Synthetic CDO

A synthetic CDO (collateralized debt obligation) is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage (or other) products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments — as in the case of a regular or 'cash' CDO — but from premiums paying for credit default swap 'insurance' on the possibility that some defined set of 'reference' securities — based on cash assets — will default. 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.'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.''...the collateralized debt obligations ... sponsored by most every Wall Street firm ... were simply a side bet — like those in a casino — that allowed speculators to increase society’s mortgage wager without financing a single house ... even when these instruments are used by banks to hedge against potential defaults, they raise a moral hazard. Banks are less likely to scrutinize mortgages and other loans they make if they know they can reduce risk using swaps. The very ease with which derivatives allow each party to 'transfer' risk means that no one party worries as much about its own risk. But, irrespective of who is holding the hot potato when the music stops, the net result is a society with more risk overall.' He argued that speculative CDS should be banned and that more capital should be set aside by institutions to support their derivative activity.insurers put aside reserves in case of a loss. In the housing boom, CDS were sold by firms that failed to put up any reserves or initial collateral or to hedge their exposure. In the run-up to the crisis, AIG, the largest U.S. insurance company, would accumulate a one-half trillion dollar position in credit risk through the OTC market without being required to post one dollar’s worth of initial collateral or making any other provision for loss. “The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen...When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.” A synthetic CDO (collateralized debt obligation) is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage (or other) products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments — as in the case of a regular or 'cash' CDO — but from premiums paying for credit default swap 'insurance' on the possibility that some defined set of 'reference' securities — based on cash assets — will default. 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. Synthetics thrived for a brief time because they were cheaper and easier to create than traditional CDOs, whose raw material, mortgages, was beginning to dry up.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. Synthetic issuance jumped from $15 billion in 2005 to $61 billion in 2006, when synthetics became the dominant form of CDOs in the US, valued 'notionally' at $5 trillion by the end of the year according to one estimate. Synthetic CDOs are 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. Synthetic CDOs have been criticized for 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. By 2012 the total notional value of synthetics had been reduced to a couple of billion dollars. In 1997, the Broad Index Secured Trust Offering (BISTRO) was introduced. It has been called the predecessor to the synthetic CDO structure. From 2005 through 2007, at least $108 billion in synthetic CDOs were issued, according to the financial data firm Dealogic. The actual volume was much higher because synthetic CDO trades are unregulated and 'often not reported to any financial exchange or market'. Journalist Gregory Zuckerman, states that 'according to some estimates', while there 'were $1.2 trillion of subprime loans' in 2006, 'more than $5 trillion of investments', i.e. synthetic CDOs, were created based on these loans. Some of the major creators of synthetic CDOs who also took short positions in the securities were Goldman Sachs, Deutsche Bank, Morgan Stanley, and Tricadia Inc. In 2012, the total notional value of synthetic CDOs arranged was only about $2 billion. 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. In this regard, a synthetic CDO requires investors on both sides—those taking a long position and those taking a short position. Various financial intermediaries, such as investment banks and hedge funds, may be involved in finding the counterparties and selecting the reference securities on which exposures are to be taken. One counterparty typically pays a premium to another counterparty in exchange for a large payment if certain loss events related to the reference securities occur, similar to an insurance arrangement. 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 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.