Synthetic CDO
Encyclopedia
A Synthetic CDO is a complex financial security used to speculate or manage the risk that an obligation will not be paid (i.e., credit risk
Credit risk
Credit risk is an investor's risk of loss arising from a borrower who does not make payments as promised. Such an event is called a default. Other terms for credit risk are default risk and counterparty risk....

). It is a derivative
Derivative (finance)
A derivative instrument is a contract between two parties that specifies conditions—in particular, dates and the resulting values of the underlying variables—under which payments, or payoffs, are to be made between the parties.Under U.S...

, meaning its value is derived from events related to a defined set of reference securities that may or may not be owned by the parties involved.

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
Leverage (finance)
In finance, leverage is a general term for any technique to multiply gains and losses. Common ways to attain leverage are borrowing money, buying fixed assets and using derivatives. Important examples are:* A public corporation may leverage its equity by borrowing money...

 bet, meaning it may result in a potentially large payout without requiring that a large amount of funds (collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...

) be set aside. These securities are not typically traded on stock exchange
Stock exchange
A stock exchange is an entity that provides services for stock brokers and traders to trade stocks, bonds, and other securities. Stock exchanges also provide facilities for issue and redemption of securities and other financial instruments, and capital events including the payment of income and...

s.

In technical terms, the synthetic CDO is a form of collateralized debt obligation
Collateralized debt obligation
Collateralized debt obligations are a type of structured asset-backed security with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand...

 (CDO) in which the underlying credit exposures are taken on using a credit default swap
Credit default swap
A credit default swap is similar to a traditional insurance policy, in as much as it obliges the seller of the CDS to compensate the buyer in the event of loan default...

 rather than by having a vehicle
Structured investment vehicle
A structured investment vehicle was an operating finance company established to earn a spread between its assets and liabilities like a traditional bank...

 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
Balance sheet
In financial accounting, a balance sheet or statement of financial position is a summary of the financial balances of a sole proprietorship, a business partnership or a company. Assets, liabilities and ownership equity are listed as of a specific date, such as the end of its financial year. A...

 and arbitrage
Arbitrage
In economics and finance, arbitrage is the practice of taking advantage of a price difference between two or more markets: striking a combination of matching deals that capitalize upon the imbalance, the profit being the difference between the market prices...

 CDOs, although it is often impossible to distinguish in practice between the two types. They generate income selling insurance
Insurance
In law and economics, insurance is a form of risk management primarily used to hedge against the risk of a contingent, uncertain loss. Insurance is defined as the equitable transfer of the risk of a loss, from one entity to another, in exchange for payment. An insurer is a company selling the...

 against bond
Bond (finance)
In finance, a bond is a debt security, in which the authorized issuer owes the holders a debt and, depending on the terms of the bond, is obliged to pay interest to use and/or to repay the principal at a later date, termed maturity...

 defaults
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

 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 bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...

s or hedge fund
Hedge fund
A hedge fund is a private pool of capital actively managed by an investment adviser. Hedge funds are only open for investment to a limited number of accredited or qualified investors who meet criteria set by regulators. These investors can be institutions, such as pension funds, university...

s.

Synthetic CDOs are highly controversial, because of their role in the subprime mortgage crisis
Subprime mortgage crisis
The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

. 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.

Characteristics of the synthetic CDO

A synthetic CDO is a portfolio of credit default swaps (CDS). It may help to understand what a CDS is first before discussing them as a portfolio. Each CDS is a form of insurance on a bond or other obligation (the "reference security"). The CDS seller provides protection (insurance) in the event of a default
Default (finance)
In finance, default occurs when a debtor has not met his or her legal obligations according to the debt contract, e.g. has not made a scheduled payment, or has violated a loan covenant of the debt contract. A default is the failure to pay back a loan. Default may occur if the debtor is either...

 or specified "credit event" related to the reference security. The CDS buyer pays a premium in exchange for this protection. In some cases, this represents a hedge
Hedge (finance)
A hedge is an investment position intended to offset potential losses that may be incurred by a companion investment.A hedge can be constructed from many types of financial instruments, including stocks, exchange-traded funds, insurance, forward contracts, swaps, options, many types of...

, meaning the buyer actually owns the reference security they are insuring so losses on one or the other offset. In other cases, the bet is purely speculative, meaning a debt security not owned could be the reference security involved in the bet.

CDS Example: Party A might own certain bonds of Company B. Concerned that Company B might default (i.e., fail to pay interest or principal) on its bonds, Party A can buy protection from Party C, paying a premium to Party C. In the event Company B defaults, Party C pays Party A whatever amount has been agreed between them. This arrangement is a credit default swap and represents a hedge. Party A does not have to own the bonds of Company B to enter into this arrangement; this would be a speculative or "naked" CDS.
The problem with buying a CDS is that it usually references only one security, and the credit risk to be transferred in the swap may be very, very large. In contrast, a synthetic CDO references a portfolio of securities and is itself securitized into notes in various tranche
Tranche
In structured finance, a tranche is one of a number of related securities offered as part of the same transaction. The word tranche is French for slice, section, series, or portion, and is cognate to English trench . In the financial sense of the word, each bond is a different slice of the deal's...

s, 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"
Long (finance)
In finance, a long position in a security, such as a stock or a bond, or equivalently to be long in a security, means the holder of the position owns the security and will profit if the price of the security goes up. Going long is the more conventional practice of investing and is contrasted with...

 position, meaning they are betting the referenced securities (such as mortgage bonds or regular CDOs) will perform. The buyer of the synthetic CDO is paying premiums and is 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 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 "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."

Another interesting characteristic of synthetic CDOs is that they are not usually fully funded like money market funds or other conventional investments. In other words, a synthetic CDO covering $1 billion of credit risk will not actually sell $1 billion in notes, but will raise some smaller amount. That is, only the highest-rated tranches are fully funded and the more risky tranches are not.

In the event of default on all the underlying obligations, the premiums paid by Party A to Party C in the above example would be paid back to Party A until exhausted. The next question is who actually pays for the remaining credit risk on the more risky tranches, as well as the "super-senior" risk that was never structured into tranches at all (because it was thought that no properly structured synthetic CDO would actually undergo complete default). In reality, many banks simply kept the super-senior risk on their own books or insured it through severely undercapitalized "monoline" bond insurers. In turn, the growing mountains of super-senior risk caused major problems during the subprime mortgage crisis.

Impact on the subprime mortgage crisis

Joe Nocera wrote in the New York Times that prior to the creation of CDS and synthetic CDOs, you could have only as much exposure as there were mortgage bonds in existence. At their peak, approximately $1 trillion in subprime and Alt-A mortgages were securitized by Wall Street. However, the introduction of the CDS and synthetic CDO changed that. Unlike a “normal” CDO, which contained the bonds themselves, the synthetic version contains CDS — derivatives that “referenced” a particular group of mortgage bonds. Once synthetic CDO’s became popular, Wall Street no longer needed to actually originate new subprime loans. It could make an infinite number of bets on the bonds that already existed, as long as investors agreed to take the other side of the bet. One of the reasons synthetic CDO became popular was that the subprime companies were starting to run out of risky borrowers to make bad loans to in 2006-2007. Synthetic CDO enabled investors to bet against (take a "short" position in) mortgage bonds and housing prices more generally.

The New York Times reported that from 2005 through 2007, at least $108 billion of synthetic CDO were issued, according to Dealogic, a financial data firm. The actual volume was much higher because synthetic CDO and other customized trades are unregulated and often not reported to any financial exchange or market.

Debate and criticism

The crisis has renewed debate regarding the duty of financial intermediaries or market-makers such as investment banks to their clients. Intermediaries frequently take long or short positions on securities. They will often assume the opposite side of a client’s position to complete a transaction. The intermediary may hold or sell that position to increase, reduce or eliminate its own exposures. It is also typical that those clients taking the long or short positions do not know the identity of the other. The role of the intermediary is widely understood by the sophisticated investors that typically enter into complex transactions like synthetic CDO.

However, when an intermediary is trading on its own account and not merely hedging financial exposures created in its market-maker role, potential conflicts of interest arise. For example, if an investment bank has a significant bet that a particular asset class will decline in value and has taken the short position, does it have a duty to reveal the nature of these bets to clients who are considering taking the long side of the bet? To what extent does a market-maker that also trades on its own account owe a fiduciary responsibility to its customers, if any?

For example, during April 2010 certain Wall Street investment banks and hedge funds were criticized for allegedly creating CDO or synthetic CDO securities designed to favor the short position, without adequately disclosing this to the long investors. The New York Times quoted one expert as saying: “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.” One bank spokesman said that synthetic CDO created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market.

Former Federal Reserve Chairman Paul Volcker
Paul Volcker
Paul Adolph Volcker, Jr. is an American economist. He was the Chairman of the Federal Reserve under United States Presidents Jimmy Carter and Ronald Reagan from August 1979 to August 1987. He is widely credited with ending the high levels of inflation seen in the United States in the 1970s and...

 has argued that banks should not be allowed to trade on their own accounts, essentially separating proprietary trading and financial intermediation entirely in separate firms, as opposed to separate divisions within firms. His recommendation has been called the Volcker Rule
Volcker Rule
The Volcker Rule is a specific section of the Dodd–Frank Wall Street Reform and Consumer Protection Act originally proposed by American economist and former United States Federal Reserve Chairman Paul Volcker to restrict United States banks from making certain kinds of speculative investments that...

. Proprietary trading can be speculative in nature, while pure financial intermediation would typically involve hedging, with the profit to the intermediary based on fees for arranging transactions only.

Economist Paul Krugman
Paul Krugman
Paul Robin Krugman is an American economist, professor of Economics and International Affairs at the Woodrow Wilson School of Public and International Affairs at Princeton University, Centenary Professor at the London School of Economics, and an op-ed columnist for The New York Times...

 wrote in April 2010 that the creation of synthetic CDO should not be allowed: "What we can say is that the final draft of financial reform...should block the creation of 'synthetic CDOs,' cocktails of credit default swaps that let investors take big bets on assets without actually owning them." Financier George Soros
George Soros
George Soros is a Hungarian-American business magnate, investor, philosopher, and philanthropist. He is the chairman of Soros Fund Management. Soros supports progressive-liberal causes...

 said in June 2009: "CDS are instruments of destruction which ought to be outlawed."

Author Roger Lowenstein
Roger Lowenstein
Roger Lowenstein is an American financial journalist and writer. He graduated from Cornell University and reported for the Wall Street Journal for more than a decade, including two years writing its Heard on the Street column, 1989 to 1991. Born in 1955, he is the son of Helen and Louis Lowenstein...

 wrote in April 2010: "...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.

Columnist Robert Samuelson wrote in April 2010 that the culture of investment banks has shifted from a focus on the most productive allocation of savings, to a focus on maximizing profit through proprietary trading and arranging casino-like wagers for market participants: "If buyers and sellers can be found, we'll create and trade almost anything, no matter how dubious. Precisely this mind-set justified the packaging of reckless and fraudulent "subprime" mortgages into securities. Hardly anyone examined the worth of the underlying loans."

See also

  • Shelf corporation
    Shelf corporation
    A shelf corporation, shelf company, or aged corporation, is a company or corporation that has had no activity. It was created and left with no activity - metaphorically put on the "shelf" to "age"...

  • Special purpose entity
    Special purpose entity
    A special purpose entity is a legal entity created to fulfill narrow, specific or temporary objectives...

  • Subprime mortgage crisis
    Subprime mortgage crisis
    The U.S. subprime mortgage crisis was one of the first indicators of the late-2000s financial crisis, characterized by a rise in subprime mortgage delinquencies and foreclosures, and the resulting decline of securities backed by said mortgages....

  • Magnetar Capital
    Magnetar Capital
    Magnetar Capital is a hedge fund based in Evanston, Illinois. Among its many activities, the firm was actively involved in the collateralized debt obligation market during the 2006–2007 period...

The source of this article is wikipedia, the free encyclopedia.  The text of this article is licensed under the GFDL.
 
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