Question about Synthetic MBS CDOs?

Question by Michael T: Query about Synthetic MBS CDOs?
After investigating the issues with toxic assets, it seems that most of the major troubles occurred with synthetic mbs cdos. The reason that it seems that the main dilemma exists with synthetic mbs cdos is that final summer Merrill Lynch sold $ 30 billion worth of super senior tranches for $ five.five billion or 22 cents on the dollar. Merrill Lynch also financed $ four billion of the deal.

A super senior tranche is element of a synthetic cdo and not component of a regular cdo so it seems that the dilemma lies with the synthetic cdo.

Apparently the difficulty with synthetic cdos is that the super senior tranche is unfunded/unhedged. After reading numerous articles about synthetic cdos, I nevertheless do not really realize what exactly is in a synthetic cdo.

Can any individual clarify what is specifically contained in a synthetic cdo and how this is advantageous to each the seller and purchaser of the cdo?

The following are a handful of articles explaining the synthetic cdo.

http://www.portfolio.com/views/blogs/industry-movers/2008/12/01/whats-a-super-senior-tranche?tid=correct

http://www.tavakolistructuredfinance.com/ifr2.html

http://en.wikipedia.org/wiki/Collateralized_debt_obligation
Mark,
I sort of realize the whole thing except for the reality that the super senior tranche is unfunded/unhedged but the junior tranches are totally funded/hedged. As a result the articles indicate that there is not any key difficulties with the quite risky junior tranches.

So I don’t understand where is the money that is supposed to fund/hedge the senior tranche. Normally this cash is utilized to arbitrage the difference paid compared to what is received by the bank in a synthetic bond. If a default occurs, this money is normally utilized to spend off the owners of the insurance coverage.

Does a synthetic CDO not perform arbitrage and is only insures the danger against default and does not in fact spend the interest of the uinderlying bonds like a synthetic bond?
Mark,

If you liked these articles, you will possibly like these articles. The second link explains CDO squared securities in plain English.

http://www.smartcompany.com.au/Free of charge-Articles/The-Briefing/20081119-The-CDO-timebomb–how-it-works-and-why-it-could-sink-or-save-the-globe-economy-Kohler.html

http://www.math.utexas.edu/customers/zariphop/pdfs/ProtterTheFinancialMeltdown.pdf

Very best answer:

Answer by Mark L
These are wonderful articles and I discovered a lot about this topic.

To answer your query, this is how I see it. In the synthetic CDO, the assets or collateral are promises to spend from other parties. As the wikipedia article states, the CDO is a credit default seller, meaning it receives payment from some other celebration to insure the bet that that celebration created on a group of assets (let’s contact that third party, the CDS purchaser). The CDS buyer could be an owner of asset backed securities that it wishes to get insurance coverage on against default. The CDS buyer buys this insurance coverage from the synthetic CDO (it makes use of element of the principal and interest on the asset backed bonds that it owns to fund these payments to the CDO). The synthetic CDO gets the periodic payments from the CDS buyer which it gets to hold and reinvest until there is a default on the portfolio that is owned by the CDS purchaser. The CDO now is collecting a stream of cash payments (very comparable to the a cash stream from mortgage backed securities). The CDO can now structure those cash payments and sell interests in them like a standard securitization. The CDO arranger-seller sells the decrease rated securities in this CDO to hedge fund investors while retaining the most senior piece (the super senior piece) and almost certainly gives the funding for the hedge funds to buy these products (thereby earning interest and costs).

This sort of deal most likely worked because the hedge fund buyers got a much better deal on these securities than on similarly rated ones, plus they got financing to get these securities probably at good prices, plus it probably supplied a hedge (or so they believed) on some other asset that they owned. The CDO arranger-seller got costs and also benefited by offloading most of the threat that it would have to pay out on the insurance provided to the CDS buyer, whilst nonetheless sustaining an interest in the cashflow stream. Given that there was no marketplace for this super senior piece, it got to make up the cost for what it carried this asset at on its books at a level greater than what a typical AAA piece would go for.

Everything is hunky dory till the very first defaults occur in the pool of assets initially bought by the CDS purchaser. Then the CDS purchaser comes calling on the CDO for its insurance coverage payment. The hedge funds that bought the junior pieces quit getting their cashflow since the CDO now has to spend the insurance coverage premium cashflow back to the CDS buyer instead of paying it via to the securities issued by the CDO. The hedge fund purchasers bonds drop in value, which cause them to default on their borrowings to the CDO arranger seller. The CDO arranger seller then has to create down the worth of that loan it made to the hedge fund, and given that it ends up with the junior securities formerly sold to the hedge fund (when the hedge fund defaults), it possibly continues to take writedowns on these. The CDO arranger seller now has a larger obligation on the CDS insurance coverage to pay than the cashflow coming in so its super senior tranches also get written down as the losses on the insured pool owned by the CDS buyer continue to grow. I suspect the provider of credit default insurance (the CDO in this case), upon paying off the insurance claim, gets the asset that it insured (comparable to your auto insurance coverage organization receiving your crashed auto following you total it) which they can then use to mitigate the claim that they paid out. But in this case, the losses have been probably much worse than predicted (and priced for). If the asset backed deal included pay selection ARM mortgage loans that permitted borrowers to defer their payments till their balance equaled 125% of the home worth, then the losses possibly multiplied.

So what you have is the mispricing of insurance in at least 3 compounding ways. The losses on the underlying pools had been higher and much more widespread. The CDS premiums had been not high sufficient to compensate for the loss potential and loss quantity on the asset-backed securities and the CDS arranger mispriced the worth of its super senior considering that the losses worked their way up to hit it.

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Can someone please explain what synthethic CDO’s are?

Question by Alex G: Can someone please explain what synthethic CDO’s are?
It’s for my project on the Great Recession. I understand the tranches & securitization process behind regular CDO’s so you don’t have to start at the beginning. Thanks so much

Best answer:

Answer by Mike
Synthetic CDOs are just side bets on mortgages. Typically they have a similar structure as regular CDO except the “senior” tranche is called the “super senior” tranche”. Typically a synthetic CDO is comprised of mortgages from other CDOs. Sometimes the synthetic CDOs are packaged with only the lower tranches of another CDO which then may be known as “CDO squared”.

Typically a synthetic CDO is protected by “credit default swaps” but seldom is the “super senior” tranche protected. It was assumed that since the “super senior” tranche was rated AAA, that tranche would not default but with all the manipulation, it was guaranteed to default.

Most of the problems during the credit crisis were caused by the synthetic CDOs and not the regular CDOs. The “super senior” tranches were the ones that were selling for 20 cents on the dollar (if they could find buyers).

http://www.tavakolistructuredfinance.com/ifr2.html
http://clickbroker.blogspot.com/2008/04/super-seniors-take-control-of-cdos.html
http://www.math.utexas.edu/users/zariphop/pdfs/ProtterTheFinancialMeltdown.pdf
http://www.portfolio.com/views/blogs/market-movers/2008/12/01/whats-a-super-senior-tranche?tid=true
http://www.nakedcapitalism.com/2008/04/merrills-reckless-mortgage-bond-binge.html
http://www.roubini.com/financemarkets-monitor/253166/is_merrill___s_cdo_transaction_with_lone_star_consistent_with_markit_abx_pricing_

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Can someone explain Securitizations and CDOs and how they contributed to the economic collapse?

Question by Charlie: Can someone explain Securitizations and CDOs and how they contributed to the economic collapse?
I’m writing a research paper and I can’t get a grasp of HOW these aided in the collapse of companies.

Best answer:

Answer by LouBee
It made it easy to unload toxic loans on unknowing investors.

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