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quickblur asked in Business & FinanceCredit · 1 decade ago

Can anyone explain in simple terms how a synthetic collateralized debt obligation works?

Can anyone explain in simple terms how a synthetic collateralized debt obligation works? I get the basics but I'm having a hard time seeing how the whole thing works start to finish.

2 Answers

  • 1 decade ago
    Favorite Answer

    Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) whose value and payments are derived from a portfolio of fixed-income underlying assets. CDOs securities are split into different risk classes, or tranches, whereby "senior" tranches are considered the safest securities. Interest and principal payments are made in order of seniority, so that junior tranches offer higher coupon payments (and interest rates) or lower prices to compensate for additional default risk.

    A few academics, analysts and investors such as Warren Buffett and the IMF's former chief economist Raghuram Rajan warned that CDOs, other ABSs and other derivatives spread risk and uncertainty about the value of the underlying assets more widely, rather than reduce risk through diversification. Following the onset of the 2007-2008 credit crunch, this view has gained substantial credibility. Credit rating agencies failed to adequately account for large risks (like a nationwide collapse of housing values) when rating CDOs and other ABSs.

    Many CDOs are valued on a mark to market basis and thus have experienced substantial write-downs on the balance sheet as their market value has collapsed.


    What Does Synthetic Collateralized Debt Obligation Mean?

    A form of collateralized debt obligation (CDO) that invests in credit default swaps (CDSs) or other non-cash assets to gain exposure to a portfolio of fixed income assets. Synthetic CDOs are typically divided into credit tranches based on the level of credit risk assumed. Initial investments into the CDO are made by the lower tranches, while the senior tranches may not have to make an initial investment.

    All tranches will receive periodic payments based on the cash flows from the credit default swaps. If a credit event occurs in the fixed income portfolio, the synthetic CDO and its investors become responsible for the losses, starting from the lowest rated tranches and working its way up.

    Investopedia Says

    Investopedia explains Synthetic Collateralized Debt Obligation

    Synthetic CDOs are a modern advance in structured finance that can offer extremely high yields to investors. However, investors can be on the hook for much more than their initial investments if several credit events occur in the reference portfolio.

    Synthetic CDOs were first created in the late 1990s as a way for large holders of commercial loans to protect their balance sheets without actually selling the loans and potentially harming client relationships. They have become increasingly popular because they tend to have shorter life spans than cash flow CDOs and there is no extended ramp-up period for earnings investment. Synthetic CDOs are also highly customizable between the underwriter and investors.


    Synthetic CDO. A collateralized debt obligation (CDO) which, instead of being backed by assets such as bonds and loans like a standard CDO, it is backed by credit derivatives. These assets could include options and forward contracts.

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  • Alice
    Lv 4
    4 years ago

    I would be happy to if you would first explain to me how it impacts upon Obamanomics and keynesian economics Collaterlized Debt Obligations are debts which are guaranteed by collateral or something of value backing or guaranteeing a loan & Credit Default Swaps are defaulted loan swaps made between lending institutions Neither has anything to do with the fact that if Obama was a CEO of a major corporation......Obama's total lack of any expertise at cost saving , spending cutbacks or balancing a budget would result in banrupting the corporation Simply put.......our community organizer President could not run a lemonade stand or paper route without being " in the red "

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