Page 174 - untitled

THE CDO MACHINE 

Through May , Goldman received  million from IKB, Wachovia, and TCW as a
result of the credit default swaps against the A tranche. As was common, some of the
tranches of Abacus - found their way into other funds and CDOs; for example,
TCW put tranches of Abacus - into three of its own CDOs.
In total, between July , , and May , , Goldman packaged and sold 
synthetic CDOs, with an aggregate face value of  billion.  Its underwriting fee
was . to . of the deal totals, Dan Sparks, the former head of Goldman’s
mortgage desk, told the FCIC.  Goldman would earn profits from shorting many of
these deals; on others, it would profit by facilitating the transaction between the
buyer and the seller of credit default swap protection.
As we will see, these new instruments would yield substantial profits for investors
that held a short position in the synthetic CDOs—that is, investors betting that the
housing boom was a bubble about to burst. They also would multiply losses when
housing prices collapsed. When borrowers defaulted on their mortgages, the in-
vestors expecting cash from the mortgage payments lost. And investors betting on
these mortgage-backed securities via synthetic CDOs also lost (while those betting
against the mortgages would gain).  As a result, the losses from the housing collapse
were multiplied exponentially.
To see this play out, we can return to our illustrative Citigroup mortgage-backed
securities deal, CMLTI -NC. Credit default swaps made it possible for new
market participants to bet for or against the performance of these securities. Syn-
thetic CDOs significantly increased the demand for such bets. For example, there
were about  million worth of bonds in the M (BBB-rated) tranche—one of the
mezzanine tranches of the security. Synthetic CDOs such as Auriga, Volans, and
Neptune CDO IV all contained credit default swaps in which the M tranche was ref-
erenced. As long as the M bonds performed, investors betting that the tranche
would fail (short investors) would make regular payments into the CDO, which
would be paid out to other investors banking on it to succeed (long investors). If the
M bonds defaulted, then the long investors would make large payments to the short
investors. That is the bet—and there were more than  million in such bets in early
 on the M tranche of this deal. Thus, on the basis of the performance of 
million in bonds, more than  million could potentially change hands. Goldman’s
Sparks put it succinctly to the FCIC: if there’s a problem with a product, syn thetics
increase the impact. 
The amplification of the M tranche was not unique. A  million tranche of the
Glacier Funding CDO -A, rated A, was referenced in  million worth of syn-
thetic CDOs. A  million tranche of the Soundview Home Equity Loan Trust
-EQ, also rated A, was referenced in  million worth of synthetic CDOs. A
 million tranche of the Soundview Home Equity Loan Trust -EQ, rated
BBB, was referenced in  million worth of synthetic CDOs. 
In total, synthetic CDOs created by Goldman referenced , mortgage securities,
some of them multiple times. For example,  securities were referenced twice. In-
deed, one single mortgage-backed security was referenced in nine different synthetic