LO 34.6: Describe synthetic C D O s and single-tranche C D O s.

LO 34.6: Describe synthetic C D O s and single-tranche C D O s.
In a traditional CDO, which is also called a cash CD O , the credit assets owned by the SPV are fully funded with cash, and the repayment of the obligation is tied directly to cash flow from the underlying debt instruments. There is an alternative form of CDO called a synthetic CDO, which takes a different approach. With a synthetic CDO, the originator retains the reference assets on their balance sheet, but they transfer credit risk, in the form of credit default swaps, to an SPV which then creates the tradable synthetic CDO. This process is typically used to provide credit protection for 10% of the pool of assets held on the originators balance sheet. The other 90% of the default risk is hedged with a highly- rated counterparty using a senior swap. This complex derivative is a way of betting on the default prospects of a pool of assets rather than on the assets themselves.
There is also a form of CDO that is highly customizable. This is called a single-tranche CDO. With this credit derivative, an investor is trying to earn a better spread than on comparably rated bonds by selecting a specific reference asset with customizable maturity, coupon, collateral, subordination level, and target rating. This customization feature creates open dialogue between the single-tranche CDO buyer and seller, and by default will help prevent the seller from dumping unwanted risks on the buyer without prior knowledge. One key customizable feature is the attachment point, which is the point at which default begins to be the financial responsibility of the single-tranche CDO buyer.
R a t i n g C D O s B e f o r e t h e C r e d i t C r u n c h

Write a Comment