Synthetic Collateralized Debt Obligations and their Applications

Collateralized Debt Obligations (CDOs) are packages of debt securities (such as mortgages, auto loans, and credit card receivables among others). To create CDOs a financial intermediary will buy the debt securities, form a portfolio, and sell portions of this portfolio to investors. Usually, the portfolio is separated into tranches which represent payment order. That is, the second tranche will receive its interest payment only if the first tranche has been paid in full. This structure causes the lowest tranches to be first affected by defaults on the underlying debt securities. The effect of this ordering is to allow investors to purchase the level of risk they desire (low tranches for investors seeking high risk and high return, and high tranches for risk averse investors). Note, the tranche structure allows varying risk/return profiles to be created from a potentially homogeneous portfolio of securities. Ultimately ownership of the debt within the portfolio is transferred to the CDO buyers. CDOs also provide investors with a diversified portfolio of debt securities with low transaction costs. Further, by facilitating investor capital inflows to these debt securities, CDOs provide borrowers with lower financing costs.

Synthetic CDOs

Synthetic CDOs, alternatively, provide investors with all the economic benefits of owning the CDOs, just without the transfer of ownership of the underlying debt securities. Instead of many debt securities making up the underlying portfolio, a Credit Default Swap (CDS) is bought from the Synthetic CDO buyer, the payments on which form the 'interest' on the CDO.

CDS are a form of protection, or insurance, on debt securities. The insurance is structured such that the CDS buyer makes periodic payments to the CDS seller. These payments are quoted in basis points per year (with the annual payment being the basis points times the face value), and can readily be thought of as standard insurance premium payments. If the underlying debt securities experience a credit event (default), then the terms of the CDS would commonly transfer the par value of the defaulted bond in cash from the CDS seller to the buyer. The buyer would transfer the ownership of the defaulted bond to the seller1.

To construct a Synthetic CDO an underlying reference portfolio of debt securities is first selected. Then CDS are sold (by the Synthetic CDO buyer) against tranches of the underlying portfolio. The Synthetic CDO buyer is usually required to put up capital against their CDS sale with the financial intermediary. This payment is analogous to the investment in the underlying securities in the case of a plain CDO. The periodic insurance payments are then passed through from the Synthetic CDO seller to the Synthetic CDO buyer as if they were interest payments. In the case of defaults on the underlying debt securities, just as in a plain CDO, owners of the lower tranches would lose their capital held with the financial intermediary first, which is transferred to the Synthetic CDO seller. This represents the standard settlement of a CDS in the case of default; the CDS seller transfers the face value of the bond in return for the value of the bond in default.

Hypothetical Application

Say we work for a company which wants to build a Hydroelectric generating station in Brazil. The station will be highly profitable if successful, however if Brazilian electricity prices fall while constructing the station, our company may incur substantial losses. Since this is a sizable investment for our company, this risk may preclude us from making this investment unless we can hedge the risk.

In this case we can hedge our risk by selling a Single-Tranche Synthetic CDO on a portfolio of bonds issued by Brazilian electricity producers. By entering into this Synthetic CDO, if the Brazilian electricity producing industrial sector does well, so will our Hydroelectric station. We therefore earn our expected profit, less our insurance payments. If the industry experiences trouble, we will incur losses on our station, but these losses are mitigated by payments received on our short Synthetic CDO. Note, since this entails us buying CDS on the bonds, without owning them, this is often termed a naked purchase of CDS. This term is not apt, however, because we are hedging our economic interest in the health of the Brazilian electricity producing industry.

Importantly, since this is a Synthetic CDO we don't have to worry about obtaining actual ownership of the underlying bonds. Buying the bonds may be troublesome if Brazilian markets for the bonds are illiquid, causing high transaction costs.

Footnotes:

1

The settlement of a CDS can be complicated if there are many CDS written on a particular security. Then, usually, an auction is held to determine the value of the defaulted security so settlement may be done in cash instead of transferring ownership of the defaulted bond.

Author: Matthew Brigida

Created: 2014-08-22 Fri 14:13

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