Synthetic CDO

A Synthetic CDO (Collateralized Debt Obligation) is a complex derivative financial security whose value is derived from events related to a defined set of reference securities. Its payment stream comes not from mortgages, credit card payments, or other cash assets, as in the case of a regular, non-synthetic CDO, but from premiums paying for credit default swap "insurance" on the possibility that a defined set of "reference" securities -- based on mortgages, credit card payments, or other cash assets -- will default (i.e., credit risk). The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.

In 2005 the synthetic CDO market in corporate bonds spread to the mortgage-backed securities market, where the counterparties providing the payment stream were primarily hedge funds or investment banks hedging or often betting that certain debt the synthetic CDO "referenced" (usually "tranches" of subprime home mortgages), would default. By 2006 synthetics were the dominant form of CDO's in the US, valued at $5 trillion by the end of the year according to one estimate.

Synthetic CDO's have been criticized as serving as a way of hiding short position of bets against the subprime mortgages from unsuspecting triple-A seeking investors, and contributing to the 2007-2009 financial crisis by amplifying the subprime mortgage housing bubble.