetic-CDO deals containing or related to Lehman, Washington Mutual and U.S. mortgage companies Fannie Mae and Freddie Mac.

The problems with synthetic CDOs stem in part from the way they were made. In many cases, the banks that created the CDOs stuffed them with companies, such as Lehman and Iceland's Glitnir, that paid the highest possible return for their top-notch credit ratings. That made the CDOs more attractive, but also riskier, because they contained companies that the market perceived as more likely to get into trouble.

Perhaps the weakest link in the market are specialized funds, known as "constant-proportion debt obligations," that work much like synthetic CDOs but with one important difference: They use borrowed money, or leverage, to boost the returns they can provide for investors, a strategy that also magnifies losses.

CPDOs, for example, typically borrowed about $15 for every dollar their investors put in. They also contain safety triggers that force them to get out of their investments if their losses reach a certain level. Analysts estimate that most CPDOs reach those triggers when the cost of default insurance hits about the level where it is now.

Three CPDO funds launched in 2006 by Dutch bank
ABN Amro Holding NV have already been forced to liquidate after credit insurance costs spiked and they were downgraded by S&P.;

Other specialized funds, known as "credit derivative product companies," borrow as much as $80 for every dollar invested, according to a recent report from Citigroup Inc. One prominent such fund -- Theta Corp., a $10 billion fund run by London-based firm Gordian Knot -- had its credit rating slashed to Aa2 from AAA by Moody's earlier this month. Two other funds, Primus Financial Products and Athilon Capital Corp., have also had downgrades in recent weeks.

A representative of Gordian Knot declined to comment. Primus and Athilon couldn't be reached for comment.

If those funds are forced to exit from their investments, it "could wreak havoc on the marketplace," Citigroup analysts wrote in the report.

My reaction: I have been thinking about how to explain how synthetic CDOs, and, for now, I have given up. To explain synthetic CDOs, I would first have to explain how credit default swaps work, and explaining CDSs is conceptually nasty. For now, I will explain the ramifications of the article above.

ramification#1—synthetic CDOs, CPDOs, and CDPCs are investments or assets which are held by financial institutions, insurance companies (like AIG), pensions, money market funds, individual investors, etc. These assets were rated AAA by rating agencies, but now they have become toxic and are being downgraded. No one whats to buy unless it is at a very steep discount (50 cents or less on each dollar of the original investment). This means that financial institutions, insurance companies, etc are going to have to write down these investments. So the collapse of synthetic CDOs investments is going to cause another round of heavy losses or for banks, insurance companies, etc…

ramification#2—synthetic CDOs, CPDOs, and CDPCs sold insurance on corporate debt in exchange for insurance premiums. Investors pored money into these synthetic CDOs, CPDOs, and CDPCs, which these funds used to sell a massive amount of insurance on all forms of debt. Because so many sellers of insurance, the cost of insuring corporate debt became artificially low, making corporate debt seem less risky. Since corporate debt seemed less risky, companies were able to borrow at very attractive interest rates. Now that investors are pulling money out of synthetic CDOs, CPDOs, and CDPCs, these funds are not only selling less insurance, but are also having to buy back the insurance they sold to close out positions. This is driving up risk premiums and increasing the borrowing costs of companies and governments.

Taken together, these two ramifications mean another huge hit for financial firms and higher borrowing costs for everyone else. The fallout from collapsing synthetic CDOs, CPDOs, and CDPCs is likely to completely counteract the benefit of the 700 billion bailout package. Credit market will go into an even greater freeze, and this freeze is going to wreck the economy and the financial system. The Dow is guaranteed to fall below 5000 before this is all said and done.

The only investments I would put money in today are physical gold, funds backed by physical gold, and unhedged gold mining stocks.

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