The Fantasy CDOs

Jan D Weir
4 min readDec 24, 2024

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“I do not think you can trust bankers to control themselves. They are like heroin addicts”.

— Charlie Munger

By 2002, the ingenious solution to the lagging demand for CDOs was a new CDO that would buy the unsalable CDOs, the “synthetic CDO”. It would have no assets but only reference other CDO’s.

The screenwriter for The Big Short. gave us an example of a man and a woman (Selena Gomez) at a roulette wheel placing bets.

* In the first row behind them, people bet on whether the man or woman would win.

* In the second row, people were betting on which of the people in the first row would win, and so on.

On his financial blog, banking lawyer Richard I. Isacoff, gave us another description of a synthetic derivative, betting on how well another bettor will do:

“Here’s the easiest way to think about it — there is a real Football league made up of real football teams….Then we have a Fantasy Football League, made up of the same teams but with the players on each team made up of peoples’ “dream team” — players taken from any team and put together (only on paper). Based on how each player and the REAL TEAM he plays on does each week, these made up teams are ranked. People actually bet on these MADE UP TEAMS- “FANTASY TEAMS”- which are DERIVED from the real teams. A Fantasy League is a DERIVATIVE.

Now imagine a second “Fantasy Football League” made up of the same players BUT instead of being based on the outcome of the Real Teams it’s based on the outcome of the FANTASY TEAMS and ranked according to how the players and the FANTASY TEAMS do each week. This is a Synthetic Derivative — it’s a bet about how well another bet will do! Will Pete win or lose on his bet on Fantasy Team #1. That’s what is being bet on.”

In an interview on Pensions Plus, Janet Tavakoli gave an example of a synthetic derivative that Goldman Sachs created by issuing 30 new derivatives betting in sequence on the performance of that first CDO.

Now how did they do that? They did that with the magic of derivatives,” she said, adding, “Now, they stopped at around thirty debt pools; they could have done a hundred and thirty.”

Sometimes the bankers called these daisy-chain like strings of CDOs based on one original CDO, a CDO 2.

Synthetic derivatives are impossible to value: How do you determine the value of a bet on a bet? Let’s say you are at a roulette wheel in Las Vegas and you place your chips on 38 black. Your chips are worth $100 and if you are successful, the prize is $1000. Someone bets on your bet. One minute before the croupier spins the wheel, how do you value their bet?

However, that doesn’t stop the banks from putting sizable values for these synthetic CDOs on their balance sheets. It the Berkshire Hathaway annual report for 2002, Buffet warned about this unreliable valuation of synthetic CDOs:

But before a contract is settled, the counter-parties record profits and losses — often huge in amount — in their current earnings statements without so much as a penny changing hands. Reported earnings on derivatives are often wildly overstated.” [Emphasis added]

The Alchemical CDO

Just when you might’ve thought that the artificial creation of the CDO had reached its limit, the bankers came up with another ingenious ploy to transform the un-salable into the salable.

As noted above, by 2004 the availability of qualified applicants was drying up. At the same time the market for CDOs was doing the same. There were no customers for the bottom tranches. To keep the appearance of a strong market for CDOs our creative bankers created a CDO to buy the lower tranches of other CDO’s.

Warren Buffet observed, “When you start buying tranches of other instruments, nobody knows what the hell they’re doing.”

He further noted that doesn’t stop the banks from putting sizable values for these ultra synthetic CDOs on their balance sheets. In that 2002 letter to shareholders Buffet also warned:

“As a general rule, contracts involving multiple reference items and distant settlement dates increase the opportunities for counter-parties to use fanciful assumptions. The two parties to the contract might well use differing models allowing both to show substantial profits for many years. In extreme cases, mark-to-model degenerates into what I would call mark-to-myth.” [my emphasis]

Derivatives expert Janet Tavakoli agrees that the banks are making up value where there isn’t any. Synthetic income can be created from synthetic CDOs.

“The advantage to all of this smoke and mirrors is that one can fiddle around with the model assumptions. One can change the hedge ratio and create a lot of synthetic income at will. Senior managers and risk managers will rarely successfully challenge this sleight of hand.”

How can this be?:

* If total world GDP is 100 trillion ( Statistica 2023), how can there be derivatives valued at 700 trillion ( ISDA 2123)?

* In other words, how could there be more contracts for the sale of pork bellies than there are pigs?

Because, with synthetic derivatives, the banks can assign any value they want to make their present-day financial statements look far better than they are.

Acknowledgement: Image by Essow K on pexels

Originally published at https://jandweir.substack.com.

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Jan D Weir
Jan D Weir

Written by Jan D Weir

Retired trial lawyer, has taught Business Law at the University of Toronto, Author, text on business law @JanWeirLaw

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