I stuggled with this last year too…I don’t fully understand the whole strucuring of a Synthetic CDO. I hate the way Schweser explains it… anybody can do better? …Try explainin it to like a 10 year old!!
Cash CDOs are based on a portfolio of cash assets, synthetic CDOs are based on sold CDS. Funding – cash vs. synthetic 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 receives a periodic payment (the swap premium), with the junior tranches offering higher premiums. 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. Some of this credit exposure is funded at the time of investment by the investors in funded tranches. Typically, the junior tranches that face the greatest risk of experiencing a loss have to fund at closing. 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 counterpaty 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. 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. http://en.wikipedia.org/wiki/Collateralized_debt_obligation
Geez until the end, I thought that he had factoids like “Funded synthetic issuance exceeded $80 billion in 2006” in his head.
good ole Wikipedia…now why didn’t I think of that!! Thanks maratikus…this actually makes sense now!! What I was not getting I think was the funded/unfunded bit… Basically what they are saying is that the senior tranches do not need to invest any capital … because no assets are being bought as collateral for the CDO - correct? However, they must be paying something to enter into this CDO…what is that referred to? Is it just a premium of some sort??
mumukada Wrote: ------------------------------------------------------- > good ole Wikipedia…now why didn’t I think of > that!! Thanks maratikus…this actually makes sense > now!! > > What I was not getting I think was the > funded/unfunded bit… > > Basically what they are saying is that the senior > tranches do not need to invest any capital … > because no assets are being bought as collateral > for the CDO - correct? > Yes > > However, they must be paying something to enter > into this CDO…what is that referred to? Is it > just a premium of some sort?? > No they are getting paid by the CDO.
In synthetic CDO’s the senior notes work on some kind of notional assets. The junior notes are funded by issuing Debt obligations and they absorb all the losses to their bearable limits and the rest gets mitigated to senior notes. So the note holders receive a premium for entering into such obligatory contracts. But then… I am on Aspirins today since I read the Synthetic-CDO’s yesterday night and still not able to recover from the veisalgia of it!! Will re-do those readings again today from the CFAI dumbbells. Time to tear open that carton (and I though I could have passed those as unilateral gift to my cousins)
mumukada Wrote: ------------------------------------------------------- …Try explainin it to like > a 10 year old!! Ah, if only it were this easy. The thing is mumukada, a 10 year old can’t understand synthetics, or CDOs, or the combination of the two, no matter who is explaining it. Derivs simply take higher cognitive ability. Ability of say a CFA Level 2 candidate… Try drawing a diagram of a CDO transaction e.g. draw 1 box containing the CDO (perhaps seperated by tranche), another box containing the portfolio of assets, and the cash flows transfered between the two and the cash flows to an investor in a given CDO tranche. Next replace the portfolio of assets with CDS and work through what happens in the event of default. The idea is that you can gain similar credut exposure via derivatives (synthetically) as you can via a portfolio of assets. Of course to do this, you need to know something about CDS as well. This takes some time, but it is worth the effort if you want to understand.
Synthetic CDOs are made up of assets which are reference entities or credit default swaps. Instead of receiving principal and interest they receive credit premiums to protect against default.
basically you sell credit insurance and get paid premium for that.
thanks all…all this makes sense now…
altt1 Wrote: ------------------------------------------------------- > mumukada Wrote: > -------------------------------------------------- > ----- > …Try explainin it to like > > a 10 year old!! > > > Ah, if only it were this easy. The thing is > mumukada, a 10 year old can’t understand > synthetics, or CDOs, or the combination of the > two, no matter who is explaining it. Derivs > simply take higher cognitive ability. Ability of > say a CFA Level 2 candidate… > In fact, it appears that the Bear Stearns Corporation couldn’t understand CDO’s (synthetic or otherwise) and the collective understanding at C and LEH was similarly flawed.
JoeyDVivre Wrote: > In fact, it appears that the Bear Stearns > Corporation couldn’t understand CDO’s (synthetic > or otherwise) and the collective understanding at > C and LEH was similarly flawed. i like it!
The problem with CDOs was that its so far removed from the underlying cashflows. When you a just buying Mortgage bonds without any knowledge of the collateral backing them you are skating on thin ice. All those banks where so addicted to the fees from structuring the CDOs that they didn’t care what assets they were purchasing. CDOs are a fine concept but not at the level of issuance from the last couple years.