A synthetic CDO is a variation of a collateralized debt obligation (CDO) that generally uses credit default swaps (CDSs) and other derivatives to obtain its investment goals.Lemke, Lins and Picard, Mortgage-Backed Securities, §5:16 (Thomson West, 2017-2018 ed.). 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 CDS "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets. 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.
A synthetic CDO is the opposite of a standard CDO in the following sense: investors in an ordinary CDO put up a principal to purchase the CDO's assets upfront and receive interest on their investment. In a synthetic CDO the investor is awarded a revenue stream upfront and only in the case of a credit default has to put up the principal, when their involvement in the synthetic CDO terminates.
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,McLean, Bethany and Joe Nocera, All the Devils Are Here: The Hidden History of the Financial Crisis Portfolio, Penguin, 2010, (p.264) 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,FINANCIAL CRISIS INQUIRY REPORT, p.191 when synthetics became the dominant form of CDOs in the US, valued "notionally"the total of the underlying debt of synthetics on which investors were betting at $5 trillion by the end of the year according to one estimate.Zuckerman, Gregory, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, Broadway Books, 2009, p.176
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.NYT-Banks Bundled Bad Debt, Bet Against It, and Won|Gretchen Morgenson| December 24, 2009
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,Quote: "the other side of the bet wasn't someone who had investigated the mortgage-backed security – like Burry and Redleaf did – and thought they were betting on its performance. It was someone who was buying a [triple A] rating and thought he couldn't lose money" (p.266) McLean and Nocera, All the Devils Are Here 2010 and contributing to the 2008 financial crisis by amplifying the subprime mortgage housing bubble.Quote: the synthetic CDOs "turned that keg of dynamite [subprime loans] into the financial equivalent of a nuclear bomb", (p.263) McLean and Nocera, All the Devils Are Here 2010quote="The losses were magnified by derivatives such as synthetic securities" p.xvi FINANCIAL CRISIS INQUIRY REPORT By 2012 the total notional value of synthetics had been reduced to a couple of billion dollars.
History 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.
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. 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.
Parties
Investors in synthetic CDOs included "funded" long investors, who paid cash to purchase actual securities issued by the referenced CDO. These investors received interest if the reference securities performed, but they could lose all of their investment if the reference securities defaulted. "unfunded" long investors, who entered into swaps with the synthetic CDO, making money if the reference securities performed. These investors were highest in the payment "waterfall" – receiving premium-like payments from the CDO as long as the reference securities performed – but they would have to pay if the reference securities deteriorated beyond a certain point and the CDO did not have sufficient funds to pay the short investors. "short" investors, who bought credit default swaps on the reference securities, making money if the securities failed. These investors were often hedge funds. They bought the credit default swaps from the CDOs and paid premiums unfunded investors received.
One example is Abacus 2004-1, the first of 47 synthetic CDOs Goldman Sachs packaged and sold. The deal was worth $2 billion. About one-third of the swaps referenced residential mortgage-backed securities, another third referenced existing CDOs, and the rest, commercial mortgage-backed securities (made up of bundled commercial real estate loans) and other securities.
The short investor for the entire deal – "betting it would fail" – was Goldman, which purchased credit default swap protection on the reference securities and paid premiums.
The funded investors of that CDO were IKB (a German bank), the TCW Group, and Wachovia. These firms put up a total of $195 million to purchase "mezzanine" tranches of the deal (rated AA to BB) and in return would receive scheduled principal and interest payments if the referenced assets performed. If those assets did not, Goldman would receive the $195 million. In this sense, IKB, TCW, and Wachovia were “long” investors, betting that the referenced assets would perform well.
The unfunded investors – TCW and GSC Partners (asset management firms that managed both hedge funds and CDOs) – did not put up any money up front; they received annual premiums from Goldman via the CDO in return for the promise that they would pay the CDO if the reference securities failed and the CDO did not have enough funds to pay the short investors. (As of 2011, Goldman, the CDO creator and short investor has received about $930 million, while the long investors lost "just about all of their investments".)
Characteristics
A synthetic CDO is a tranche or tranches on a portfolio of credit default swaps (CDS). The portfolio could either consist of an index of reference securities, such as the CDX or iTraxx indices, or could be a bespoke portfolio, consisting of a list of reference obligations or reference entities selected by or specifically for a particular investor.Structured Products and Related Credit Derivatives - A Comprehensive Guide for Investors. pp254-255. Lancaster Schultz Fabozzi. John Wiley & Sons, Inc., 2008 Bespoke portfolios were more popular in Europe than in North America, and thus acquired the British term "bespoke", implying a suit tailored for a specific customer by a London Savile Row tailor.
A single-name CDS references only one security and the credit risk to be transferred in the swap may be very large. In contrast, a synthetic CDO references a portfolio of securities and is sliced into various tranches of risk, 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 position 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