Synthetic CDO: Definition, How It Works in Finance, and Example

What Is a Synthetic CDO?

A synthetic CDO is a financial product that invests in non-cash assets such as swaps, options, and insurance contracts to obtain exposure to a portfolio of fixed-income assets.

It is one kind of collateralized debt obligation (CDO). A CDO is a financial product structured by banks that pool and package cash-generating assets into financial securities. These are then sold to investors.

For example, a mortgage-backed security is a CDO. Mortgages are the collateral. Investors expect to make money on their investment from the repayment of mortgage loans.

Synthetic CDOs are typically divided into tranches, or sections, based on the level of credit risk an investor wishes to assume. Initial investments in the CDO occur in the lower tranches. Senior tranches may not involve an initial investment.

Key Takeaways

  • A synthetic CDO is one type of collateralized debt obligation.
  • It is structured with non-cash derivatives such as swaps, options, and insurance contracts.
  • Synthetic CDOs are divided into tranches based on the risk assumed by investors.
  • Senior tranches have lower risk and offer lower returns, while junior, equity-level tranches carry higher risk and offer higher returns.
  • The value of a synthetic CDO is the cash flow derived from swaps, options, and insurance contract premiums (from, e.g., credit default swaps).

A Primer On Collateralized Debt Obligation (CDOs)

Understanding Synthetic CDOs

Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors. They are unlike other CDOs, which typically invest in traditional debt products such as bonds, mortgages, and loans.

Instead, synthetic CDOs generate income from non-cash derivatives such as a credit default swap (CDS), options, and other contracts.

While a traditional CDO generates income for the seller from cash assets like loans, credit cards, and mortgages, the value of a synthetic CDO comes from, for example, insurance premiums of credit default swaps paid for by investors.

The seller takes a long position in the synthetic CDO, assuming the underlying assets will perform. The investor, on the other hand, takes a short position, assuming the underlying assets will default.

Investors can be on the hook for much more than their initial investments if several credit events occur within the reference portfolio. In a synthetic CDO, all tranches receive periodic payments based on cash flows from the credit default swaps.

Normally, synthetic CDO payoffs are only affected by credit events associated with CDSs. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest-rated tranches and on up.

Synthetic CDOs generate income from non-cash derivatives such as credit default swaps, options, and other contracts.

Synthetic CDOs and Tranches

Tranches are also known as slices of credit risk between risk levels. The three tranches primarily used in CDOs are known as senior, mezzanine, and equity. The senior tranche includes securities with high credit ratings, tends to be low risk, and thus has lower returns.

Conversely, an equity-level tranche carries a higher degree of risk and holds derivatives with lower credit ratings, so it offers higher returns. Although the equity-level tranche may offer higher returns, it is the first tranche that would absorb any potential losses.

Tranches make synthetic CDOs attractive to investors because they can gain exposure that matches their risk appetite. For example, assume an investor wishes to invest in a high-rated synthetic CDO that included U.S. Treasury bonds and corporate bonds that are rated AAA (the highest credit rating offered by Standard & Poor's).

A bank can create the synthetic CDO that offers to pay the U.S. Treasury bond's yield plus the corporate bonds' yields. This would be a single tranche synthetic CDO that only includes the senior-level tranche.

Synthetic CDOs: Then and Now

Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without selling the loans and potentially harming client relationships.

They became increasingly popular because they tended to have shorter life spans than cash flow CDOs, and there was no extended ramp-up period for earnings investment. Synthetic CDOs were also highly customizable, to the degree desired by the underwriter and investors.

They were highly criticized for their role in the subprime mortgage crisis, which led to the Great Recession. Investors initially only had access to subprime mortgage bonds for as many mortgages as existed. However, with the creation of synthetic CDOs and credit default swaps, exposure to these assets increased.

Investors didn't realize that the underlying assets carried high risk. As homeowners defaulted on their mortgages, ratings agencies downgraded CDOs, leading investment firms to notify investors that they wouldn't be able to pay their money back.

Despite their checkered past, synthetic CDOs may be experiencing a resurgence. Investors looking for high yields are turning to these investments once again, and large banks and investments firms are responding to the demand by hiring credit traders who specialize in this area.

What Does Synthetic Mean for CDOs?

The term synthetic refers to the nature of a derivative. The investor has indirect exposure to the CDO's underlying debt securities and the credit of the borrower. Income is generated not from the debt but from insurance sold against defaults on the debt.

What's a Collateralized Debt Obligation?

It's a product that's created when a financial institution such as a bank takes loans on its books and repackages them into a single security that it then sells to investors in the secondary market. Investors hope to receive a return via payments made on the loans by the borrowers.

What Is a Tranche?

In French, the term tranche means slice. Used as a financial term in English, it refers to one portion of an overall investment. A collateralized debt obligation offers different tranches to investors, based on their desire to assume different levels of risk.

Article Sources
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  1. Federal Reserve. "Understanding the Risk of Synthetic CDOs."

  2. Board of Governors of the Federal Reserve System. "Finance and Economics Discussion Series (FEDS): Understanding the Risk of Synthetic CDOs," Page 1.

  3. Guggenheim Investments. "The Rise of Collateralized Synthetic Obligations: Beware the Rhyme of History."

  4. Fitch Ratings. "Structured Finance: Synthetic Overview for CMBS Investors."

  5. Connecticut General Assembly. "OLR Research Report: Credit Default Swaps and Collateralized Debt Obligations."

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