Page 172 - untitled
P. 172
THE CDO MACHINE
ditional CDOs at the same time as the supply of mortgages was beginning to dry up.
Because there were no mortgage assets to collect and finance, creating synthetic
CDOs took a fraction of the time. They also were easier to customize, because CDO
managers and underwriters could reference any mortgage-backed security—they
were not limited to the universe of securities available for them to buy. Figure .
provides an example of how such a deal worked.
In , Goldman launched its first major synthetic CDO, Abacus -—a deal
worth billion. About one-third of the swaps referenced residential mortgage-
backed securities, another third referenced existing CDOs, and the rest, commercial
mortgage–backed securities (made up of bundled commercial real estate loans) and
other securities.
Goldman was the short investor for the entire billion deal: it purchased credit
default swap protection on these reference securities from the CDO. The funded in-
vestors—IKB (a German bank), the TCW Group, and Wachovia—put up a total of
million to purchase mezzanine tranches of the deal. These investors would
receive scheduled principal and interest payments if the referenced assets performed.
If the referenced assets did not perform, Goldman, as the short investor, would re-
ceive the million. In this sense, IKB, TCW, and Wachovia were “long” in-
vestors, betting that the referenced assets would perform well, and Goldman was a
“short” investor, betting that they would fail.
The unfunded investors—TCW and GSC Partners (asset management firms that
managed both hedge funds and CDOs)—did not put up any money up front; they re-
ceived annual premiums from the CDO in return for the promise that they would
pay the CDO if the reference securities failed and the CDO did not have enough
funds to pay the short investors.
Goldman was the largest unfunded investor at the time that the deal was origi-
nated, retaining the . billion super-senior tranche. Goldman’s billion short po-
sition more than offset that exposure; about one year later, it transferred the
unfunded long position by buying credit protection from AIG, in return for an an-
nual payment of . million. As a result, by , AIG was effectively the largest
unfunded investor in the super-senior tranches of the Abacus deal.
All told, long investors in Abacus - stood to receive millions of dollars if the
reference securities performed (just as a bond investor makes money when a bond
performs). On the other hand, Goldman stood to gain nearly billion if the assets
failed.
In the end, Goldman, the short investor in the Abacus - CDO, has received
about million while the long investors have lost just about all of their investments.
In April , GSC paid Goldman . million as a result of CDS protection sold by
GSC to Goldman on the first and second loss tranches. In June , Goldman received
million from AIG Financial Products as a result of the CDS protection it had pur-
chased against the super-senior tranche. The same month it received million from
TCW as a result of the CDS purchased against the junior mezzanine tranches, and
million from IKB because of the CDS it purchased against the C tranche. In April ,
IKB paid Goldman another million as a result of the CDS against the B tranche.
