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Synthetic Bonds for Dummys

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August 11, 2009 – Comments (0)

The Fool article about the existence of CDS' on Treasuries resurrected an old memory about "synthetic bonds". Last fall, when Hell was freezing over, credit default swaps (CDS) where often mentioned as an important villain. I had never even heard of them, so did research about it on the web, and ran into something called synthetic bonds. I will explain it to the best of my ability (not that I really understand it, however).
The key here is how a CDS works: it generates a cash flow. Say A sells a CDS on, say, $100M of LEH bonds, and B buys it. B gives A small % of the CDS value periodically; in return, A promises to pay out $100M if the bond defaults. Neither A nor B owns the underlying LEH bond.
You want to buy $1M worth of long-term corporate bonds for eMeringue. Problem: eMeringue is not selling bonds currently, and those who have them won't sell them to you. So, you fabricate one, called a synthetic bond, out of thin air.
1) You buy $1M worth of long-term Treasury bonds.
2) Then, you sell a CDS on $1M of eMeringue bonds, using the Treasury as collateral
3)  this is OK with the buyer, because you will simply fork over the Treasury if eMeringue defaults
This is what happens:
a) you get the interest from the Treasury
b) you get the interest payments from the buyer of the CDS
c) the total of a & b equals the interest rate on a real eMeringue bond
d) when time is up, you cash in the Treasury, and the CDS simply expires
e) if eMeringue defaults, you get to keep a & b, but lose the Treasury
Note that the behavior of your synthetic bond in c, d, & e is identical to the behavior of the real thing: you get the interest, but lose the initial investment if it defaults. The key: it can only happen if you can find someone who wants to buy a CDS on eMeringue bonds.  

By analogy, you can also fabricate an MBS or CDO. You can keep fabricating them, as long as there is someone willing to short the underlying security; and, of course, you can also keep selling them. There were some media reports that synthetic MBS' was how some financial institutions were leveraging. They owned a real MBS that was making a lot of cash, so they kept selling synthetic ones based on the real one over, and over, and over again.
I have a headache; I am going to lie down now.

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