Synthetic CDOs are a collateralized debt obligation that generally uses credit default swaps (CDS) and other derivatives to meet their performance targets. It is a modern structured finance instrument that can offer extraordinary returns to investors. The term synthetic is used because in this case the CDO is not the owner of the underlying assets from which the risk emanates. In a synthetic CDO, CDO debt holders absorb economic risk, but not legal ownership of a pool of assets.
The value and payment flows of a synthetic CDO are not derived from cash assets such as mortgages or credit card payments – as in the case of regular CDOs – but from the premiums paid for the “insurance” CDS on the probability of default on a defined set of reference instruments in a fixed income portfolio.
How Synthetic CDOs Work
Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. All tranches will receive a periodic payment based on the flows produced by the CDS. If a credit event occurs in a fixed income portfolio, the synthetic CDO and its investors assume the losses, starting from the lowest tranche up.
A synthetic CDO is usually traded by two counter parties who have different views about what will eventually occur with respect to the underlying reference instruments. In this regard, a synthetic CDO requires investors on both sides of the operation: those who take “long” positions and those who position themselves “short”. Various financial intermediaries such as investment banks and hedge funds may be involved in the search for investors and in the selection of the reference instruments on which the hedge is made.
A counter party generally pays a premium to receive a higher payment in the event of a credit event that affects the recovery of the investment, which makes it an insurance in such situations. These instruments are usually not traded on stock exchanges.
How is a synthetic CDO structured?
In order to distribute the risk associated with the reference assets, the synthetic CDO is divided into two parts:
- Senior Section
- Junior Section
In a typical structure of a synthetic CDO, the Senior section corresponds to 90% of the total, while the Junior corresponds to 10%. The losses are charged, first, to the Junior section, until their nominal value is reached. The losses are then applied to the Senior section.
Synthetic CDOs were created in the late 1990s as a way to enable commercial lending institutions to protect their balance sheets from potential losses without having to sell their loansÂ and potentially damage customer relationships.