Synthetic CDOs

Abstract

The idea of securitization started with mortgages more than 30 years ago. The ability to redistribute the risk exposure embedded in a pool of risky mortgage loans by using it as collateral and creating new classes of mortgage-backed securities completely transformed mortgage finance in the U.S. Since then, this powerful concept has been extended in many directions to cover many types of risk, with structures that have become increasingly complex. A major recent growth area has been the securitization of ordinary bonds and loans, in the form of Collateralized debt obligations (CDOs), to manage default risk more efficiently. In this article, Laurie Goodman describes another significant step towards separation of risk bearing from ownership of the underlying securities in which that risk is embedded: synthetic CDOs. The special feature of these instruments is that the issuer of the CDO does not own the securities on which it bears the risk. Rather, it acquires risk exposure through a credit default swap. A major purpose of many synthetic CDOs is to optimize regulatory capital treatment for the bank that sets up the structure. If this sounds complicated, it is. Very! Fortunately, Goodman explains it all for us.