A synthetic collateralized debt obligation, or synthetic CDO, is a variation of a standard CDO, but underlying pool is made up of derivatives, such as credit default swaps (CDS), CLN and so on. Thus, a synthetic CDO is classified as a credit derivative. They are popular vehicles for trading the credit risk of a portfolio of assets.
Compared with conventional cashflow deals, which feature an actual transfer of ownership or true sale of the underlying assets to a separately incorporated legal entity, a synthetic securitization structure is engineered so that the credit risk of the assets is transferred by the originator of the transaction to the investors by means of credit derivative instruments. This credit risk transfer may be undertaken either directly or via an SPV. Using this approach, underlying or reference assets are not necessarily moved off the originator’s balance sheet and the primary objective is to achieve risk transfer.
The value and cash flow of a synthetic CDO is derived from premiums paying for credit default swap insurance on the possibility of default of some defined set of reference securities. The insurance-buying counterparties may own the reference securities and be managing the risk of their default, or may be just speculators.
There could be significant economic advantages of issuing synthetic CDOs. Synthetic deals are cheaper for originators, because in case where credit default swaps are used, the sponsor pays a basis point fee. In a cash CDOs structure the cost to the sponsor would be the benchmark yield plus the credit spread, which would be higher compared to the default swap premium. Synthetic CDOs are much easier to create, compare to cash CDOs, because they don’t need any real pool of assets. They are often described as a bet on the performance of the underlying securities.
However, synthetic CDOs could cause significant run-up in stock prices – so called stock market bubble – because the amount of such deals could growth without a corresponding increase in the capitalization of the based assets. Synthetic CDOs played a big role in the 2008 financial crisis.