The Journal looks at how investments that were supposed to reduce risk by spreading it instead magnified it by spreading it to every corner of the globe, and this case to a town of 10,000 in Australia that has tens of millions in exposure to synthetic CDOs.
The linkage between Messrs. McCormack and Gahan demonstrates how far a vast superstructure of credit derivatives such as synthetic CDOs, built up over the past decade, has spread the risk of lending to U.S. companies — and how far the pain is likely to reach. They’re called derivatives in part because they don’t entail any direct investment into companies. Instead, they’re more like side bets on the companies’ fortunes.
JP Morgan, which created this particular CDO, brought in half a billion dollars in revenue in 2006 on the stuff, the paper reports.
Here’s a good explanation of what these complex things are and how they work:
Synthetic CDOs are vulnerable at this stage in the financial crisis, because of the way they work. They generate income by selling insurance against bond defaults, typically on a pool of 100 or more companies. One way they do so is by entering into contracts known as “credit-default swaps.” Investors, such as the town of Parkes, receive regular payments from credit-default-swap buyers, which are usually banks or hedge funds.
In return for the income, investors agreed to make huge payments in what was seen as a highly unlikely event: a wave of corporate defaults greater than any experienced in the previous two decades. Now, though, as financial firms implode and a slump in consumer spending hits retailers and manufacturers, that event is starting to happen.
As a result, synthetic-CDO deals are poised to trigger a massive transfer of wealth from investors such as Parkes to hedge funds and the trading units of big U.S. investment banks. By various estimates, the amount of money set to change hands could be anywhere from tens of billions to hundreds of billions of dollars.
It’s not the most elegant story, but you try to write one on synthetic collateralized debt obligations.