Synthetic CDO

A Synthetic CDO (Collateralized Debt Obligation) is a complex financial security used to speculate or manage the risk that an obligation will not be paid (i.e., credit risk). It is a derivative, 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 bet, meaning it may result in a potentially large payout without requiring that a large amount of funds (collateral) be set aside. 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 on 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.

Synthetic CDOs are highly 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.

Characteristics of the synthetic CDO

Synthetic CDO Diagram from Financial Crisis Inquiry Commission

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

Author Roger 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
• Special purpose entity
• Subprime mortgage crisis
• Magnetar Capital

Further reading

• Kohler, Alan (19 November 2008). "A tsunami of hope or terror?". Business Spectator. http://www.businessspectator.com.au/bs.nsf/Article/A-tsunami-of-hope-or-terror-LHRJP?OpenDocument.  Article on synthetic CDOs.