Synthetic CDO

A synthetic CDO (collateralized debt obligation) is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. 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. 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 that some defined set of "reference" securities — based on cash assets — will default. 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. In 2005 the synthetic CDO market in corporate bonds spread to the mortgage-backed securities market, 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, when synthetics became the dominant form of CDO's in the US, valued "notionally" at $5 trillion by the end of the year according to one estimate.

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.

Synthetic CDOs have been criticized as serving as a way of hiding short position of bets against the subprime mortgages from unsuspecting triple-A seeking investors, and contributing to the 2007-2009 financial crisis by amplifying the subprime mortgage housing bubble. By 2012 the total notional value of synthetics had been reduced to a couple of billion dollars.

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