What Is a Synthetic CDO?

Synthetic CDO is a form of CDO based on credit default swaps (CDS, Credit Default Swap).

Synthetic CDO

The schematic diagram of the synthetic CDO is shown in the figure, and its construction process generally includes the following steps:

First, the issuing bank purchases a CDS from the SPV through direct or indirect transactions. The issuing bank acts as the buyer and regularly pays the SPV as the seller, while also transferring the credit risk of the asset portfolio to the SPV;

Second, SPV issues CDO securities at all levels based on the signed CDS contract. CDO securities are classified into several levels according to their credit ratings. Senior notes are generally AAA, AA, or A credit ratings, and are generally fixed or floating rate. The highest priority is to obtain a medium-sized note (MezzanineNotes) will generally have a BBB to B credit rating, and it will also have a fixed or floating interest rate. It has a lower priority in obtaining cash flow than a senior note. There are also some of the worst subordinated notes in the CDO. These are assets with a loss priority in the CDO. Its dividend may be postponed or cancelled directly according to the cash flow situation. The cash flow in the CDO must first meet the senior level. Dividend requirements for notes and intermediate notes;

Third, SPV sells the above-mentioned securities at various levels to institutional investors;

Fourth, SPV will invest the proceeds from the sale of CDO securities and invest in a separate Collateral Asset Pool. All assets in the asset pool are AAA risk-free assets.

Fifth, if no default event occurs in the reference entity, SPV will use CDS premiums and cash flows generated by the mortgage asset pool to pay interest to securities investors; if a default event occurs in the reference entity, SPV will use the mortgage asset pool's Income, or use the income from the sale of risk-free assets in the mortgage asset pool to compensate the promoters;

Sixth, when the term of CDO securities expires, SPV sells all assets in the mortgage asset pool and pays the principal to investors.