Introduction to Structured Finance

CHAPTER 7

Synthetic Collateralized Debt Obligation Structures

The ongoing development of securitization technology has resulted in more complex structured finance products, as illustrated by the synthetic collateralized debt obligation (CDO). This structured credit product was introduced to meet differing needs of originators, where credit risk transfer is of more importance than funding considerations. Compared with cash CDO deals, which feature an actual transfer of ownership or true sale of the underlying assets to a separately incorporated legal entity, a synthetic securitization structure is engineered so that the credit risk of the assets is transferred by the sponsor or originator of the transaction, from itself, to the investors by means of credit derivative instruments. The originator is therefore the credit protection buyer and investors are the credit protection sellers. This credit risk transfer may be undertaken either directly or via an SPV. Using this approach, underlying or reference assets are not necessarily moved off the originator's balance sheet, so it is adopted whenever the primary objective is to achieve risk transfer rather than balance sheet funding. The synthetic structure enables removal of credit exposure without asset transfer, so it may be preferred for risk management and regulatory capital relief purposes. For banking institutions, it also enables loan risk to be transferred without selling the loans themselves, thereby allowing customer relationships ...