Quick Q re:advantage of a synthetic CDO

[lylcheng88]

Hey guys,

I noted that one of the advantages of creating a synthetic CDO as opposed to a CF CDO is that the senior section doesn’t require funding - what does this really mean?

Thanks in advance

[JJ1337]

As you correctly noted, in a synthetic CDO only junior debt obligations are issued (by the SPV). Further, the proceeds from the junior noteholders are invested in high-quality bonds.

At the same time, the asset manager buys an insurance against credit risk (a CDS) of the reference asset from the SPV. Hence, the junior noteholders receive interest from high-quality bonds as well as the insurance premium.

That’s all? Yes, until a credit event may occur. In such a case, the junior noteholders have to pay the “insurance” to the asset manager (typically the difference between par and fair value of the reference asset).

So, there is no need to fund a senior section.

[lylcheng88]

@JJ1337

As you correctly noted, in a synthetic CDO only junior debt obligations are issued (by the SPV). Further, the proceeds from the junior noteholders are invested in high-quality bonds.

At the same time, the asset manager buys an insurance against credit risk (a CDS) of the reference asset from the SPV. Hence, the junior noteholders receive interest from high-quality bonds as well as the insurance premium.

That’s all? Yes, until a credit event may occur. In such a case, the junior noteholders have to pay the “insurance” to the asset manager (typically the difference between par and fair value of the reference asset).

So, there is no need to fund a senior section.

Thanks for this explanation. I think my question is more around the comparison between a synthetic CDO vs. a cash CDO. Perhaps I should reword it this way, why is there a need to fund a senior section for a cash CDO?

[RoundhouseKick]

Synthetic CDO allows the risk/rewards to the underling assets without actually owning the assets within the pool, as is the case in an actual CDO.

[ro424]

This thread may be helpful: http://www.analystforum.com/comment/91495471#comment-91495471

[JJ1337]

I cannot explain it very well. So, has anybody a short answer (with practical orientation), who/what absorbs the losses on the senior section. Maybe that helps lylcheng88.

[C0re]

In short -

Cash CDO buys assets that need actual cash payment to buy them - example bonds, loans. So to buy 300mm assets you need 300mm cash (assuming everything at par) and on the back of this you issue 300mm liabilities (composed of senior and junior). Hence you need the senior bondholders and junior bondholders to provide the funding upfront so you can buy assets

Synthetic CDOs would “invest” in unfunded instruments like CDSs for which you may not need any upfront cash (as it is a swap). As a result you can have liabilities that are not funded (theoretically none or very little may be funded). Usually junior liabilites of a synthetic CDO are funded as you may need ready access to cash while senior liabilities are kept unfunded and are asked to be funded if needed.

[lylcheng88]

@C0re

In short -

Cash CDO buys assets that need actual cash payment to buy them - example bonds, loans. So to buy 300mm assets you need 300mm cash (assuming everything at par) and on the back of this you issue 300mm liabilities (composed of senior and junior). Hence you need the senior bondholders and junior bondholders to provide the funding upfront so you can buy assets

Synthetic CDOs would “invest” in unfunded instruments like CDSs for which you may not need any upfront cash (as it is a swap). As a result you can have liabilities that are not funded (theoretically none or very little may be funded). Usually junior liabilites of a synthetic CDO are funded as you may need ready access to cash while senior liabilities are kept unfunded and are asked to be funded if needed.

thanks a lot! This makes a lot of sense!

[JJ1337]

Great.