A synthetic CDO is a variation of a CDO (collateralized debt obligation) that generally uses credit default swaps and other derivatives to obtain its investment goals.[1] As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage (or other) products, rather than a real mortgage security.[2] The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments – as in the case of a regular or "cash" CDO—but from premiums paying for credit default swap "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
Synthetics thrived for a brief time because they were cheaper and easier to create than traditional CDOs, whose raw material—mortgages—was beginning to dry up.[3] In 2005, the synthetic CDO market in corporate bonds spread to the mortgage-backed securities market,[4] where the counterparties providing the payment stream were primarily hedge funds or investment banks hedging, or often betting that certain debt the synthetic CDO referenced – usually "tranches" of subprime home mortgages – would default. Synthetic issuance jumped from $15 billion in 2005 to $61 billion in 2006,[5] when synthetics became the dominant form of CDOs in the US,[6] valued "notionally"[7] at $5 trillion by the end of the year according to one estimate.[6]
Synthetic CDOs are controversial because of their role in the subprime mortgage crisis. They enabled large wagers to be made on the value of mortgage-related securities, which critics argued may have contributed to lower lending standards and fraud.[8]
Synthetic CDOs have been criticized for serving as a way of hiding short position of bets against the subprime mortgages from unsuspecting triple-A seeking investors,[9] and contributing to the 2007-2009 financial crisis by amplifying the subprime mortgage housing bubble.[10][11] By 2012 the total notional value of synthetics had been reduced to a couple of billion dollars.[12]
- ^ Lemke, Lins and Picard, Mortgage-Backed Securities, §5:16 (Thomson West, 2017-2018 ed.).
- ^ The Financial Crisis Inquiry Report: Final Report of the National Commission. Washington, DC: GPO. 2010. p. xxiv, 8. ISBN 9780160883590.
- ^ Cite error: The named reference
FCIR-p142-3was invoked but never defined (see the help page). - ^ McLean, Bethany and Joe Nocera, All the Devils Are Here: The Hidden History of the Financial Crisis Portfolio, Penguin, 2010, (p.264)
- ^ FINANCIAL CRISIS INQUIRY REPORT, p.191
- ^ a b Zuckerman, Gregory, The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, Broadway Books, 2009, p.176
- ^ the total of the underlying debt of synthetics on which investors were betting
- ^ NYT-Banks Bundled Bad Debt, Bet Against It, and Won|Gretchen Morgenson| December 24, 2009
- ^ Quote: "the other side of the bet wasn't someone who had investigated the mortgage-backed security – like Burry and Redleaf did – and thought they were betting on its performance. It was someone who was buying a [triple A] rating and thought he couldn't lose money" (p.266) McLean and Nocera, All the Devils Are Here 2010
- ^ Quote: the synthetic CDOs "turned that keg of dynamite [subprime loans] into the financial equivalent of a nuclear bomb", (p.263) McLean and Nocera, All the Devils Are Here 2010
- ^ quote="The losses were magnified by derivatives such as synthetic securities" p.xvi FINANCIAL CRISIS INQUIRY REPORT
- ^ Gongloff, Mark (20 March 2013). "Synthetic CDOs Return To Wall Street, What Could Possibly Go Wrong?". 03/21/2013. huffingtonpost.com. Retrieved 4 September 2013.
Synthetic CDOs on about $2 billion in debt were sold last year, Bloomberg writes, citing Citigroup data, and CDOs on another $1 billion have been sold so far this year.