How Synthetic CDOs Allocate Credit Risk Through CDS

# Clarification on how synthetic CDOs work


# Clarification on how synthetic CDOs work












According to my understanding, synthetic CDOs are essentially credit default swaps (CDS) for a bunch of loans, stored in a special purpose vehicle (SPV). Here, the investor (the one who buys the synthetic CDO) is essentially buying insurance against defaults of loans that the investor doesn't hold. Therefore, if the loan defaults the investor gets paid by the issuer of the CDSs, and until that happens the investor pays a premium to the issuer of the CDSs (somehow?).

My understanding is mostly based on the assumption that 1) buying synthetic CDO (i.e. being an investor) means betting against the loans, 2) synthetic CDOs don't contain any loans.

I wouldn't be surprised if I'm wrong, so please correct me where I'm wrong. In particular, it doesn't make sense to me why is there even CDO in the name of this synthetic CDO, as it is just a basket of CDSs and there are no loans in it. Also, how can the investor payout the premium to the issuer if it is bundled?

## Answer by AlRacoon (score 4, accepted)

https://quant.stackexchange.com/a/69400

You are right in that a synthetic CDO comprises a basket of CDS. Like cash CDOs, this is a way to take a long or short position in a basket of credits.

In a cash CDO, the issuer creates a basket of physical bonds which underly a payout structure, the most simple of which is the payouts are based on seniority of claims on the coupon and maturity of the underlying bonds in the cash CDO. Initially, these structures were created to recapitalize the banks as their loan books became full or their bond portfolios became full.

A CDS is a derivative contract for banks to offload single name risk. For example, if a bank had a lot of exposure to a single entity the they loaned money to (or bought bonds of) and wanted to reduce their exposure without selling off the exposure directly, they could sell all or part of their risk through a CDS. They in effect short the debt by buying protection from an investor. The bank pays the seller of protection a premium. Their long position in the actual debt of the underlying is the hedge against their short position in the debt via being long protection through the CDS. The bank makes money by earning the difference payoffs of the debt they own and the premium they pay to the seller of protection. If there was no default, this basically amounts to the difference between the interest they received from the credit less the premium they paid to the seller of protection. In the event of default, the seller of protection would pay par for the debt; the buyer of protection (loan holder) would deliver the debt instrument to the seller of protection; and the seller of protection would keep any debt recovery in bankruptcy.

As the CDS market developed, the banks discovered they could create "synthetic" basket of loans by selling protection; and they could in turn create a "synthetic CDO" by selling this basket of "synthetic loans" by buying protection from an investor. These "synthetic CDOs" were similarly structured by seniority on claims as the cash CDO so that investors could take the risk they wanted.

The investor in the "synthetic CDOs" is a seller of protection (or long the credits) in the basket of names. They will continue to receive the premium as long as the names do not default. If an entity defaults, the same settlement procedure of the CDS is followed. The original deals were physically settled as mentioned above. The seller of protection (investor in the synthetic CDO) would pay par for the debt; the issuer would deliver the debt obligation; and the seller of protection would get what they could in recovery. Obviously this meant the buyer of protection would have to own the underlying debt or acquire it. This and other complications led to a "cash settlement" mechanism. The CDS market has evolved to address other complications as well, but is beyond the scope of this response.

The investor in a synthetic CDO wishes to get long a basket of names on an unfunded basis (not actually using capital to buy the bonds), either outright or as a hedge. The issuer of the synthetic CDO wishes to sell a basket of names, either as an outright bet or as hedge against a portfolio of debt (funded or unfunded). As banks are the typical issuers of "synthetic cdos" they are usually hedged with the underlying portfolio of bonds or a portfolio of CDS, where they are the seller of protection. As such they are not incented to issue "bad loans". As the middle man, they are looking to earn the spread between their long debt portfolio and the amount they are paying for protection via the "synthetic CDO".

However, as the CDS market evolved, and banks found it easy to offload the loans they were making, one could argue that the underwriting standards of loan writing became lax as banks were looking to just collect the fees from underwriting the loan and selling it off via the CDS market. (One could argue this at least contributed to the 2008 Housing crisis.)

This is a basic description of these structures and instruments to hopefully assist you in your understanding of why these structures exist and how they are created. However, the instruments and structures have evolved over time and are much more complicated than this description. The payoff structures, big bang, upfront premium, cash settlement process, replacement of credits, etc are all developments to address investor and issuer needs and risks. This is a long and complicated topic.