Collateralized Debt Obligations: Structures and Analysis, Second Edition

CHAPTER 13

Synthetic Arbitrage CDOs

In this chapter, we discuss synthetic arbitrage CDOs. As explained in detail in Chapter 11, a synthetic CDO does not actually own the portfolio of assets on which it bears credit risk. Instead, it gains credit exposure by selling protection via credit default swaps. In turn, the synthetic CDO buys protection from investors via the tranches it issues. These tranches are responsible for credit losses in the reference portfolio that rise above a particular attachment point; each tranche's liability ends at a particular detachment or exhaustion point. Unlike balance sheet synthetic CDOs discussed in Chapter 12, the motivation in an arbitrage synthetic CDO is investors' desire to assume tranched credit risk in return for spread.

Issuance of synthetic arbitrage CDOs got under way in earnest in 2000, but exploded the next year to about $60 billion, including both funded and unfunded tranches. By 2005, synthetic arbitrage issuance was over $500 billion, if one counts in the standard tranches of credit default swap indices.

Synthetic arbitrage CDOs come in the following forms:

• The oldest are full-capital structure CDOs that include a full complement of tranches from super senior to equity. These CDOs have either static reference portfolios or a manager who actively trades the under-lying portfolio of credit default swaps (CDS).
• Single-tranche CDOs are newer, and are made possible by dealers' faith in their ability to hedge the risk of a CDO tranche through ...