Cash versus Synthetic Arbitrage CDOs
The chief cause of the phenomenal growth in the CDO market through most of 2007 was the use of synthetics in both arbitrage and balance-sheet CDO structures. Other reasons include new structures, regulatory capital arbitrage, economic effects, and organizational idiosyncrasies. Exploitation of these features also led to the downfall of the market and the rapid decline of new issuance in 2008. This technology is still in use, but usually without cash flow diversions that can deceive naïve investors. Let’s examine some of the features of cash and synthetic securitizations by comparing and contrasting the peculiarities of a managed cash arbitrage CDO and a managed synthetic arbitrage CDO during every step of deal creation.
COMPARISON OF MANAGED ARBITRAGE CDO FEATURES: CASH VERSUS SYNTHETIC DEALS
Both deals are cash flow deals. This means that the assets themselves, not the total return generated from active management of the portfolio, are the primary source of repayment of the liabilities. The liabilities are the deal expenses and tranche payments.
We’ll discuss balance sheet CDOs and special regulatory considerations later. I start with the arbitrage CDO market since most of the key economic considerations are exemplified by this comparison. This initial comparison of cash and synthetic arbitrage CDOs uses senior unsecured bonds and generic credit derivatives as assets, respectively. I choose to use this comparison because most people ...