The Audacity Of Synthetics (or how Paulson pocketed a quick $5 Billion)

Discussion in 'Politics' started by hvactec, Feb 16, 2010.

  1. hvactec
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    hvactec VIP Member

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    Tuesday, February 09, 2010 12:33:39 PM

    As Fiderer explains, Paulson asked the banks to create those CDOs “so that they could be sold to some suckers at close to par. That way, Paulson’s hedge fund could approach some other sucker who would sell an insurance policy, or credit default swap, on the newly minted CDOs. Bear, Deutsche and Goldman knew perfectly well what Paulson’s motivation was. He made no secret of his belief that the CDOs subordinate claims on the mortgage collateral were close to worthless. By the time others have figured out the fatal flaws in these securities which had been ignored by the rating agencies, Paulson could collect up to $5 billion.

    Let's step back a second.

    A "CDO", or "Collateralized Debt Obligation", is in theory a very simple instrument. It is, at it's core, a collection of income-producing "assets" that have a cash flow that can be diced up paid to people who have purchased components of the CDO.

    The usual thought process when someone says "CDO" is that some bank bought a bunch of bonds, compiled them into a CDO and then sold off the tranches.

    The CDO itself is typically held off-balance sheet in a SIV/SPV, lest the bank be forced to recognize it as part of it's "assets." This is permissible because the bank doesn't own the assets, the legal entity does, and it got the money to buy them from the people who bought the tranches that were issued. The banks do this because they get a nice fee for filing the papers to establish the entity along a management fee as the servicer - that is, the "guy in the middle" who takes the money that comes in from the debt instruments and slices it up, paying out those funds to the buyers of the CDO's tranches.

    So you can think of a CDO, in it's simplest form, as a way of taking a bunch of bonds, putting them together, and then deciding by some mathematical formula who gets the lion's share of the risk in those bonds, along with (of course) the larger set of the rewards.

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