Tom A's Stock Picks

What got me started was reading MBIA (MBI) CEO Jay Brown's comments to Hank Paulson on the potential usefulness of the TARP Guarantee Program. Brown is on the topic of synthetic CDOs, kind of esoteric and not something I had given too much thought to. I was aware that some investors might prefer their exposure to certain asset classes in synthetic form, much as James Bond preferred his martinis shaken, not stirred. A matter of taste, really, and not that important.

Here is what Brown had to say:

We believe that it is critical that eligible collateral be in securitized or certificated form. Neither "whole loans" nor synthetic exposure on a referenced basis should be accepted. More specifically, synthetic exposure is a position taken in credit default swap form where the party does not have an insurable interest in the underlying asset, but rather only references an asset through their derivative, hence suffering from an inability to deliver under the Direct Purchase Program of TARP...

The volume of synthetic assets created, transacted and insured among market participants could easily overwhelm the capacity of this program. In addition, guaranteeing positions in these contracts has no direct impact on the real economy. When these contracts settle in the ordinary course or as a result of losses in the reference portfolios, no wealth is created or destroyed - it is merely a "zero sum" game. MBIA has been a participant in this part of the market, guaranteeing over $100 billion of such contracts. Nevertheless, we strongly urge that the Treasury avoid extending the Guarantee Program to synthetically referenced assets. If the performance of underlying mortgages improves, the synthetic assets and derivatives based on them will take care of themselves.

First, as a shareholder I was not pleased. Readers are familiar with my concerns about "naked" CDS, that is, CDS that are not supported by an insurable interest. I believe these deals may create moral hazard. Eric Dinallo, NY State Superintendent of Insurance, in an effort to bring some degree of regulation to the CDS market, determined that CDS are insurance when supported by an insurable interest. "Naked" CDS in his analysis fall into two classes, grey area cases where there might be some social benefit, and unregulated gambling.

MBIA will not be providing future protection in CDS form, and from the tone of the above I doubt they will provide any form of credit insurance in the absence of an insurable interest, going forward. As an investor, I am sorry that they got involved in the zero sum game, but I have been hopeful that in the absence of collateral requirements they can wait this one out.

But the 100 billion from one company, at stake in a zero-sum game, with no direct impact in the real economy, got me thinking: what is this stuff, how much of it is there, and what if it does have an impact in the real world economy? What was the involvement of other companies in the financial sector? Then I went on to other interests.

Today in the WSJ we learn that AIG had about 10 billion of this stuff. The Maiden Lane III facility, which is supposed to buy the assets underlying AIG's troubled Super Senior CDO portfolio, has a problem: the insured party does not own them - the exposure was in synthetic form. The WSJ article mentions "Abacus" and Goldman Sachs: a search of the terms reveals the following from a Moody's downgrade announcement: "Abacus 2005-CB1 is a synthetic collateralized debt obligation (CDO) that closed on Dec. 7, 2005 created to enter into credit default swaps with Goldman Sachs Capital Markets." Making bets with Goldman Sachs hasn't been profitable to anyone, as far as I can see, it's like betting against the house, the odds are in their favor. Why it would be a suitable investment for anyone is beyond me.

Personally, I prefer to take my exposure to certain asset classes in natural form: "no synthetic, please."

Comments: View Comments |  Wednesday December 10, 2008  |  Stocks: AIG, MBI,