what is a synthetic cdo?

What Is A Synthetic CDO?

Here it is, more Wall Street lingo that does nothing but confuses people. At first glance, the word synthetic CDO might not mean anything to you.

Unfortunately, however, this term holds much more relevance in the financial world today than does anything even the chairman of the Federal Reserve can spew.

Why do you ask? Well, it’s because the synthetic CDO was the lead cause of the 2007-2008 financial crisis.

Though not the only cause of the financial crisis, synthetic CDOs played a huge role in amplifying an already fragile market and sinking many Americans into debt and poverty.

So without further ado, let’s discuss exactly why a Synthetic CDO is relevant, and how it helped cause the financial crisis of 2007.

What Is A CDO?

I’m first going to lay the groundwork for what a regular CDO is.

Think of a synthetic CDO as a CDOs twin brother that went bad. CDOs are defined as a collateralized debt obligation or an asset that is supposed to create cash flow from debt obligations like mortgages.

Think of it as a pool of money gathered by investors to make more money off of the debt obligations of others.

Since CDOs allowed for more lenient lending requirements due to their ability to generate large sums of cash flow. It’s like a win, win, and a win scenario.

A synthetic cdo diagram

As seen above, the main source of the CDO cash flow comes from mortgage loan payments. Tranches are what they call the categorized payents. Tranches are like the meat and potatoes of the CDO.

It’s like biting into a sandwich, the bread tastes good but everyone wants what’s in the middle.

The riskiest is the B tranches, these loans are the most likely to fail from lack of payment. They can also be the most profitable since they have a higher yield than AAA tranches.

The highlighted columns above represent the lower-tier tranches that have failed to pay up in the long run.

The AAA payments have less yield but are pretty much guaranteed to receive its payment.

The CDO is the sum amount of all these payments. CDOs basically acts as a replacement for the revenue lost from the failed lower-rated tranches.

CDO Squared

So if you’re thinking “yeah that’s great and all..but..why is this important again?” Well, it’s because these things were like the toxic plague of the financial world.

You all know how the plague spread right? It was rats that were spreading the virus from European ships. Well, CDOs really aren’t much different.

These things were infected with faulty mortgage payments that, with time, were destined to capitulate.

The different banks that were buying into theses were all infected with faulty collateralized debt obligations that were being backed by irresponsible subprime mortgage loans.

The CDO squared is something even more interesting. CDO squared, as ridiculous as it sounds, is a compilation of CDOs.

Instead of being backed directly by debt obligations such as bonds and mortgages, CDO squared is backed by the tranches of the CDOs.

What this means is that by investing in a CDO squared you can diversify your risk with different kinds of mortgages and credit instruments.

The CDO squared diagram

CDO cubed is even more complex acting as a CDO backed by CDO squared tranches.

A derivative of a derivative is a catchy way to think of a CDO cubed. If you’ve taken calculus before this concept might sound familiar to you.

The diversification of CDO squared and CDOs offers tremendous low risk with high return for the investor. CDO cubed is not where the insanity of this mortgage investment stops.

CDO to the nth power is backed by the tranches of CDO cubed, decreasing the risk to the investor even more.

At this point, there is an infinite amount of CDOs together with tranches from CDO cubed, CDO squared, CDOs, and at the root, faulty mortgage loans.

Credit Default Swaps

I bet, after all of that, you just wanna know what a synthetic CDO is now right? Well hold on there tiger, there’s still something important missing here, and that is the credit default swaps or CDS.

A credit default swap is a wonderful tool for you to use when you’re in a pickle.

It’s a contract that allows you to essentially swap a defaulted loan with a reimbursed CDS from another investor. These really are great, I mean you could invest into something and not have to worry about it going bust.

They do cost a fee to maintain though, basically making them an insurance policy on your investment.

So what does this all have to do with CDOs and the financial crisis of 2008? Well, if you put a CDO and a CDS together you essentially get a synthetic CDO

At Last, What Is A Synthetic CDO?

Here we go, we are ready to discuss the evil twin of the CDO family tree, the synthetic CDO. A synthetic CDO is a CDO that is backed by a credit default swap and not a debt obligation like a mortgage.

Think of the swaps as a shield for the investor, limiting their general risk associated with the CDO. These things offered tremendous returns for anyone that purchased them prior to the 2008 financial crisis.

However, even if these do sound like an amazing alternative to CDOs, investors are still liable for any payment defaults.

This normally wouldn’t be an issue as long as the majority of Americans were paying their mortgages on time. The problem begins with the leniency of the subprime mortgage loans.

When you play monopoly, you must own pieces of property before you buy a house so you can prove to the bank that you’re good for it.

It didn’t matter if you didn’t qualify for a mortgage, the banks still gave them to you. The conditions became so lenient that people without any source of income were qualifying for loans.

Clearly, the rules of monopoly didn’t apply here.

When it came to fruition that CDOs, synthetic CDOs, and CDO squared’s were all full of junk bonds that were unpayable; the entire housing market collapsed.

In 2007, the prices of an overheated housing market began to fall, this triggered major defaults on subprime mortgage bonds. Imagine the price of your home skyrocketing for a decade and then suddenly plummeting out of nowhere.

Combine that with the majority of borrowers that benefited off lenient loans and inflated housing prices, and you got a bad situation on your hands.

The number of people defaulting was insane.

For the housing market, the synthetic CDO financial crisis was here. The economy of the United States was about to take a nose dive down for the next few years.

Conclusion

So what makes these things so important today? Surely Wall Street must have corrected their mistakes and pledged to never make them again right? Well, not exactly.

Wall Street has definitely become more responsible since 2008 to prevent another market collapse. But CDOs are still in use today by hedge funds and other banks looking to make a profit.

This doesn’t mean that they will cause another market collapse though, mortgage loans are much more strict than before 2007.

A more secure and responsible housing market is backing the new CDOs. Yet, this doesn’t mean that you shouldn’t be skeptical. After all, it was peoples negligence that let the housing market bubble to burst.

The lesson here is that when something seems too good to be true, it probably is.

Hi, I'm Alex a freelance writer and blogger. I have been writing about finance for a little over a year now. I Really enjoy reading and writing about finance, it is one of those topics that inspires me to do better and achieve greatness.

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