Learning outcome (LO 54.3, 2007 FRM)

• Describe the difference between a cash and synthetic CDO

Synthetic CDO assumes default risk by selling credit protection

Previously, I introduced the cash collateralized debt obligation (cash CDO). Next, the FRM candidate is asked to understand the synthetic CDO. The assigned reading and the source, again, is Gunter Meissner's Credit Derivatives.

In regard to a cash CDOs, we located the originator on the left and the investors on the right. The cash CDO is largely motivated by the originator: in selling assets to the SPV, the originator receives cash, shrinks the balance sheet and transfers credit (default) risk to investors. On the other hand, we could say the synthetic CDO is motivated by investors. Unlike the cash CDO, the credit-sensitive assets are not sold. As Meissner says, "the difference between the cash CDO and the synthetic CDO lies in the fact that the SPV in a synthetic CDO does not acquire the original assets in a standard cash transaction, but gains long exposure to the assets via selling credit protection." To illustrate:

Note the following:

• As with the cash CDO, investors (above right) purchase securities with cash, in tranches according to their risk/return appetites. Unlike the cash CDO (where the cash was effectively directed to the originator to buy the credit-sensitive assets), the cash is invested by the trustee in high quality assets (blue box at bottom). This cash purchase is represented by the green line above: investor cash effectively purchases safe assets. The safe assets will payback a safe coupon but those coupon will be enhanced by the CDS premiums paid by the originator (see below)
• Instead of purchasing credit sensitive assets (as with a cash CDO), the SPV synthetically gains credit exposure by selling credit protection (i.e., default insurance) to the asset owner. That is, the asset owner purchases credit default swaps (CDS) from the SPV. As Meissner says, "the assets do not appear on the balance sheet of the SPV."
• In regard to credit risk, the asset owner is in a similar position to the cash CDO. Instead of selling the assets to "insure" against defaults, the originator will "exercise" the credit default swaps (CDS)
• As with the cash CDO, the investors earn above-market yields, and similarly they bear the default risk. The "cash flow waterfall" (the priority of cash flow distributions from the coupons paid by the safe asset) goes first to compensate the originator for defaults and so they have a risky (residual) cash flow participation
• However, unless the synthetic CDO is fully-funded (rarely the case), the collateral "held" by the SPV in the safe asset is less than (probably much less than) the total credit-sensitive asset exposure. So, some of the originator's exposure will be funded (covered by collateral) but much is likely unfunded (bears counterparty risk)
• The blue line and the red line above illustrate the cash flow waterfall. The "cash inflow" is the cash paid by investors combined with the CDS premium paid by the originator. The "cash outflows" are: first, to pay for the originator for defaults. Second, to pay the investor securities.

The two differences

We see that much is similar between a cash and synthetic CDO. In both, investors earn above-market yields to essentially bear the credit risk on the credit-sensitive assets owned by the originator. But some differences:

• In a synthetic CDO, the assets do not leave to balance sheet and go to the SPV. The SPV bears default risk not because it owns the assets, but instead because it sells credit protection
• Because the assets don't leave the originator's balance sheet, in a synthetic CDO says Meissner, the SPV has no operational risk with respect to those assets. If there are operational risks related to collecting the coupon payments, the originator worries about them. But in a cash CDO, the SPV who owns the assets must bear these operational risks

Comments

1. fullofquestions 30 Oct 2009

   Is the asset owner usually the same as the originator? Why are both terms used as opposed to just one (for simplification purposes)?

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