English: Synthetic CDO Diagram

Summary

This is a diagram of an illustrative synthetic CDO, from page 144 of the FCIC Report. The explanation below was written by a Wikipedia editor (who is stretching his understanding of this complex instrument, so an expert review would be helpful) to provide additional clarification on the captions in the diagram. 1a. Premiums: A premium in this case refers to recurring cash payments made by the short investors to the CDO to purchase protection should a specified credit event occur. An example of a credit event would be a company entering bankruptcy that stops paying interest to its bondholders (i.e., a bond default is a credit event). If these bonds are reference securities in the CDO arrangement, this triggers a payment from the entity selling protection (the CDO) to the entity buying protection and paying premiums (the short investor). 1b. Credit protection: The mechanism the CDO uses is to take the protection seller side of a portfolio of credit default swaps (CDS), which obligate it to pay should credit events occur related to some or all of the CDS it contains. The short investors are paying premiums related to these CDS into the CDO, while the CDO's obligations depend on whether credit events occur related to these CDS. 3. Funded investors / bond holders: A key point here is that the funded investors (who are funding the establishment of the CDO and the portfolio of CDS that it contains) are getting interest payments, funded by the short seller premiums and cash flows related to the assets the CDO purchases other than CDS. It is helpful to think of the funded investors as the ones who put up the initial money to create the CDO and fill it with CDS. 2. Unfunded investors: These investors have taken the opposite side of the transaction from the short investor, making the CDO a pass-through arrangement. Think of the CDO as a trust holding the CDS on behalf of the unfunded investors (who are selling the credit protection) and the short investors (who are paying premiums to purchase credit protection). The effect of each CDS contract in this arrangement is to enable a wager on any reference securities, of any amount, provided there are parties willing to take either side of the transaction (e.g., protection buyer/premium payer and protection seller/premium recipient). The synthetic CDO arrangement enables the benefits and risks of these CDS to be pooled. The cash flows received by the funded and unfunded investors simulate the cash flows received in a (non-synthetic) CDO. This means that the synthetic CDO, by using a bundle of CDS, has simulated the cash flow of a non-synthetic CDO. If the reference securities involved were mortgage-backed securities, this enables enormous wagers to be made on the housing market without the origination of new mortgages.

With the synthetic CDO, if credit events occur, unfunded investor payments are required to the short investors via the CDO and its portfolio of CDS. Further, the funded investor may lose its income as well.