Anyone care to take a stab at explaining these? They still confuse me…
Just remember that it’s the same thing as a cash CDO except you don’t actually own the underlyer/reference security - they get the exposure via a credit derivative - thus the name synthetic.
Remember too that investors in a synthetic CDO are taking on the credit risk of the underlying assets, through the portfolio of CDS’s on those assets which make up the CDO. The cash flows they receive are the premiums from the CDS’s, and they will be responsible for any losses as a result of a credit event’s on the assets which the CDS’s are based, with the usual tranching mechanisms
If I understood it right, synthetic CDOs are just like normal CDOs, but instead of bonds generating coupons/ mortgage payments we have CDS premiums which generate the cash flows. So if I am a speculator who believes municipal bonds will default for example, but am not sure which ones will, I can buy a synthetic CDO where the underlying is a bunch of say 50 CDSs on munis (rather than the munis). So if there are say any 5 muni defaults, I get to make money. Is that correct?
Except maybe your last line, if there are defaults, then the investor’s in the synthetic CDO, will be resonsible for losses, starting with the subordinated tranche, otherwise its a win win situation
Oh, so my inflows will be the CDS premium, and outflows will be when there is a default. That seems to make more sense. Yea. Thanks.
Ill have to re-check all this, there are lots of parties to the synthetic CDO, what we want is from the perspective of an investor in the CDO,
If you think Muni bonds are going to go bust you would short the synthetic CDO not long
^^ Thats what I was thinking, can you short and long the CDO? How is that possible?
sorry I got it wrong The seller 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 buyer of the synthetic CDO is paying premiums and is taking the “short” position, meaning they are betting the referenced securities will default. The buyer receives a large payout if the referenced securities default, which is paid to them by the seller.
Shd be enuf if we know this much about synthetic CDOs. Guess there are more important things to break our heads on.
The way I think of it is this. In a traditional CDO, I buy it as an investor for the yield. In the event of credit risk, I can lose principal and stop receiving interest payments. If the CDO is synthetic: A senior and junior tranche are established. The senior may make up 90%, and the junior 10%. For the example, we call call it a 100MM deal. The senior puts nothing down. The junior actually puts down cash for ther part of the deal (10MM) like a traditional bond purchase. The 10MM is invested in high quality bonds. 100MM of credit default swaps are then written by the CDO towards 100M notional of the reference asset. The key is that where with a cash CDO, you are risking principal in exchange for an interest yield, with a synthetic CDO you are risking principal in exchange for a cds premium yield. In both cases you are screwed if the collateral goes bad, and you can lose principal equal to the notional value of your CDO. The junior tranch holder bears 100% of the investment outlay (again 10MM) and in return they receive the CDS premium PLUS the add on yield from the safe bonds their money was invested in. The senior tranch holder knows the first 10MM of losses will be covered by the bonds bought with the juniors cash, so because of this buffer, the senior gets paid a lower yield. If more than 10% of the deal goes sour, then the senior has to pay out of pocket to the long end on the cds. The advantage of the synethic structure is that there is less initial outlay and no need to actual build a portfolio of investments. Someone shorting the CDO, like Paulson for example did, would be paying the “interest” to the synthetic cdo holders in hopes of wiping out their principal if the reference assets went sour.
in ref to the note above… when you sell a CDS and collect the premiums you are actually LONG the ref and not short. the short position pays premiums and collects once the event occurs…
Yes after all that for such a small los, all i think you have to know with who gets what, is long gets premiums and aborbs defaults, short pays premiums and gains from default