Credit Default Swaps & CDO’s

Why Wall St. Needed Credit Default Swaps

Take a CDO with a 50 basis point spread over US Treasures. Banks will buy credit default swaps costing them 20 basis points, but by doing so, even they seem to make less profit (50 vs. now only 30 bp spread), banks can actually book the difference in spread for the whole life of this CDO instantly, something called negative-basis trade.

If this CDO life is 10 years, banks can book the whole 10 years of phantom profits this year, even if this CDO defaults sometime in next 10 years. And I don’t need to mention its implications for the bonuses of the structured product groups at Wall St firms, or hedge funds with 2/20 fee structure.

In other words, who cares whether this CDO defaults next year, let us just realize the next 10 years of bonuses today! There is a common secret at Wall St. – it doesn’t matter whether a product is good or bad, the only thing matters is how you structure it. As former Secretary of the Treasury, John Connely, said to European central banks in 1970s’ “It might be our currency (US dollar), but it is your problem”. Same thing here. If CDO defaults, they have already bumped up the stock price, cashed out the stock options and their vested shares, collected the yearend bonuses, now it is investors’ problem.

This kind of accounting manipulation can fool people for a few years, but not forever, since the well of CDOs gets sucked dry very quickly when every single firm on Wall St. has found out about this and is doing it. Any firm owning a mortgage originator has a competitive “advantage” since it guarantees the source for the well. Now you know why Stanley O’Neal at Merrill Lynch wanted to buy First Franklin (a mortgage loan originator) so badly, because for every loan First Franklin originates, Merrill Lynch executives and their structured product groups will advance 10 years of their firm’s earnings and future bonuses today.

Now you understand why Wall St wants to package and collateralize everything from residential to commercial, from mortgage to credit card to auto loan. Now you also realize what is behind the major shift and increase from traditional M&A fees in the good old days to the so-called trading “profit” in recent years “earned” by investment banks.

But at the same time, this raises a lot of questions about how real are the past earnings reported by both Wall St firms and hedge funds with large CDO profits. For example, if a hedge fund manager can trade minor reduction of profit (from 50 to 30 bps) with an immediate bonus of 10 times (1 vs. 10 years) paid today, what would he choose?

He would be nuts for not using credit default swaps to “structure” his CDO holdings. If the CDO defaults next year and take his fund under the watermark, it’s no a big deal. He already collected 20% money from the “profit” the year before. He can just close the fund and open another new one, raising money probably from the same sucker pool of investors. If you want to see a pyramid scheme, there is nothing more live and vivid than this.

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