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Monday, January 4, 2016

False Equivalency of the Week: GSE Risk Sharing Like Synthetic CDOs

"Taxpayers have borne the bulk of mortgage credit risk ever since Fannie Mae and Freddie Mac were put into conservatorship more than seven years ago,” writes John Carney in The Wall Street Journal's Heard On The Street column. "In an ironic twist, a plan to ease this burden relies on a version of one of the instruments most demonized in the financial crisis—the synthetic collateralized debt obligation."

Well that's about six degrees of separation from reality. GSE risk sharing is a version of a synthetic CDO the same way that aspirin is a version of heroin, (you know, they are both painkillers that can be lethal when taken in excessive doses).  Carney wanted to make a comparison that was provocative--in The Big Short movie, Selena Gomez explains synthetic CDOs at a blackjack table--though I wasn't sure if he aimed for a false equivalency that was so ridiculously misleading.

In a nutshell, GSE risk sharing involves syndicating, or selling off pieces of, the GSE guarantee obligation that applies to every mortgage pool it securitizes.  It’s very much like the centuries-old reinsurance market. There is one tangible asset, a specific mortgage pool owned by investors in the GSE securitization, insured by the GSEs, who now share that fee income and risk with outsiders.

Synthetic CDOs were portfolios of credit derivatives—ISDA contracts that were specifically invented in 2005 to make these CDOs possible. As Greg Lippmann (played by Ryan Gosling in the The Big Short movie) explained, during the first 10 years of his career as a trader, he could only go long or less long in RMBS. Without those Pay As You Go derivatives, which he helped invent, The Big Short would have been impossible. Pay As You Go derivatives provided a method for estimating a “fair market value” for triple-B bonds that never traded because they were stuffed in CDOs; and they provided a method for payout by way of “credit event” (i.e. rating agency downgrade) which occurred long before the bond suffered a payment default.

Synthetic CDOs never insured mortgages, only structured finance bonds, triple-B subprime mortgage bonds that were certain to fail because their breakeven could not withstand slowdown in home price appreciation.

Those credit default swaps act like insurance contracts without the standard protections against insurance fraud.  Synthetic CDOs were all about people insuring bonds they did not own for amounts that far exceeded the bonds’ face value. And it was all done in secret, because everything about credit default swaps and CDOs was kept secret, away from public view or scrutiny.  

The fatal flaws of all structured finance CDOs were threefold:

  1. The rating agencies assumed that defaults by structured finance entities, which operate like dumb machines, are similar to defaults by corporations, which are run by people who continually adapt to changing circumstances;
  2. As noted before, the rating agencies ignored the impact of hyper-subordination, which can wipe out principal in a very brief timeframe; and
  3. In the face of hard evidence proving otherwise, the rating agencies assumed that the deeply subordinated residential mortgage backed securities in a CDO portfolio were uncorrelated, that there was no reason to expect that all the bonds would would face similar problems during a housing downturn.

Synthetic CDOs never financed a single home. They were created so that some insiders, who recognized that the rating agencies'  processes for rating mortgage bonds and CDOs had devolved into a sham, could take advantage of suckers--at MBIA, AMBAC, ACA and elsewhere--who placed their blind faith in the triple-A ratings of senior CDO tranches.

Which is why synthetic CDOs are nothing like GSE risk sharing.

Guess who came up with a new pretext for saying the GSEs are evil incarnate? A day later, the Journal's editorial writers doubled down, informing readers that one, "Fan and Fred to use synthetic collateralized debt obligations (CDOs) to offload some of the mortgage risk they are holding." The fig leaf pretense, of GSE risk sharing being a version of a synthetic CDO, was gone.

That verbal sleight of hand fits into an old and familiar pattern. Whenever the public is reminded of a financial disaster that occurred under the Bush Administration, the Journal's editorial writers take a piece of financial jargon, pervert its original meaning, and then make the spurious claims that Fannie and Freddie are just as bad as Enron, or predatory subprime originators, or greedy Wall Street types who bet against the housing market.  

In "Fannie Mae Enron?" Journal editorial writer Susan Lee used an assortment of propagandistic tricks like this one: "By the way, last year Fan's derivative strategy went, um, somewhat amiss and she had to write down shareholder equity by $7.4 billion."  Lee's grasp of accounting went, um, somewhat amiss. A mark-to-market loss is not "written down," because that loss can be reversed on the next trading day. But here's the critical point about hedging and derivatives. Like every balance sheet lender in America,  Fannie hedged the interest rate risk embedded mortgage loans, with interest rate swaps and other derivatives. Under accounting rules the derivatives are always marked-to-market while the loans are recorded at historical cost. There is always a disconnect that tells you nothing about the true cash flow or economic hedges that manage interest rate risk. 

Lee tried to equate Enron's energy derivative trading with Fannie's reliance on interest rate swaps, which, in terms of volatility and transparency, is like equating LSD with a glass of wine.

As noted before here and here, the ensuing Fannie Mae "accounting scandal" is one of the great Emperor's New Clothes phenomena of the 21st century. Apparently, I was the first to write about the absence of any debits-and-credits explanation.  

As for Fannie and Freddie leading the race to the bottom because Ed Pinto discovered 27 million subprime mortgages hidden in plain sight on June 30, 2008, I've lost count how many times--it's probably 2,579 by now--that somebody in the Opinion pages has repeated that famous canard.  Whereas in capitalismland people want to know which loans paid back with interest and which did not. And anyone who denies that the GSEs have the best loan performance in the industry is lying. 

And now at year-end 2015, after the movie starring Ryan Gosling and Brad Pitt reminded everyone that synthetic CDOs were inside bets that made some guys rich when the economy tanked, the Journal's editorial board wants readers to believe that Fannie and Freddie are reviving the toxic triple-A investments that crippled MBIA, AMBAC, and a few others.

As I've written before and will write many times again, corruption in finance is rooted in corruption of language.  GSE critics use the same tricks and devices used by other doublespeak artists who deny the dangers of cigarette smoke or the reality of climate change.


  1. Nice work, David.

    You'll probably have to match those first two thousand plus communications efforts, because indoctrinated people are stubborn and don't like to give up their ideas, even when those ideas are wrong.

  2. Thanks for the GSE risk sharing lesson, David. Very informative, which is more than I can say for anything John Carney writes.

    Keep up the good work!

    G. Buckman

  3. Excellent explanation. Worth submitting as an op-ed piece to one of the bigger newspapers.

  4. Bravo, this analysis should be in one of the major distribution papers.

  5. This comment has been removed by the author.

    1. I'd like to be extra clear about something that may be obvious to Journal readers but not everyone else. The news side and the editorial side have always had a Jekyll and Hyde relationship. I have a lot of respect for the news side of The Wall Street Journal.

  6. David,

    At times the news and editorial blend and are in discernable especially when editorial folks are making the news.

  7. The biggest problem with your analysis is that the GSEs are not in fact selling off their guarantee obligations. They are selling a synthetic guarantee obligation - a derivative derived from a hypothetical basket of GSE insured bonds - which is why these are synthetic CDOs and not real CDOs.