in this scene from the Big Short (movie about the housing crisis) A CDO Manager explained systhetic CDOs to Mark Baum:


From what I understand, regular CDO's are basically just a package of a bunch of risky mortgages. The home owners pay the CDO's owners yearly interest and in return the owners of the CDO's take on the risk of the home owners defaulting on their loans.

Synthetic CDO's (or CDO squared) on the other hand are insurance on those CDO's. So the owner of the regular CDO's pay the owners of the synthetic CDO's insurance premiums in case the home owners start defaulting on their mortgages.

But the CDO Manager mentions that on 50 Million \$ worth of mortgages, there may be 1 Billion \$ of synthetic CDO's. Which means the owner of the 50 million dollar mortgage/CDO package needs to pay premiums to all the owners of the synthetic CDO's.

So in case I understand that correctly, I have some questions about this:

  • Since the only source of actual profit are the home owners paying their interest, how the owners of the 1 Billion dollars make any significant profit at all? Is it just diluted between all of them are the CDO's just a purely speculative investment?
  • What did the CDO Manager mean by he assumes no risk
  • What did the CDO Manager mean by opposite side of the bet?
  • $\begingroup$ It is between two counterparties where on pays a premium to the other counterparty in exchange for a (sizeable) payment if a "default" (based on some pre-defined conditions /definitions) occurs (opposite side means on the other side of your counterparty) - since you only pay a premium in the case of Baum's position - you cannot lose more than that). It is kind of like an insurance on a car you do not own. If there is a car crash, you cash out (and only paid a premium). I think the Wikipedia article is quite helpful for understanding this. $\endgroup$
    – AKdemy
    Commented Oct 3, 2022 at 13:20
  • $\begingroup$ CDO-Squared is essentially a CDO backed by CDOs. $\endgroup$
    – AKdemy
    Commented Oct 3, 2022 at 13:23
  • $\begingroup$ SO tthat means besides baum, Burry and the other fund, there where loads of people betting billions against the housing market (that was supposed to be invicible) and paying premiums for the priviledge? $\endgroup$ Commented Oct 3, 2022 at 16:25

1 Answer 1

  • A CDO (collateralized debt obligation) is a combination of obligations that depend on the performance of the of underlying assets (collateral), which are typically (commercial) loans, bonds, or asset-backed securities.

  • A CDO-squared (CDO^2) invests in (tranches of) other CDOs.

  • A Synthetic CDO is using credit derivatives such as credit default swaps as opposed to the actual cash market.

For the first question, the crux is to understand that it is NOT the homeowner who pay - it is the counterparty. If you watch the video you linked, you see Thaler and Gomez explaining this. The Wikipedia article also explains this.

For the second question , and I admit in my comment I did neither read your question properly, nor did I watch the video, the CDO manager (Wing Chau in real life) assumes no risk (emphasis: for himself) because he just packages these products and sells them for fees. It is like an independent insurance broker who sells insurance to clients and gets money for it. The only risk for him is that he will run out of business if the market (or Merrill Lynch) collapses.

For the third question, the opposite side of the bet (you made with the swaps): That refers to Mark Baum's (or Steve Eisman, which is his real name) position. The swaps Wing Chau mentions are credit default swaps (CDSs) that (simplified) pay in the event of default. That was the vehicle used by Eisman (and others) to benefit from the collapse in the mortgage market. Since a synthetic CDO is combining CDSs. So the underlying payments are not mortgages (or whatever other cash instrument) but CDS premiums that are being collected. Insofar, Chau was on the opposite side, packaging CDSs into synthetic CDOs.

  • $\begingroup$ Then why were so many people buying CDS on a market they thought was invincible? $\endgroup$ Commented Oct 5, 2022 at 5:45
  • 1
    $\begingroup$ The bulk of people were not buying CDS - they were on the opposite side (with synthetic CDOs). It may help to watch a different section of the movie, where the market starts to turn and swaps are all of a sudden what people want (need) - Shorts turn the tables. $\endgroup$
    – AKdemy
    Commented Oct 5, 2022 at 6:56

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