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). 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. 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.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.The synthetic CDO is highly controversial, due to its role in the subprime mortgage crisis. It enabled large wagers to be made on the value of mortage-related securities, which critics argued may have contributed to lower lending standards and fraud
Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.
All tranches will receive periodic payments based on the cash flows from the credit default swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up.
The buyer 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 CDO’s) will perform. The seller of the synthetic CDO is paying premiums and is taking the “short” position, meaning they are betting the referenced securities will default. The seller receives a large payout if the referenced securities default, which is paid to them by the buyer.
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.