Synthetic Balance Sheet CDOs
The first synthetic CDOs were initiated by U.S. and European banks in 1997 for balance sheet purposes. The motivation was to achieve regulatory capital relief without forcing the banks to sell loans they had originated. Instead, synthetic balance sheet CDOs allowed sponsoring banks to purchase credit protection on loans they continued to own, which reduced banks' credit risk and required capital.
A synthetic CDO's ability to delink the credit risk of an asset from the ownership of an asset affords banks substantial flexibility in balance sheet management. In this chapter, we look at synthetic balance sheet CDOs, focusing on their structure, capital efficiencies, and funding benefits. We highlight the difference between fully funded and partially funded synthetic balance sheet CDOs. We begin by summarizing the problems associated with cash balance sheet collateralized loan obligations (CLOs).
CASH CLOs FOR BALANCE SHEET MANAGEMENT
Cash (as opposed to synthetic) balance sheet CLOs were the first CDOs to address the balance sheet management needs of commercial banks. In a cash CLO, a bank sells a pool of loans to a special purpose vehicle (SPV, more commonly referred to simply as “the CLO”).
A bank gains a huge capital advantage by using a balance sheet CLO. If a bank holds loans directly in portfolio, it must hold risk-based capital equal to 8% of the loans. (Loans are a 100% risk weight asset, and as bank capital must equal 8% of risk-weighted ...