Synthetic CDO Structures

The notes issued to investors are linked to the credit risk of the portfolio through the credit-default swap—which usually has the same term 

If a credit event occurs, the SPV usually pays out a cash amount equal to the par value of the underlying assets covered by the credit default swap, less their post-default price. Less commonly, the SPV physically settles the credit-default swap by purchasing the defaulted assets at par value. The credit loss is then passed on to the investors according to the priority of the tranches they hold. 

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The cumulative benefits to synthetic CDO structures versus cash structures, if they are all in play, amount to dramatically improved economics. For instance, if all of the asset side (flexibility, ramp-up, basis) benefits sum to only 10 bps, and the liability benefit is 40 bps on 70% of the capital structure, the savings would amount to 38 bps (= 40 x 0.7 + 10) on a 1 billion transaction. For a 5-year synthetic CDO, the PV of those 38 bps amounts to over 17 million. In a leveraged structure, of course, these benefits will primarily accrue to the equity and their impact will be magnified as shown in Exhibit 22.8. Clearly, the synthetic CDO may be an efficient vehicle for investors to use in accessing diversified tranches of risk. 

Having examined a snapshot of the no-loss potential return to investors as well as the potential execution benefits of synthetic CDO structures, the next question becomes the potential for loss. The allocation of gains and losses, and their order of priority (the waterfall ), is negotiated and governed by the language of the synthetic CDO. In a typical syn-... 

For the balance of the discussion we will assume a traditional type of structure, but it is worth noting that, in lengthy bilateral contracts, issues far removed from attachment points and spread can have large impacts on pricing. The very flexibility available to investors in synthetic CDO structures means that additional attention is required to evaluate transactions. 

RiskMetrics Group CDOManager is designed to analyze cash and synthetic CDO structures. It helps assess the risk associated with a CDO and calculate prices. CDOManager produces expected cash flow from the assets and feeds them into a waterfall to determine the cash flow to the notes. Exhibit 22.16 provides a screenshot from CDOManager. 

As discussed, CDOs are generally categorised as either balance sheet CDOs or arbitrage CDOs depending on their intended purpose. In terms of operating mechanics, balance sheet CDOs are almost exclusively cash-flow-based while, arbitrage CDOs are structured either as cashflow-based or market-value-based. A later development, synthetic CDOs, now account for a growing number of transactions. 

This value proposition may be conservative. CSFB assigns 15 bps of value to the basis alone, and 40 bps of value to 87% of the capital structure on the liahility side. Neil McPherson, Helen Remeza, and David Kung, Synthetic CDOs and Credit Default Swaps, CSFB (November 2002). 

The issuer of the bonds under a traditional CDO or ABS structure or of credit-linked notes in a synthetic funded structure is a special purpose vehicle (SPY). The structure relies on the fact that such SPY is bankruptcy remote, that is, the entity is unlikely to become subject to bankruptcy proceedings or claims by other investors. For these purposes, the constitutional documents of the SPY usually prohibit any merger, or consolidation, the SPY is prohibited from engaging in business other than those directly related to the transaction and is restricted from incurring any additional debt. 

CDO structures may be either conventional or synthetic. The conventional structures were the first to be widely used, but synthetic ones have become increasingly common since the late 1990s. The difference between the two structures lies in how they transfer credit risk from the originator to the SPV in conventional CDO structures, this is achieved by transferring assets in synthetic structures, credit derivative instruments are used. 

There are two types of CDO liability structures utilized in synthetic transactions completely unfunded structures that use portfolio swaps exclusively to transfer the entire credit risk of the reference portfolio to investors and partially funded structures which transfer only the highest credit risk segment of the portfolio. 

A variation on the generic TRS has been used in structured credit products such as synthetic collateralised debt obligations (CDO). An example of this is the Jazz I CDO B.V., which is a vehicle that can trade in... 

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