Synthetic CDO - Characteristics of The Synthetic CDO

Characteristics of The Synthetic CDO

A synthetic CDO is a portfolio of credit default swaps (CDS). It may help to understand what a CDS is first before discussing them as a portfolio. Each CDS is a form of insurance on a bond or other obligation (the "reference security"). The CDS seller provides protection (insurance) in the event of a default or specified "credit event" related to the reference security. The CDS buyer pays a premium in exchange for this protection. In some cases, this represents a hedge, meaning the buyer actually owns the reference security they are insuring so losses on one or the other offset. In other cases, the bet is purely speculative, meaning a debt security not owned could be the reference security involved in the bet.

CDS Example: Party A might own certain bonds of Company B. Concerned that Company B might default (i.e., fail to pay interest or principal) on its bonds, Party A can buy protection from Party C, paying a premium to Party C. In the event Company B defaults, Party C pays Party A whatever amount has been agreed between them. This arrangement is a credit default swap and represents a hedge. Party A does not have to own the bonds of Company B to enter into this arrangement; this would be a speculative or "naked" CDS.

The problem with buying a CDS is that it usually references only one security, and the credit risk to be transferred in the swap may be very, very large. In contrast, a synthetic CDO references a portfolio of securities and is itself securitized into notes in various tranches, with progressively higher levels of risk. In turn, synthetic CDOs give buyers the flexibility to take on only as much credit risk as they wish to assume.

The seller of the synthetic CDO gets premiums for the component CDS and is taking the "long" position, meaning they are betting the referenced securities (such as mortgage bonds or regular CDOs) will perform. The buyers of the component CDS are paying premiums and taking the "short" position, meaning they are betting the referenced securities will default. The buyer receives a large payout if the referenced securities default, which is paid to them by the seller. The buyers of the synthetic CDO are taking a long in the component CDS pool, as if the referenced securities default the seller of the synthetic CDO must pay out to the buyers of the component CDS rather than the buyers of the synthetic CDO.

The term synthetic CDO arises because the cash flows from the premiums (via the component CDS in the portfolio) are analogous to the cash flows arising from mortgage or other obligations that are aggregated and paid to regular CDO buyers. In other words, taking the long position on a synthetic CDO (i.e., receiving regular premium payments) is like taking the long position on a normal CDO (i.e., receiving regular interest payments on mortgage bonds or credit card bonds contained within the CDO).

In the event of default, those in the long position on either CDO or synthetic CDO suffer large losses. With the synthetic CDO, the long investor pays the short investor, versus the normal CDO in which the interest payments decline or stop flowing to the long investor.

Synthetic CDO Example: Party A wants to bet that at least some mortgage bonds and CDOs will default from among a specified population of such securities, taking the short position. Party B can bundle CDS related to these securities into a synthetic CDO contract. Party C agrees to take the long position, agreeing to pay Party A if certain defaults or other credit events occur within that population. Party A pays Party C premiums for this protection. Party B, typically an investment bank, would take a fee for arranging the deal.

One investment bank described a synthetic CDO as having "characteristics much like that of a futures contract, requiring two counterparties to take different views on the forward direction of a market or particular financial product, one short and one long. A CDO is a debt security collateralized by debt obligations, including mortgage-backed securities in many instances. These securities are packaged and held by a special purpose vehicle (SPV), which issues notes that entitle their holders to payments derived from the underlying assets. In a synthetic CDO, the SPV does not own the portfolio of actual fixed income assets that govern the investors’ rights to payment, but rather enters into CDSs that reference the performance of a portfolio. The SPV does hold some separate collateral securities which it uses to meet its payment obligations."

Another interesting characteristic of synthetic CDOs is that they are not usually fully funded like money market funds or other conventional investments. In other words, a synthetic CDO covering $1 billion of credit risk will not actually sell $1 billion in notes, but will raise some smaller amount. That is, only the highest-rated tranches are fully funded and the more risky tranches are not.

In the event of default on all the underlying obligations, the premiums paid by Party A to Party C in the above example would be paid back to Party A until exhausted. The next question is who actually pays for the remaining credit risk on the more risky tranches, as well as the "super-senior" risk that was never structured into tranches at all (because it was thought that no properly structured synthetic CDO would actually undergo complete default). In reality, many banks simply kept the super-senior risk on their own books or insured it through severely undercapitalized "monoline" bond insurers. In turn, the growing mountains of super-senior risk caused major problems during the subprime mortgage crisis.