The role of synthetic assets in the financial crisis

Carolyn Sissoko
October 12, 2009

In analyzing the causes of the recent financial crisis, there has been an ongoing discussion over the
relative importance of destabilizing financial activity emanating from the US and of current account
imbalances that led to large scale financial inflows into the US. Proponents of the global imbalance view
argue that the demand for highly rated dollar denominated bonds drove American financiers to develop
structured finance products to meet this demand. While these individuals recognize that defective
products could not have been originated in the absence of inadequate regulation, they also argue that in
the absence of outsized demand for safe investments these products would not have grown as fast as
they did.

It is important to realize that the argument that imbalances fed dangerous financial innovation can be
reversed: the production and sale of defective bonds as if they were high quality bonds elevated bond
yields above their natural rate, and the fact that bond yields did not fall to derisory levels helped sustain
global imbalances. In particular emerging market funds would likely have shifted more to equity
investments, if the real return on fixed income assets had declined close to zero. Certainly the world
economy would have been encouraged to think about the path of these imbalances earlier, if yields on
bonds had not been elevated by the practice of selling bad bonds as good ones.

In order to understand how structured finance goosed interest rates on structured bonds, let’s think for
a moment about the markets for bonds and for bond insurance (also known as credit default swaps) as
they existed eight to ten years ago. The two markets were distinct and for the most part the
participants in these two markets were different.

Households, foreigners and insurance companies are and were the most important buyers in the bond
market. About half of the household participation in the market is through mutual and retirement funds
and half is direct investment. Corporations and governments are the major entities that raise money on
the bond market.

A decade ago the insurance market for bonds was very small. Financial institutions were important
buyers of insurance as they sought to reduce their exposure to the default of firms that they had
funded. Municipal governments also bought insurance because it made their bond issues easier to
place with the public. Financial institutions were sellers as well as buyers of insurance. Frequently the
sellers were highly specialized financial institutions like the monoline insurers, MBIA and Ambac. In
some cases the sellers were banks and insurance companies, for example AIG.

In this early stage we can say that there was price discovery in the market for bond insurance, because
the participants in the market chose deliberately to participate in the market and understood the
product they were trading. (See diagrams 1A and 1B for a depiction of demand and supply in these two
markets.)

1
 Diagram 1A Diagram 1B
The Bond Market The Insurance Market
Interest Annual for Bonds
Funds from Bond insurer
Rate bond investors Premium commitments

Demand for funds Demand for insurance

Quantity of Quantity of
bonds (dollars) insurance
(dollars)

By 2006 the firms that specialized in bond insurance had already taken on hefty obligations and were
either drawing back from the market (e.g. AIG) or at least becoming very careful about the terms of their
insurance obligations. In the meanwhile many in the financial industry were beginning to view fixed
income markets as overvalued and this combined with the growth of products like the ABX index led to
a large increase in the demand for insurance. If the participants in the market for bond insurance had
stayed the same, these dynamics would have resulted in much higher prices for insurance.

The participants in the market for bond insurance, however, changed dramatically over the first decade
of the 21st century. Innovative financial products took bond insurance and repackaged it into a variety
of fixed income assets. This sleight of hand allowed financiers to turn bond investors into sellers of
insurance.

For example, by 2006 the vast majority of CDOs were not just packaging loans, they were packaging
loans together with insurance on loans and marketing the CDOs to investors as assets. It became so
common to treat these insurance products as “synthetic” bonds that even fixed income mutual funds
got into the act. By the end of 2008 some mutual funds had sold so much insurance that they were
levered almost two to one. (That is, every dollar of investors’ money was both invested in a bond and
used to guarantee payment on an insurance policy.)

There is no question that many, many bond investors had no idea that their money wasn’t just being
used to purchase bonds, but also to sell insurance on bonds. A principal reason for this confusion was
that the investment banks were claiming that a credit default swap is in fact a synthetic bond and saw
little need to distinguish between bonds and synthetics when marketing products to investors.

While credit default swaps may under certain circumstances reproduce the returns of a bond, there is a
crucial difference between a swap and a bond: The bond is sold by a firm that expects to earn a higher
return on the cash provided by the bond than the bondholder will receive, whereas the swap is traded
by someone who believes that the prospects of the firm are so questionable that the cost of the
premium will be outweighed by the coming insurance payment. Because the bond investor is
2
participating in a process by which the productive capacity of the economy is increased, the purchase of
the bond benefits all parties to the transaction. The swap transaction, by contrast, can only take place if
somebody believes that the bond is likely to go into default.

In short, by selling credit default swaps to bond investors the financial community pulled these investors
out of capital markets – an environment where everybody wins – and redirected them to derivative
markets – a zero sum environment where somebody always loses. If the investors had understood the
change that was taking place, this phenomenon would be unobjectionable – however, it is abundantly
clear that many investors had no idea that they were selling insurance instead of (or in addition to)
buying bonds.

The fact that many of the end users selling insurance on the credit default swap market did not
understand the nature of the product they were trading in makes the argument that there was price
discovery in these markets ridiculous. After all, a large number of market participants did not
understand that their “bond” income was in fact being paid as insurance premiums by fellow investors
who expected them to lose a significant part of their investment. It is a fundamental principle of both
economics and the law that a meaningful market price can only be found if the participants in the
market understand what they are trading.

Bond investors put their money into these products because they were marketed as fixed income assets
that offered higher yields than the competition. Thus bond investors thought they were buying an asset
that would behave like a bond – and in a very superficial sense this was true: the asset would pay a fixed
return if it did not default. The difference between these fixed income assets and bonds lay in the risk
structure underlying the surface similarities. Because these fixed income assets were leveraged – that
is, they used credit default swaps to convert bonds and loans into products that combined higher yield
with higher risk – they were far, far riskier than a simple bond investment. In fact, the risk created by
leveraging bonds and loans meant that the risk of loss for these assets was more comparable to an
equity investment than to a bond investment.

The risks involved in the fixed income mutual fund example are the easiest to explain. For every dollar
of investors’ money, the mutual fund manager bought a dollar’s worth of bonds and sold a dollar’s
worth of insurance on another bond. In late 2008 when corporate bond values plummeted by 15%, the
value of the mutual fund fell by 30% because the bond holdings fell in value by 15% and the fund owed
15% on the insurance. Of course, if the value of the bonds had increased instead of falling, the mutual
fund manager would almost certainly have outperformed his unleveraged competition.1

CDOs are more complicated, in part because there are so many different varieties of CDOs. I will
describe a hybrid CDO of the type that was common in 2006 and early 2007. A hybrid CDO owns cash

1
This example is modeled on the Oppenheimer Core Bond fund as described in this Morningstar article
by Eric Jacobson “Oppenheimer bond funds missed the forest fire for the trees”:
http://news.morningstar.com/articlenet/article.aspx?id=268433

3
assets like bonds and loans and it also sells insurance. Because the sale of insurance involves a
commitment to make payment in the future it does not require the seller to put up any cash. Thus a
hybrid CDO only needs to collect enough money from investors to fund the purchase of the bonds and
loans. On the other hand, the CDO will need to have the means to honor the insurance policy that was
sold even if all the bonds and loans go into default. To protect against the possibility that the CDO runs
out of cash before the insurance obligation has been honored, the CDO buys a reinsurance policy to
cover any losses in excess of the cash available to the CDO. This reinsurance policy is called the super
senior tranche of the CDO.

In general, the cash assets of a hybrid CDO make up less than one third of the CDO’s structure. Every
dollar invested in a CDO that is composed of one third cash assets and two thirds insurance sales is
leveraged three times – that is, one dollar is used to buy one dollar’s worth of bonds and to sell two
dollars worth of insurance. Thus the investors are exposed to three times the losses they would face by
simply investing in bonds. This is true because these investors are in the first loss position and thus any
losses from either the bonds or the insurance will come from the bond investors’ funds before the
reinsurer has to kick in any money.

The important thing to understand is that all cash investors in a hybrid CDO – that is all the investors,
including the AAA investors, who thought they were buying a bond-like product – sit in the bottom third
of the CDO structure and absorb losses on three times as many assets as the money invested. The
advantage that the AAA investors have over those who invested in the lower tranches is that they are
only three times levered. For example, if we assume that the combination of the AAA tranche with the
super-senior tranche makes up 80% of the CDO, then every tranche below the AAA tranche effectively
faces at least five times leverage.

When a CDO experiences significant losses the fact that the bond investors who were sold these CDOs
sit at the bottom of the CDO structure will mean that these investors are unlikely to benefit from the
recovery value of the defaulted loans. The cash flow from the recovery on the loans is used to protect
the reinsurer who occupies the top of the CDO structure from having to make a payment. Only after the
recovery has been sufficient to protect the reinsurer from any losses on the CDO will bond investors
benefit from the recovery value of the underlying loans. Because the bottom segments of the CDO only
has claim to the residual value of the CDO after the higher level tranches have been protected from loss,
one can describe the subordinate tranches of a CDO as an equity investment with a return that is
structured to mimic a bond.

Because so many fixed income “assets” included hidden leverage, yields were much higher than they
would have been in the absence of leverage. By raising the yield on fixed income assets (that were
preferred by investors precisely because they were supposed to be safer than equity) investment banks
kept more money flowing into these markets than would have been possible if investors had understood
that the return profile of a product like a hybrid CDO or a mutual fund with significant derivative
exposure is really more comparable to equity than to debt.

4
The sale of credit default swaps as capital market products had two direct effects: It reduced the cost of
insuring bonds and raised the cost of issuing bonds.

• In the bond market, the funds from bond investors were used both to purchase bonds and to
capitalize the sale of derivatives marketed as bonds. This effectively increased the demand for
funds on the bond market – and drove up the interest rate that bond investors received relative
to the interest rate in a market without synthetic bonds. Thus, the introduction of derivatives
into the bond market raised the cost of funds for firms that were financed on the bond market.

• In the insurance market for bonds, the supply of insurance was increased as bond investors’
funds were used to capitalize insurance sales. This reduced the rates paid by insurance buyers.

Both of these effects are depicted in Diagram 2.

Diagram 2A Diagram 2B
The Bond Market The Insurance Market Bond insurer
supply
for Bonds
Interest Annual Bond insurer
Rate Demand for Premium supply + funds
Funds from
funds from bond
bond investors
investors

Demand for funds

+ insurance sold
Demand for insurance
by bond investors

Insurance sold Insurance sold

as bonds by bond
investors
Bond investor income from insurance sold as bonds

The sale of credit default swaps as capital market products had indirect effects too. By raising the cost
of funds to brick and mortar businesses, this process caused a decline in real investment and
undermined the long-term productivity of the economy. It is a fact that during the recovery from the
2001 recession annual growth in real investment was lackluster at best and never approached the levels
that were normal through most of the 90s. As diagram 2A above demonstrates it is likely that in the
absence of “synthetic assets” corporations would have issued more bonds at lower rates and the state
of investment in the economy would have been much improved.

At the same time by keeping insurance premiums low, the marketing of credit default swaps as bonds
enabled sophisticated financiers who understood the nature of these markets to make their fortunes.
Unfortunately, this wealth derived from a dysfunctional market where individuals who intended to
participate in capital markets were misled into selling derivatives instead.
5
Finally, the connection between the marketing of swap as bonds and global imbalances is due to the
effect of synthetics on bond yields. Because structured finance used hidden leverage to create a supply
of high yield highly rated assets, it kept inflows of demand from driving bond yields down to their
natural level. By offering another outlet for investors seeking “safe” assets and artificially supporting
the yields on those assets, synthetics discouraged a shift into equity and foreign assets and thereby
slowed the adjustment of current account imbalances.