Synthetic CDO

Synthetic CDO, which stands for synthetic Collateralized Debt Obligation, is a financial instrument involving a bundled investment in non-cash assets. The main purpose of this type of CDO is to invest in fixed-income securities and gain enough exposure to them. 

The synthetic CDO does not hold any physical assets. Instead, it relies on credit default swaps (CDS). The CDOs pool such non-cash assets and sell them to the investor. However, they have to bear the entire risk associated with it. 

• Synthetic CDOs are collateralized debt obligations that act as a synthetic to imitate the fixed income securities. They originated in 1997 as cash CDO. 
• Tranches in these CDOs allow financial institutions to group various assets into pools and sell to investors. 
• Here, the risk is taken by the investor. Therefore, the seller does not have to stress on the default cases. 
• But, if the buyer defaults anytime, the senior tranche investors will be the first to receive the payment. 

Synthetic CDOs are a form of CDO with no physical assets. Instead, they indirectly hold them in credit default swap format. They possess the qualities of fixed-income securities to protect investors from the adverse effects of market volatility. 

These synthetic CDO pricing structures are divided into tranches based on the associated risk. They can be single-tranche CDOs or fully distributed. These tranches are formed based on the seller's balance sheet. So, investors can choose CDOs according to their risk tolerance level. Thus, the initial investments are placed in the lower tranches. Likewise, higher investments fall in the top tranches. 

On the other hand, the banks will try to pool various cash-generating assets into financial securities. Later, the banks sell them to investors. Here, the investors do not buy the asset but deal with default swaps. Therefore, there is no direct involvement of physical assets. However, the pool of securities formed does include them.

The origin of the synthetic CDOs dates back to the late 1990s. The Broad Index Secured Trust Offering (BISTRO) created the synthetic CDO pricing structure in 1997. It allowed issuers like banks to protect their assets without selling the loans. As a result, the relationship with the customer remains the same. However, the major influence of synthetic CDO pricing occurred in the 2000s. According to a financial firm Dealogic study, between 2005 and 1007, there were $108 billion in synthetic CDOs. 

The synthetic CDO valuation models became immensely popular among sellers. Likewise, in 2012, the synthetic CDO market size only reached $2 billion. However, behind the roses was a huge downfall waiting for them. During the Great Recession period, there was excess creation of synthetic CDO. As a result, exposure to risks towards these assets increased. 

However, the individuals were not aware of the underlying risk. Thus, the CDO's ratings fell when the homeowners defaulted on the loan. The latter failed to repay the principal plus interest amount to the investors. As a result, it caused a severe divergence in the investor's expectations.

Let us look at the examples of synthetic CDO valuation to comprehend the concept in a better way:

Example #1

Suppose ABC Bank provides various services to customers. Out of which, mortgage or loan provider services are the vital ones. So, the bank accumulated, in total, $100 million worth of collateral assets. However, they wanted to earn more out of it. As a result, they started issuing synthetic CDOs. In these CDOs, the issuer will pool multiple assets, place them into tranches, and sell them to investors. In continuation, the sellers will bear the risk associated with it. However, if the original debt owner defaults on it, it can bring a huge risk to the seller and buyer. 

Example #2

According to a research report as of October 2023, the global CDO (collateralized debt obligation) market size is estimated to reach $56536.1 million by the end of 2031. This industry will grow within this period at a compounded annual growth rate of 9.26%. In addition, the research also included the rise of synthetic CDOs and collateralized loan obligations (CLOs) in recent years. Hence, these financial products are also prevalent and popular today. 

Let us look at the main benefits of synthetic CDO:

#1-Diversification

As a prime feature of synthetic CDOs, investors can access various assets. Due to this, the risk concerning them gets spread out to various assets and not just one. In addition, the investors also get exposure to different securities. 

#2-Promotes Liquidity

While a bank holds a single security, it can be highly illiquid. There has to be a suitable buyer to unleash it. Therefore, synthetic CDOs provide liquidity features by grouping a single security with others and then selling it to the buyer. 

#3-Minimizes Repayment Risk

Since the investors bear the entire risk, the issuer's (bank) load automatically reduces. Also, they can generate additional reserves out of it. 

#4-Repayment Priority

With the hierarchy of tranches, the buyers are always at ease. So, if a buyer has an investment in a higher tranche, they will get prioritized first. Thus, in case of default, the higher-ranking buyers will be prime to receive payment.

Let us look at the risks associated with the synthetic CDOs:

1. The financial institutions and rating agencies must undergo a two-way verification process to review the CDO risks. 
2. Synthetic CDOs involve a complex process that is difficult to cope with. As a result, understanding the terms and obligations is vital at any stage. 
3. With multiple assets and parties involved, there is always a failure of default repayment by the counterparty. Plus, it can accumulate losses for the issuer plus the investor. 
4. As these CDOs are treated confined, the process has enough opacity. Thus, the chances of false or misleading synthetic CDO pricing are high. 

Let us look at the main differences between synthetic CDOs and traditional CDOs:

This article has been a guide to what is a Synthetic CDO. Here, we compare it with CDO, and explain its examples, evolution, benefits, and risks. You may also find some useful articles here –

• Asset Backed Securities (RMBS, CMBS, CDOs)
• ABS and MBS Index
• Structured Finance