Credit Default Swaps and Synthetic CDOs
More financial weapons of mass destruction
In our last article we managed to get a feel for the complex rabbit hole of CDOs, and we finished off with what are called synthetic CDOs. To quickly recap, these are basically bets on a CDO (which are a bunch of mortgages pooled together), although exactly how they work is slightly more complicated than that. Their functionality is predicted on another kind of security, known as a credit default swap (CDS).
Right off the bat we can begin to dissect this term: we know from our derivatives article what swaps are, financial instruments in which cash flows are exchanged for a certain period of time. Credit refers to the amount of trust a prospective borrower has in terms of them being able to pay back their loan. And defaults are when people fail to pay debt. So we know that CDSs involve swapping payments of some sorts, and that they have something to do with credit and people defaulting.
Interestingly enough, this interpretation actually has the right idea of what a CDS is. But onto a more complete definition: a credit default swap is an arrangement wherein the seller, who’s lending money to someone else, agrees to reimburse the buyer in case the borrower defaults. The idea is to offset credit risk (that is, the risk of a borrower’s failure to repay debts and thus the seller losing all that money) with another investor who’s willing to take it on.
Let’s set up an example to further illustrate. We have an investor named Bob who’s lending money to William. Despite agreeing to give William $1000 in exchange for 10% interest every year, Bob is uneasy as to whether William will end up defaulting - if he does, then Bob has just lost a whole grand. So what does Bob do? He turns to Susan, of course, who has offered to insure the loan.
She makes Bob an offer: if he gives her 1% of the loan’s interest every year until the loan is due, she will give Bob the $1000 plus due interest in the event that William defaults. And so with that, Bob has offset the credit risk of loaning to William, since even if he throws his hands up and says that he can’t pay his loan, Susan has it covered. Here’s the catch though: who’s to say that Susan, as an insurer, is safer than William as a lender? Say that a year before the loan’s maturity, William suddenly defaults. As such, Bob turns to Susan for the insurance money, only to find that she in fact doesn’t have any. Bob has not only lost the $1k plus 9%/year in interest to William, but he also lost the interest that he gave to Susan as insurance premium.
Now that we understand credit default swaps, we can now turn to synthetic CDOs. Put simply, synthetic CDOs are the same as regular CDOs except their value isn’t derived from mortgage money - it instead comes from the premiums of a credit default swap. So if we add in a fourth person to our example, let’s say Jane, what she can do is put together a synthetic CDO that essentially bets on the premiums that Bob pays to Susan via his credit default swaps.
The value of the CDO moves in congruity with the premiums that Susan receives (no, they’re not static. Credit default swap premiums are in fact very prone to fluctuation and change constantly). As the premiums rise, so does the value of the synthetic CDO and vice versa. The idea of synthetic CDOs were attractive to higher-end investors especially for 2 reasons: firstly, they’re far easier to create and handle than traditional CDOs, the ones whose value is predicted on mortgage money flowing in. Secondly, there was simply a lot of money in these products - it’s estimated that there was around $1.2 trillion in subprime mortgages (really really risky mortgages) in 2006, but the market for essentially side-betting on these subprime mortgages through synthetic CDOs was more than $5 trillion in investments.
That’s a lot of money. I wonder what would happen if, because the mortgages went wrong, then the synthetic CDOs would in turn go wrong. What would happen to all that money? Stay tuned until next week.
Econ IRL:
The US-Canada Trade Agreement of 1989 (FTA) ended up bringing together the world’s largest trading partners, with both countries having more trade between them than any other duo on Earth. Some, however, have described the deal as an economic shock of sorts particularly on the Canadian labor market as it created sudden trade flows that hadn't previously existed. This week’s paper seeks to explore the short and long run effects of the agreement on the Canadian labor market.
Using firm-administrative data from 1984-2004, part of their findings are what people expected: Canadian tariff reductions did indeed lead to an increased likelihood of Canadian workers being laid off and their earnings from initial employers being decreased. What was not expected, however, was the following:
No reduction in total earnings in the 16 years following the FTA’s enactment
No reduction in total years worked in the 16 years following the FTA’s enactment
What all this suggests is that while the tariffs had the expected effects on the Canadian labor market, workers were able to adjust and recover at impressive speed.
‘Till next time,
SoBasically