Synthetic Collateralized Debt Obligations
Synthetic Collateralized Debt Obligations (CDOs) invest in credit default swaps or other non-cash assets to gain exposure to a portfolio of fixed income assets. As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against debt defaults, typically on a pool of a hundred or so companies or individual bonds.
Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without actually selling the loans and potentially harming client relationships. Synthetic CDOs can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio. 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.
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. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing.
A synthetic CDO tranche may be either funded or unfunded. Under the swap agreements, the CDO could have to pay up to a certain amount of money in the event of a credit event on the reference obligations in the CDO's reference portfolio. Until a credit event occurs, the proceeds provided by the funded tranches are often invested in high-quality, liquid assets or placed in a GIC (Guaranteed Investment Contract) account that offers a return that is a few basis points below LIBOR.
The return from these investments plus the premium from the swap counterparty provide the cash flow stream to pay interest to the funded tranches. When a credit event occurs and a payout to the swap counterparty is required, the required payment is made from the GIC or reserve account that holds the liquid investments. 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 funding exposure and may have to make a payment to the CDO in the event the portfolio's losses reach the senior tranche.
In October 2008, an article in The Wall Street Journal reported that synthetic CDOs could become the next crisis in the mortgage meltdown saga. According to the article, many synthetic CDOs contain a heavy dose of exposure to troubled financial companies, including Lehman Brothers, Washington Mutual Inc. and recently nationalized Icelandic banks Glitnir Bank hf, Kaupthing Bank hf and Landsbanki Islands hf. As a result, the users of synthetic CDOs are facing a wave of credit-rating downgrades and outright losses, which are coming to light gradually as ratings firms pore over hundreds of individual synthetic-CDO deals.
This was causing the market value of synthetic CDOs to fall, as hedge funds and other investors abandoned the investments. According to the Journal, dealers were already offering about 50 cents on the dollar or less for some pieces of synthetic CDOs that used to be rated triple-A rated. That was down from about 60 cents on the dollar only three weeks ago prior to the Journal's report.