cash vs synthetic CDO

[atkinsmt]

I don't recall, but did the readings suggest why you would want one vs the other, or just how one could substitute for the other?

[gaddy]

I believe a synthetic CDO generally means that no bonds are actually held. One example (I can't think of others, but I haven't really tried too hard) is that instead of purchasing bonds, the SPV just holds the investors' cash and sells credit protection to oher interested parties (CDS contracts). Then the spread payments from those CDS contracts are used as "bond payments" to the investors of the CDO, and when the contracts are up the SPV returns the principal. Also, when defaults occur, they are funded using the CDO investors' pool of cash that the SPV is holding.

In some ways I find the names to be a bit ironic, as in a cash CDO you really hold bonds but in a synthetic you hold cash. But, to the investors, there is little difference. They probably wouldn't even notice a difference I don't think. It only changes names based on what the SPV holds.

[gaddy]

PS, I realize that really didn't answer your question. But, I would say the answer is no. The investors should not care which they invest in, and I see little reason why you'd try to trade/swap one for the other.

One final piece, which I don't think is discussed but is probably implied somewhere, is that for these to be essentially equal, in the synthetic case the SPV would have to invest in risk-free assets and add the risk-free coupons to the spread payments. Probably obvious to most, but that hit me after thinking a bit more on this.

[atkinsmt]

Originally Posted by gaddy

and add the risk-free coupons to the spread payments.

I don't follow what you're saying here.

[gaddy]

Originally Posted by atkinsmt

I don't follow what you're saying here.

It's not that important. I was thinking about your question--really how do they differ? If you assume the CDS's were bought on the same bonds that otherwise would have been purchased, then those investors would be exposed to the same risk but the spread payment would be less than the bond payment right? A CDS ultimately takes a risky bond and reduces its return to the risk-free rate. If the investors in the synthetic CDO are to be compensated just as if they had invested in the bonds themselves, then the SPV would have to also generate the risk-free return to add to the CDS spread payments that it allocates off to the trances of the CDO.

Lengthy answer, but it's really quite simple. It just helped me to think it through to really grasp what's happening in a CDS vs. a regular bond, and thus the difference between cash and synthetic CDOs.

Did that answer it?

[Mosaic]

I think, to answer your question, is that there is a limit of investment-grade bonds out there, so creating a synthetic one via credit default swaps allowed more investment to occur without underlying assets. I think of this as akin to the moment that you realize that there are way more dollars in the US economy than there is printed cash.

The result of these synthetic CDO's was that it compounded the mortgage crisis.

Thoughts?

[gaddy]

Originally Posted by Mosaic

I think, to answer your question, is that there is a limit of investment-grade bonds out there, so creating a synthetic one via credit default swaps allowed more investment to occur without underlying assets. I think of this as akin to the moment that you realize that there are way more dollars in the US economy than there is printed cash.

The result of these synthetic CDO's was that it compounded the mortgage crisis.

Thoughts?

I came across a GF question that got me thinking about this idea. How could there be multiple CDS on a single underlying asset? Obviously I understand "how", but two things are odd. Why would an entity pay the spread multiple times (assuming my concept of a synthetic CDO is accurate--that the SPV has to sell credit default protection)? Second, assuming they did pay multiple spreads to different SPVs/CDOs, does that mean those entities recieved several multiples of the actual value (1-R) when they defaulted? So did some entities make out crazy fat before the whole thing came crumbling down?

Goldfarb seems to imply that multiple CDOs did exist on single underlying assets, and that this should have been taken from the readings. If anyone knows a spot in the syllabus that says this please share.