Can anyone explain to me what is Synthetic CDO with some example? like using party A(originator), B(SPV), C kind of notation?
I am not clear on who buys what? I kind of know that there is a lower quality debts and a protection but not sure who buys the protection and what happens if the default occurs?
Thanks,
Parties to Synthetic CDO:
A = Short Investor
B = Unfunded Investor
C = Funded Investor
Purpose of CDO = to create risk/return of a CDO without having to physically create one (i.e. ramp up, fundraise, etc.)
The “pool” is linked to a reference rate of some type of security, let’s call it Sub-prime mortgage securities. In exchange for the funds from Party C, the pool invest into some safe assets (i.e. AAA rated bonds) to enter into credit default swaps with party A (let’s call him Lehman Bros, who wishes to get rid of some risk on their balance sheet). The premium of the cds are paid to party B, the unfunded investors while the interest/principals from the safe assets are paid to party C, the funded investors. This Synthetic CDO, ideally, should pay out as along as there aren’t too many defaults on the referenced securities. What happens if too many defaults occur on the referenced assets? 2008.