Ruth Lee
Everyone always wants an easy explanation of what all these terms mean: MBS, CDO, synthetic CDOs. And with the lack of any “mea culpa” from Goldman, the terms are hitting the news again. This is a high level explanation of what that means.
A Mortgage is a loan on one house. If that mortgage defaults, the owner of that mortgage loses. SO… what if you bundle up a 1000 mortgages? - then if one mortgage fails, the entire investment isn’t a loss. You still have an investment that has a large portion of mortgages that are performing. When you bundle those mortgages and securitize them – that is called a Mortgage Backed Security.
Well, if you are concerned that your risk is still too high with an MBS, you can bundle up a bunch of MBSs into a CDO (collateralized debt obligation). This new CDO has 100s or 1000s of MBSs. You are now leveraging your risk of default against thousands or tens of thousands of mortgages. As an investor, you are betting long – that they will perform – or short – that they will fail. As an investor, you assess the value of your investment, perhaps saying that the value is 90 cents on the dollar or 85 cents on the dollar.
Synthetic CDOs are side “bets” on whether an investor will profit or lose from an investment in a regular CDO. They aren’t an investment really – they are just a means of hedging risk, says Blankfein of Goldman Sachs. In his spin, he feels that it is just a responsible means of leveraging risk. Not by ensuring there is quality in the MBS or the CDO… but by betting both on the Pass and Don’t Pass line - hoping to capitalize when one plays out. I can hedge my “investment” by gambling both sides of the line- but if it looks like a duck, swims like a duck, quacks like a duck - there is no spin that makes it an eagle for me.
