The Sting, Part 3  

I was pleased to see over my break that the WSJ has picked up the story about the CDS timebomb awaiting the world's widows, orphans and local councils (see here and here for background) - Synthetic CDOs hit local councils on other side of world.

ALAN McCormack, the general manager of the Parkes Shire Council in the central west of NSW has a big headache. The council is poised to lose millions of dollars if more US companies succumb to a deepening recession.

More than 16,000 kilometres away, at New York investment firm ICP Capital, hedge fund manager William Gahan is reaping big gains on McCormack's predicament.

The fortunes of the two men are connected through an investment known as a "synthetic collateralised debt obligation".

Between 2005 and 2007, the Parkes council put more than $13.5 million of its savings into synthetic CDOs. The investments offered an attractive income and a gold-standard credit rating -- in return for providing a sort of insurance on the debt of hundreds of mostly US companies.

Now, though, if even a handful of those companies renege on their debts, Parkes will have to cough up as much as $12 million to honour the insurance commitments it made. That has been a boon for Gahan, who used financial products to place bets against many of the same companies.

But it would deprive Parkes of a big chunk of the money it needs to rebuild its water supply amid an enduring drought. "It is going to be a long, hard ride," says 60-year-old McCormack, who has run the council for 18 years.

The linkage between McCormack and Gahan demonstrates how far a vast superstructure of credit derivatives such as synthetic CDOs, built up over the past decade, has spread the risk of lending to US companies -- and how far the pain is likely to reach. They are called derivatives in part because they do not entail any direct investment into companies. Instead, they are more like side bets on the companies' fortunes.

Global investors have already lost billions of dollars on derivative investments tied to US sub-prime mortgages, but many more -- including towns, charities, school districts, pension funds, insurance companies and regional banks -- put money into synthetic CDOs that insure the equivalent of trillions of dollars in mostly US corporate debt.

Synthetic CDOs are vulnerable at this stage in the financial crisis because of the way they work. They generate income by selling insurance against bond defaults, typically on a pool of 100 or more companies. One way they do so is by entering into contracts known as "credit default swaps". Investors, such as Parkes council, receive regular payments from buyers of the credit default swaps, which are usually banks or hedge funds.

In return for the income, investors agreed to make huge payments in what was seen as a highly unlikely event: a wave of corporate defaults greater than any experienced in the previous two decades. Now, though, as financial firms implode and a slump in consumer spending hits retailers and manufacturers, that event is starting to happen.

As a result, synthetic CDO deals are poised to trigger a massive transfer of wealth from investors such as Parkes council to hedge funds and the trading units of big US investment banks. By various estimates, the amount of money set to change hands could be anywhere from tens of billions to hundreds of billions of dollars.