Impact On The Subprime Mortgage Crisis
Joe Nocera wrote in the New York Times that prior to the creation of CDS and synthetic CDOs, you could have only as much exposure as there were mortgage bonds in existence. At their peak, approximately $1 trillion in subprime and Alt-A mortgages were securitized by Wall Street. However, the introduction of the CDS and synthetic CDO changed that. Unlike a “normal” CDO, which contained the bonds themselves, the synthetic version contains CDS — derivatives that “referenced” a particular group of mortgage bonds. Once synthetic CDO’s became popular, Wall Street no longer needed to actually originate new subprime loans. It could make an infinite number of bets on the bonds that already existed, as long as investors agreed to take the other side of the bet. One of the reasons synthetic CDO became popular was that the subprime companies were starting to run out of risky borrowers to make bad loans to in 2006-2007. Synthetic CDO enabled investors to bet against (take a "short" position in) mortgage bonds and housing prices more generally.
The New York Times reported that from 2005 through 2007, at least $108 billion of synthetic CDO were issued, according to Dealogic, a financial data firm. The actual volume was much higher because synthetic CDO and other customized trades are unregulated and often not reported to any financial exchange or market. Journalist Gregory Zuckerman state in reference to synthetic CDOs, while there were $1.2 trillion of subprime loans in 2006 "about 10% of the overall mortgage market ... more than $5 trillion of investments had been credated based on all those risky loans according to some estimates."
Read more about this topic: Synthetic CDO
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