Synthetic CDOs

Someone has asked me about what Synthetic CDOs is all about but I am currently busy with my In-Camp-Training now, thus I am not able to translate one of the Chinese articles on this topic.

But the reader came back with this answer himself and I wish to share with all of you here:

* Cash CDOs involve a portfolio of cash assets, such as loans, corporate bonds, asset-backed securities or mortgage-backed securities. Ownership of the assets is transferred to the legal entity (known as a special purpose vehicle) issuing the CDO's tranches. The risk of loss on the assets is divided among tranches in reverse order of seniority. Cash CDO issuance exceeded $400 billion in 2006.
* Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche pays a periodic payment (the swap premium), with the junior tranches offering higher yields.

:A synthetic CDO tranche may be either funded or unfunded. A funded tranche requires investors to fund their credit exposure. Under the swap agreement, the tranche could have to pay up to a certain amount of money in the event of a credit event on assets in CDO's reference portfolio. This credit exposure is funded at the time of investment by the tranche's investors. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund their exposure. At maturity, the funding minus any realized losses is returned to investors. In contrast, senior tranches are usually unfunded since the risk of loss is much lower. Unlike a cash CDO, investors in a senior tranche receive periodic payments but do not place any capital in the CDO when entering into the investment. Instead, the investors retain continuing liability exposure and may have to make a payment to the CDO in the rare event the portfolio's losses reach the senior tranche. Funded synthetic issuance exceeded $80 billion in 2006. From an issuance perspective, synthetic CDOs take less time to create. Cash assets do not have to be purchased and managed, and the CDO's tranches can be precisely structured.

It basically means that synthetic CDOs are technically just a Credit Default (Risk) Swap; meaning, here again, investors are made to be INSURERS of those financial institutions!

This is a double blow in the sense that for structured deposits like Lehman's Minibonds, the underlying assets may consist of synthetic CDOs as well.

Goh Meng Seng