"They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. "

This post is going to go all over God's green earth, so put on a decent pair of shoes. Also, if you carry a shillelagh, please don't prod me. I'll move as fast as I can.

I need to first introduce a new hermeneutic rule called "Searle's Sagacity", which I learned from my teacher John Searle. I believe that he acquired it from Austin, but I'm not sure. Anyway, here it is:

If a person can't explain something simply, then they don't know what they're talking about. The only exception being Kant.

Now, there's also a corollary to this, which is that questions should be simple and comprehensible, and meant to elicit a simple explanation. This rule is constantly violated, because you have to, in effect, appear less educated than you are. Most people find this one a bit rough, preferring to ask questions that demonstrate that they know more than the person being questioned.

Here's another rule, not so pleasant for me. It's called Hardy's Harangue. It's not really a harangue, but, since it's a bit rough on me, I'm giving it the flavor or taste of overdone:

"There is no scorn more profound, or on the whole more justifiable, than that of the men who make for the men who explain. Exposition, criticism, appreciation, is work for second-rate minds. "

Frankly, I'll take being a second-rate mind. Since my blog is based upon exposition, don't expect any first-rate thinking on it. But you didn't, in any case, so no problem here.

If you want to blame people for my "compulsory mis-education", although I chose to go to college, you can blame John Searle, Hubert Dreyfus, Gregory Vlastos, George Lakoff, Bernard Williams, and Paul Feyerabend. Actually you can't, since they were excellent teachers.

Williams, Vlastos, and Feyerabend have passed on, but Searle, Dreyfus, and Lakoff, are still with us, thankfully. Williams and Vlastos were wonderfully kind and decent human beings, who tolerated my presence out of pity, probably, besides being geniuses. Feyerabend and I had a different relationship. He was never, actually, my teacher, since I eventually dropped three courses of his that I started. The final straw was when he claimed that Wittgenstein knew nothing about math. My feeling was that, even if true, it shouldn't be pointed out. Even though never truly his student, I had innumerable hours of conversations with him, that involved mutual criticism bordering on insult. Nevertheless, we got along very well over a long period of time until his death.

Most people remember the ending of The Brothers K where Alyosha tells the boys to remember this moment, in order to have it as a reference point to guide them in their lives. Something similar happened to me with Prof. Vlastos. When I was tossed out of graduate school, I went by his office to see him. I was feeling sad, but also elated, because I had been very unhappy in graduate school. Professor Vlastos told that he was very sorry that this had happened, and that he didn't think it was good for philosophy, since I reminded him so much of Walter Kaufmann. Now, even if he had said this just to make me feel better, it still means more to me than anything that has ever been said to me about myself. Once Gregory Vlastos has compared you to Walter Kaufmann, you don't really care what anyone thinks about you. This kind of moment is important for all of us, because it helps protect us from the vagaries and vicissitudes of human life. Even though I'm melancholy by nature, this moment is with me always. Hoorah For Vlastos! And Walter Kaufmann has had a huge influence on my life, which I might talk about someday. As an aside, the Gargoyle Of Emerson Hall was Prof Dreyfus.

This leads us to Felix Salmons explanation of Synthetic CDOs. Here it is:

"Over the past few days, two very smart people have asked me about a passage in Michael Lewis's cover story for Portfolio in which he talks about synthetic CDOs without actually using the term. They said that they didn't quite understand it, so I'm going to try to explain what a synthetic bond is. Once I've done that, the Lewis passage should be a lot more comprehensible."

I have to admit to not liking the Lewis piece, precisely because I didn't feel that he did a decent job explaining these investments. I did a previous post on his post.

"Let's start with a simple single-credit synthetic bond. You're an investor, and looking at the credit markets, you see that IBM debt is trading at attractive levels, especially around the 5-year mark, where they yield about 150bp over Treasuries. You'd really like to buy $100 million of IBM bonds maturing in five years, but IBM isn't returning your calls (they have no desire to borrow money at these spreads), and there aren't any IBM bonds with exactly the maturity you want. What's more, even the bonds with maturities nearby are illiquid, and closely held: there's no way you can just blunder into the market and buy up that many bonds without massively skewing the market, since the overwhelming majority of the bonds are just not for sale."

Why do you want these IBM Bonds? Do you know something special about IBM?

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market. Essentially, you take the $100 million that you were going to spend on IBM bonds, and you put it into a special-purpose entity called, say, Fred. (In reality, it'll be called something really boring like Synthetic Technology Invetments Cayman III Limited, but Fred is easier to remember.) First, Fred takes the $100 million and invests it in 5-year Treasury bonds."

Fine. You've created an artificial IBM bond for yourself. Good for you. Game over?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral. The buyer of protection will pay $1.5 million per year (150 basis points) to Fred, and in return Fred promises to pay $100 million to the buyer in the event IBM defaults, less the value of IBM's bonds at the time. The buyer knows that Fred is good for the money, because it's already there, tied up in Treasury bonds."

The answer is "no", because Fred has to go out and sell these things. Here's my question: Doesn't Fred have to believe that there's a demand for his product in order to sell it? So, whose going to buy insurance on IBM bonds? And why? See, I'm sensing that Fred has an agenda here beyond mirroring unavailable IBM bonds. Are you?

"So long as IBM doesn't default, you get not only the $1.5 million per year from the buyer of protection, but also the interest on the Treasury bonds. You wanted to buy IBM bonds yielding 150bp over Treasuries, and that's exactly what you're getting: the 150bp from the CDS counterparty, and the Treasury interest from the Treasury bonds. At maturity, assuming IBM still hasn't defaulted, you get your $100 million back, the CDS contract has expired, and Fred has no contingent liability any more."

It's like an insurance transaction, including premiums.

"The effect is identical to holding an IBM bond -- and you can even sell your interest in Fred, just like you could sell an IBM bond. If IBM defaults, you lose your $100 million, but you get back the value of an IBM bond -- which again is the same outcome as if you'd bought an IBM bond for $100 million and IBM defaulted."

Should you sell these things it is. Otherwise you just own Treasury Bonds.

"But the key thing to note is that IBM itself is not involved in the transaction at all. It doesn't matter how few bonds IBM has issued, there can be many times that amount in synthetic IBM bonds, just so long as there are enough people out there willing to buy and sell credit protection on IBM."

Actually, IBM is involved, because you might have an influence on their bonds and stocks. You just didn't buy a bond from them, although, since a bond is a loan, I don't see why they couldn't accomodate your enthusiasm to loan them money.

"And just as you can create a synthetic IBM bond, you can create a synthetic bond portfolio, made up of credit default swaps on any number of corporate names or even mortgage-backed securities. The special purpose vehicles in those cases sometimes sell protection on a lot of different names; sometimes they just sell protection on a liquid CDS index. Either way, the returns that those vehicles offer are basically the same as the returns on buying the underlying securities -- if those securities were easily available."

Okay. We get the "pro" argument. Liquidity and efficiency of capital.

"Now that we've understood all that, we can return to Michael Lewis's piece, where he's talking about a chap called Steve Eisman, who was buying protection in the CDS market, and is sat at dinner next to one of his counterparties, who was selling protection.

Whatever rising anger Eisman felt was offset by the man's genial disposition. Not only did he not mind that Eisman took a dim view of his C.D.O.'s; he saw it as a basis for friendship. "Then he said something that blew my mind," Eisman tells me. "He says, 'I love guys like you who short my market. Without you, I don't have anything to buy.'¿"
That's when Eisman finally got it. Here he'd been making these side bets with Goldman Sachs and Deutsche Bank on the fate of the BBB tranche without fully understanding why those firms were so eager to make the bets. Now he saw. There weren't enough Americans with shitty credit taking out loans to satisfy investors' appetite for the end product. The firms used Eisman's bet to synthesize more of them. Here, then, was the difference between fantasy finance and fantasy football: When a fantasy player drafts Peyton Manning, he doesn't create a second Peyton Manning to inflate the league's stats. But when Eisman bought a credit-default swap, he enabled Deutsche Bank to create another bond identical in every respect but one to the original. The only difference was that there was no actual homebuyer or borrower. The only assets backing the bonds were the side bets Eisman and others made with firms like Goldman Sachs. Eisman, in effect, was paying to Goldman the interest on a subprime mortgage. In fact, there was no mortgage at all. "They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford," Eisman says. "They were creating them out of whole cloth. One hundred times over! That's why the losses are so much greater than the loans. But that's when I realized they needed us to keep the machine running. I was like, This is allowed?"

What Eisman is saying is that there were mortgage-backed securities, and then there were synthetic mortgage-backed securities; when the banks ran out of actual MBS to sell to investors, they sold them synthetic MBS instead. And yes, that was allowed."

They created products to fill the demand for a sold out product.

T"here is some hyperbole here, though. While there were undoubtedly a lot of synthetic MBS issued, they weren't a large multiple of the real MBS issued, as the "one hundred times over" quote would suggest. Which is quite obvious, if you think about it: there weren't a lot of people like Steve Eisman willing to short the MBS market -- and you need them, to take the other side of the trade."

Yes. The other side of the trade is actually the issue. Who's buying these things? And why? What's the demand being filled?

"In fact, most of the synthetic MBS issued were issued by banks which kept the underlying mortgages on their own balance sheet. Rather than put the mortgages directly into a CDO and sell that to investors, they kept the mortgages themselves and bought protection from the CDO on them -- creating a synthetic CDO which mirrored (and which they could sell to hedge) their own holdings. Why did they do that? That's the story of the super-senior tranche, and will have to wait for another day."

They keep them on their own sheet, which allows them lower capital requirements for the other tranches they sell. They also make more money by divvying the bundle up, and selling it in parts, as well as fees.

Here's my comment, which didn't get answered:

Posted: Nov 29 2008 11:11pm ET

"So you buy a synthetic IBM five-year bond instead, taking advantage of the much more liquid CDS market.'

What's your fascination with IBM bonds? There are lots of bonds out there. Does this investor have some special knowledge?

"Next thing, Fred goes out and sells $100 million of credit protection on IBM in the CDS market, using the $100 million of Treasury bonds as collateral."

Fred's motives are somewhat clear to me, in the sense that you've explained what he says his interest in these IBM bonds is. But whose the buyer? Someone who actually owns IBM bonds, and wants default protection? Or someone who doesn't like IBM's chances? Surely someone needs to feel they need this default protection before they purchase it? In other words, when Fred looks at IBM, since he's creating a product to sell, doesn't he need to have seen some reason for assuming that there's a demand.

By DonthelibertarianDemocrat

Basically, the points I made above. I think that the motive for a product is more important than the product. But Felix has descibed a product without telling us where the demand comes from. In order to mirror the IBM bonds, Fred has to Sell a Product.

Now, Robert Waldmann comments on Angry Bear:

"Given this story about the use of CDSs, I understand why Felix Salmon is convinced that they are not financial WMDs and why he is so angry that AIG was allowed by counterparties to issue CDSs without posting collateral. I also think that the story is very different from CDS reality.

Over at his blog, I asked Felix Salmon three questions

1) Why wouldn't interest rate swaps serve just as well ?

2) Why set up Fred when Fred's assets must be worth more than Fred's liabilities so there is no obvious point limited liability 100% share ownership of Fred.

3) Also if 100% collateral is posted, how can the notional value of CDSs be greater than the US national debt ?

After the jump, I explain why I find these questions challenging."

Now, these are interesting questions, but they are still technical. Who is Fred selling his product to? And why?

"1) If I want to be long IBM bonds and Own Treasury bonds I can make a synthetic IBM bond with interest rate swaps can't I ? I think the cash flows with my counterparty are exactly the same, if neither of us goes bankrupt. Thus, I think that the immense popularity of CDSs must be based either on bankruptcy law (related to the super senior tranche ?) or on accounting standards and capital requirements, or both. "

Well, here he's correct. It's the capital requirements. But that only explains the seller again, and is frankly what Felix said that he was going to explain.

"2) Why set up a a special purpose entity. I mean that has to cost something. They are set up for a reason, either to limit liability or to make balance sheets look better. "

The reason is more fees and lower capital requirements. Yes, it does cost something, which is why you have to sell it. Again, the buyer?

"3) Clearly not every dollar in CDS was collateralized 100% by US debt. There isn't enough US debt. I think it must be true that most were only partially collateralized. AIG might be an extreme case, but I think it just must be true that CDSs were used to leverage up and not just to synthesize bonds."

Correct. But here again, Felix will probably explain that next. My problem is still there's no good explantion of a simple transaction involving buying and selling, supply and demand, the basics.

"OK now my efforts at answers. Remember I am very ignorant and mostly guessing."

Join the crowd. At least Felix answers you.

"On bankruptcy law, you have to realize that it's not your father's bankruptcy code.
Bo Peng explains

Generally speaking, in bankruptcy code, derivatives counterparty claim[s] can go right through Chapter 11 protection and force liquidation. Chicago Fed in fact had a research paper in 2004 (thanks to Seeking Alpha reader emrald) analyzing the original rationale behind and the unintended consequences -- cliche of the month? -- of this exceptional treatment of derivatives.

oh my.

I think this means that if Fred's parent (I'll call it Zeke) goes bankrupt, Fred's counter-party gets to grab the T-bills and no bankruptcy court can stop it. This would not be automatic from the definition of CDS, but Zeke and Fred's counter-party would both benefit from writing the contract that way."

I don't see it quite the same way. They can force liquidation, but other claimants, taxes, for example, could preceded their claims.

"Now if equity in Fred is counted as one of Zeke's assets and Zeke has a binding capital constraint, a fast one has been pulled. These assets are not part of the pool split up among creditors in the case of bankruptcy, because Fred's losses (value of collateral minus value of the CDS) go 100 cents on the dollar to the counter-party. Also if equity in Fred appears on Zeke's balance sheet, then Zeke's creditors may be mislead. If they assume that all equity in special purpose entities is quite likely worthless now, then a whole lot of crisis can be explained."

Surely these people know the law, otherwise they wouldn't use it. I don't see the evidence that someone is being fooled here.

"Clearly not all CDSs were used to make sythetic bonds. For one thing Lehman brothers had liabilities including CDSs on its balance sheet (OK its 10-Q report). For another they were listed at fair market value which was vastly below notional value until recently. Now it seems to me clear that if firms can goose their equity to debt ration they will and clear that CDSs are very useful for that purpose so long as they are not 100% collateralized. "

That's the plan.

"I'd guess that Fred wouldn't own Treasury securities equal to 100% of notional value, but rather a lower ratio with a trigger that if the market price CDS reached ninety something percent of the value of the collateral, the collateral could be seized immediately. This means Fred could suck money out of Zeke or Zeke would have to lose 100-ninety something suddenly. Now a totally unexpected actual default would not be insured by Fred (which would go bankrupt). That is, this use of the CDS market would be to take opposite bets on the CDS price, not to insure risk. But, I mean we know that was going on."

If that's the law. I'm not sure how these CDSs are being used in his example. He seems to believe that bets on this company's viabilty take precedence over actual debt obligations of the company. I simply don't know the law.

If IBM defaults, the CDSs will work out independetly of IBM, between the Insured and the Insurer. The CDS in Felix's example are completely independent of IBM. They're simply tied artificially to its fate.

But Waldmann asked some good questions.

Here was Felix's response:

"Posted: Nov 30 2008 11:49am ET

Hi Robert -- I really was just trying to explain synthetic bonds, not anything about the larger CDS market. And synthetic bonds are really a very small part of the CDS market.

I'm not sure how you could possibly create a synthetic IBM bond using interest-rate swaps alone -- where would you get the credit-risk component from?

As for Fred's structure, it's worth remembering that these are synthetic bonds we're talking about here -- and the whole point of a synthetic bond is that it can be bought and sold in the secondary market, just like a normal bond. You can't talk about "Fred's parent" because no one ever needs to know who Fred's shareholder(s) might be.

By Felix"

So, my bottom line is that neither the post by Lewis or Felix Salmon really explained the problem. What people want to know is why people buy them. In this explanation, they seem to be creating a product without a clearly defined market, which doesn't make sense. I'm not saying that either doesn't know what they're talking about, but that explanations are much harder to construct than many people believe because they involve, not simply knowing something very well, well enough to simplify it, but also being able to explain it clearly.

So, I'll keep Hardy's Harangue, although I think explanation much harder to accomplish than he seems to believe. And I'll keep Searle's Sagacity, even though a person who knows a subject very well can have a hard time explaining it simply.