Definition
A synthetic CDO is typically negotiated between two or more counterparties that have different viewpoints about what will ultimately happen with respect to the underlying reference securities. Various financial intermediaries, such as investment banks and hedge funds, may be involved in selecting the reference securities to be wagered upon and finding the counterparties. Complex legal entities such as structured investment vehicles may be created to facilitate and administer the deal. One counterparty typically pays a premium to another counterparty in exchange for a large payment if certain events related to the reference securities occur, similar to an insurance arrangement. It represents a leveraged bet, meaning it may result in a potentially large payout without requiring that a large amount of funds (collateral) be set aside. These securities are not typically traded on stock exchanges.
In technical terms, the synthetic CDO is a form of collateralized debt obligation (CDO) in which the underlying credit exposures are taken on using a credit default swap rather than by having a vehicle buy assets such as bonds. Synthetic CDOs can either be single tranche CDOs or fully distributed CDOs. Synthetic CDOs are also commonly divided into balance sheet and arbitrage CDOs, although it is often impossible to distinguish in practice between the two types. They generate income selling insurance against bond defaults in the form of credit default swaps, typically on a pool of 100 or more companies. Sellers of credit default swaps receive regular payments from the buyers, which are usually banks or hedge funds.
Synthetic CDOs are highly controversial, because of their role in the subprime mortgage crisis. They enabled large wagers to be made on the value of mortgage-related securities, which critics argued may have contributed to lower lending standards and fraud.
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