BUSINESS
03/21/2013 09:07 am ET | Updated Mar 21, 2013

Synthetic CDOs Return To Wall Street, What Could Possibly Go Wrong?

Japan swore off nuclear weapons for generations after the bombings of Hiroshima and Nagasaki. Wall Street's memory vis-a-vis weapons of mass destruction is just a bit shorter.

Ladies and gentlemen, whether you like it or not, the synthetic collateralized debt obligation (CDO) is making a comeback, Bloomberg reports. The numbers are small so far, and the bets being made with them appear to be sober. But that's always how these things start out.

What on earth is a synthetic CDO, you likely ask? It is a side bet on a bunch of side bets on somebody else's debt. First you take a bunch of corporate bonds. Then you write insurance protection on those bonds, in the form of derivatives called credit default swaps. And then you jam a bunch of those credit default swaps together into a toxic meatball called a synthetic CDO, on which you can also bet as much money as you like, assuming you have any money, considering you are the kind of doofus who bets money on toxic meatballs.

These have absolutely no economic value, aside from enriching the bankers that sell them and maybe giving investors a way to make an extra buck. And they are potentially disastrous, depending on how they're filled: These were among the derivatives that helped nearly bring down American International Group and the financial system less than four years ago. Now, with investors hungry for anything that offers the slightest bit of yield, these derivatives are making a comeback, which I'm sure is totally fine, because Wall Street has of course learned its lesson.

So far these things are only being sold to hedge funds; they're not getting credit ratings or being pitched to less-sophisticated investors the way synthetic CDOs were during the crisis. The filler in the meatballs so far are corporate bonds, not subprime mortgages. And we're not talking about a bunch of money here, yet. Synthetic CDOs on about $2 billion in debt were sold last year, Bloomberg writes, citing Citigroup data, and CDOs on another $1 billion have been sold so far this year.

And those totals overstate the total amounts actually being wagered on CDOs, Felix Salmon points out -- they're what's known as "notional" amounts, or the total of the underlying debt on which investors are betting.

If you're betting on the default of $100 million in bonds, for example, you don't have to bet $100 million. You can just bet $1 million. So far, the amounts being bet in the synthetic CDO market are pretty tiny.

But of course this is not the only sign of pre-crisis craziness making a comeback. Last week a bunch of private-equity investors gathered together in San Francisco and observed that the ease of getting bank loans for deals has gotten right back to levels seen in 2006 and 2007, just ahead of the crash.

Unlike synthetic CDOs, private-equity deals didn't contribute to the financial crisis. They were more of a symptom of credit insanity than anything. But easy credit does encourage bankers to do dumb and damaging things with their private equity cash, like load up a company with debt in order to pay themselves huge dividends.

And even though today's synthetic CDOs don't seem quite as dangerous as those of five years ago, when they were betting on subprime mortgage debt, that doesn't mean they can't cause trouble. JPMorgan Chase's "London Whale" losses came from betting on derivatives of boring corporate debt, remember.

The return of synthetic CDOs does not signal that another crisis is around the corner. But rest assured that Wall Street will find ways to manufacture one, just as soon as it is able.

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