synthetic bonds

By Robert Waldmann

Felix Salmon explains how to make a synthetic bond.

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.

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.

He ends with teaser which frustrated super senior blogger Kevin Drum

“That’s the story of the super-senior tranche, and will have to wait for another day.”

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 ?

update: The title was supposed to be a joke “Frederal reserves” but Blogger appears to automatically correct misspelled titles.

Felix Salmon explains thing to me in a comment, which I pull back after the jump.

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

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.

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.

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.

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

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.

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.

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.

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.

OK finally my guess as to what “the super senior tranche” is. I think this refers to the money counterparties can seize immediately from a firm in Chapter 11 — the little exception to the bankruptcy code. Since not quite everyone knows about this, it is an excellent way to dilute the positions of bond holders which, ex ante, profits both parties which wrote the financial derivative contract.

Felix answers.

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.

So Felix notes that he was just talking about synthetic bonds, not claiming that making them was the main use of CDS. I should have said that I thought his example hinted at a reason for his calm views about CDSs, since the example he had in mind was of a very safe use. I was over psychoanalyzing a blog post, since the example was an answer to a question.

Felix also says that the purpose of the special purpose entity is that Zeke can sell Fred, Fred’s assets on Zeke’s books would have to be packaged into a SPE (Fred) for sale. It’s still not so clear to my why st up the SPE immediately. I mean the story began with Zeke wants to buy IBM bonds, so Zeke creates Fred whose shares are, in effect, IBM bonds. Then Zeke sells Fred, apparently immediately (why pay to set up the SPE in advance of selling its shares ?).