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Alan Kohler
Alan Kohler is one of Australia’s most experienced commentators and journalists. Alan is the founder of Eureka Report, Australia’s most successful investment newsletter, and Business Spectator, a 24-hour free business news and commentary website. He also hosts Inside Business, a half-hour Sunday programme on the ABC, is the finance presenter on the ABC News - and producer of the nightly graph (or two).
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The terror beneath the TARP

Alan Kohler11 Feb 2009, 7:26 AM

Three months ago there was still hope that a chain reaction of exploding synthetic CDOs would, miraculously, recapitalise the banks. That hope is gone, which is why Timothy Geithner's new version of the TARP plan is so urgent.

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It is a melancholy irony that much of the $US500 billion to $US1 trillion to be invested in bad bank assets via the Geithner TARP …er, Financial Stability Plan…will go into instruments that were meant to insure the banks against loss – synthetic CDOs.

That’s why there was so little detail in Timothy Geithner’s speech and why the markets were so dismayed to read it, with the Dow Jones falling, at the time of writing this morning, by more than 4 per cent – no one yet knows how to value these so-called "toxic assets” and Geithner did not even have a stab at it.

In most cases the mathematical value of synthetic CDOs is anywhere from 30 cents in the dollar to 100 cents.

But the market value – if you can call it a market when there are no trades – is usually 1c to 2c in the dollar. In other words, we are talking about hundreds of billions in assets that have essentially no value at all, but have not yet been written down by the banks.

It is ironic because these assets represent default insurance purchased from unwitting fixed interest investors who thought they were buying the Sydney Harbour Bridge. The problem is that the banks lined up with all the schmucks to buy the things from each other.

How many of these cancer sticks the banks smoked is a mystery, but it’s certainly hundreds of billions of dollars worth.

The subprime mortgages that started all the trouble have mostly been written down already and the capital replaced. What’s left on the balance sheets – the problem US Treasury Secretary Timothy Geithner is now trying to grapple with – are the collateralised debt obligations, and especially the synthetic ones.

Three months ago I wrote an article about synthetic CDOs called A tsunami of hope or terror? that is once again at the top of Business Spectator’s most-read hit parade. It seems it is time, once again, to try to figure them out. Perhaps all the new hits on the article are from US Treasury staffers working on the Geithner bailout plan.

To recap, CDOs are collections of loans assembled into various tranches that are then rated according to the underlying loans in each tranche; synthetic CDOs are securities that are not based on actual loans but on credit default swaps (CDS). That is, they are derivatives of derivatives.

The CDO entity writes CDS with the issuing bank covering a large number of unrelated companies. This can be anything from 50 to several hundred – some banks, some industrials. The deal is that if a certain number of those firms default – usually between seven and nine – the money invested in the CDO goes to the bank.

It’s essentially an insurance contract – otherwise known as a bet, or rather a series of bets – a bit like a quaddie.

In November I suggested that although the seven or eight defaults would be very bad for investors (the "terror”), it would potentially recapitalise the banking system (the "hope”), since something like half a trillion dollars would forcibly be moved from investor bank accounts onto the balance sheets of banks.

Alas, it won’t work like that, because most of the issuing banks laid off the entire amount in back-to-back CDS contracts and hedges with other banks and hedge funds, which in turn laid it off against others.

So where the cash ends up when any particular synthetic CDO blows up is anybody’s guess. It will be dispersed among hedge funds, banks and other investors.

The losses, however, are real, and are not dispersed.

There are two separate issues for investors: market value and default. For most of the synthetic CDOs, but not all, the market has evaporated and the securities have virtually no value, notwithstanding that analysts are still producing theoretical values based on the credit ratings of the entities named on the CDO.

You would think these values would not pass muster in a bank audit, but the fact that most have not yet been written back to zero (since the banks are still operating and Geithner’s FSP bailout is still worth trying) suggests that auditors are not applying market value to them – perhaps because there really is no market.

On the question of default – and thus the transfer of the invested funds to the issuing bank – it is more or less a binary outcome: the investors either keep their money or they lose it.

This is a mind-numbingly complex area, and no two synthetic CDOs are the same. Most are calibrated to some extent – for example investors keep all their money if up to six of the named entities default, lose some money if a seventh defaults and lose everything if eight default.

When setting up the synthetic CDOs, the issuing banks and investment banks listed all the companies they were worried about – for example, each other (which should have been a tip-off), the Icelandic banks, the monoline insurers (which were also used to park the cash collateral – another tip-off) and lots of US homebuilders.

That more of them haven’t fallen over yet is surprising, but all would be close to the trigger point, which is why the Geithner plan is urgent.

The first way a synthetic CDO falls over is that the holder of the collateral collapses. The money is held by banks, monoline insurers and special purpose vehicles that are, essentially, orphans without parents. Many of those are close to bankruptcy; if they go, so does the CDO for which they are holding collateral – phhht!

The second way is if eight (or six, seven or nine) of the entities listed on the CDO goes broke.

These entities were almost all investment grade – rated by the ratings agencies.

The investment bankers and financial planners who sold the securities on commission to conservative investors like charities and municipal councils, who thought they were investing in fixed interest "bonds”, were able to say at the time that the chance of eight investment grade companies going broke at once was virtually nil. (That is, where they even explained how the CDOs worked – most of the investors have absolutely no idea what they invested in).

But sales people were right – the chances of eight investment grade borrowers defaulting at once are remote indeed.

However 12 months into the US recession, very few of the entities are still investment grade. Most are now junk; the chances of eight of them collapsing is material.

But it is not 100 per cent, which is why the synthetic CDOs almost all still have some mathematical value: it’s just that no one wants to buy them.

And that’s because the named entities are falling like ninepins. The Icelandic banks have all defaulted (that’s 3), Lehman Brothers has gone (4), Fannie Mae and Freddie Mac have each partially defaulted (5?), Washington Mutual went (6).

They aren’t all listed on every synthetic CDO – it depends which entities are actually on each one as to whether it is at, or close to, full default now.

This could be a long recession. This time next year there must be a high probability that all synthetic CDOs will have fully defaulted. In that case, their investors will have lost everything and the money will have disappeared into the insatiable maw of the Ponzi scheme called the global financial system.

Australian charities and councils seem to be in for $2-3 billion worth; many of these will be seriously wounded by the loss, if not mortally. Many will sue the issuers (usually the Lehman Brothers subsidiary, Grange Securities). Some lawsuits have already launched.

But it seems Australia actually had much less than its GDP share of this market: elsewhere they were sold like Krispy Kreme donuts by investment bankers who were enthusiastically digging a new seam of gold (to end on a mix metaphor).

Follow @AlanKohler on Twitter

The Spectators

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Index	Last	Chg	% Chg
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S&P 500	1667.47	+17	+1
NASDAQ	3498.97	+33.7	+1
FTSE 100	6723.06	+35.3	+0.5
NIKKEI	15360.81	+222.7	+1.5
Hang Seng	23493.03	+410.3	+1.8

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