CDO Synthetic

By: EconomyWatch Content   Date: 30 January 2010

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A CDO synthetic is a financial portfolio in which investors obtain the ownership of only a certain part of the reference portfolio, while the rest is held by the bank or originators. A synthetic collateralized debt obligation is an outgrowth of cash CDOs, which entail a reference portfolio constructed with several cash assets, such as loans and corporate bonds. However, while cash CDO involves complete ownership transfer of the pertinent asset pool to the investor, the bank retains the assets on their balance sheet in case of a CDO synthetic.

 

Types of CDO Synthetic

Synthetic CDOs are issued by originators in different forms, with varying asset pools. Broadly speaking, there are two forms of synthetic CDOs:

  • Arbitrage CDOs: These are generally used by insurance and asset management complexes for exploiting the yield on the portfolio’s underlying assets and benefiting from the lower cost of servicing a CDO security.

  • Balance sheet CDOs: These are usually used by banks for managing risk-based capital.  

CDO Synthetic Market Growth

Synthetic CDOs are fast becoming a popular investment platform. In fact, even originators are increasingly providing CDO synthetic portfolios, for the following benefits they offer:

  • Easier administration: Synthetic collateralized debt obligations are less administratively burdensome than their cash-funded counterparts because of their ability to transfer claims on a particular credit partially. Since the assets continue to be recorded on the sponsoring originator’s balance sheet, CDO synthetic facilitates easier execution unlike other credit products.

  • Exposure to scarce assets and global markets: Certain assets may are difficult to acquire through the cash market, which may be easily obtained as a part of synthetic CDOs. Furthermore, offering synthetic CDOs enables originators to venture into the financial markets of countries where the legal framework may not permit the transfer of the title of assets.

  • Lower cost of risk transfer: In case of these "partially funded" synthetic CDOs, funding is chiefly provided by the originator at a cost lower than that of a fully funded CDO. This helps to reduce the overall cost of transfer of risk to investors.

Synthetic CDOs have also gained popularity due to their shorter duration in comparison to cash flow CDOs. Additionally, a CDO synthetic is extremely customizable between an investor and an originator.


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