Question about Synthetic MBS CDOs?

Question about Synthetic MBS CDOs?

After investigating the problems with toxic assets, it appears that most of the major problems occurred with synthetic mbs cdos. The reason that it appears that the major problem exists with synthetic mbs cdos is that last summer Merrill Lynch sold $30 billion worth of super senior tranches for $5.5 billion or 22 cents on the dollar. Merrill Lynch also financed $4 billion of the deal.A super senior tranche is part of a synthetic cdo and not part of a standard cdo so it appears that the problem lies with the synthetic cdo.Apparently the problem with synthetic cdos is that the super senior tranche is unfunded/unhedged. After reading many articles about synthetic cdos, I still don'-t quite understand what exactly is in a synthetic cdo.Can anyone explain what is exactly contained in a synthetic cdo and how this is advantageous to both the seller and purchaser of the cdo?The following are a few articles explaining the synthetic cdo.http://www.portfolio.com/views/blogs/mar…http://www.tavakolistructuredfinance.com…http://en.wikipedia.org/wiki/Collaterali…

Mark

These are great articles and I learned a lot about this topic.To answer your question, this is how I see it. In the synthetic CDO, the assets or collateral are promises to pay from other parties. As the wikipedia article states, the CDO is a credit default seller, meaning it receives payment from some other party to insure the bet that that party made on a group of assets (let's call that third party, the CDS buyer). The CDS buyer may be an owner of asset backed securities that it wishes to buy insurance on against default. The CDS buyer buys this insurance from the synthetic CDO (it uses part of the principal and interest on the asset backed bonds that it owns to fund these payments to the CDO). The synthetic CDO gets the periodic payments from the CDS buyer which it gets to keep and reinvest until there is a default on the portfolio that is owned by the CDS buyer. The CDO now is collecting a stream of cash payments (very similar to the a cash stream from mortgage backed securities). The CDO can now structure those cash payments and sell interests in them like a normal securitization. The CDO arranger-seller sells the lower rated securities in this CDO to hedge fund investors while retaining the most senior piece (the super senior piece) and probably provides the funding for the hedge funds to buy these products (thereby earning interest and fees).This type of deal probably worked because the hedge fund buyers got a better deal on these securities than on similarly rated ones, plus they got financing to buy these securities probably at good rates, plus it probably provided a hedge (or so they thought) on some other asset that they owned. The CDO arranger-seller got fees and also benefited by offloading most of the risk that it would have to pay out on the insurance provided to the CDS buyer, while still maintaining an interest in the cashflow stream. Since there was no market for this super senior piece, it got to make up the price for what it carried this asset at on its books at a level higher than what a normal AAA piece would go for.Everything is hunky dory until the first defaults occur in the pool of assets originally purchased by the CDS buyer. Then the CDS buyer comes calling on the CDO for its insurance payment. The hedge funds that bought the junior pieces stop getting their cashflow because the CDO now has to pay the insurance premium cashflow back to the CDS buyer instead of paying it through to the securities issued by the CDO. The hedge fund buyers bonds drop in value, which cause them to default on their borrowings to the CDO arranger seller. The CDO arranger seller then has to write down the value of that loan it made to the hedge fund, and since it ends up with the junior securities formerly sold to the hedge fund (when the hedge fund defaults), it probably continues to take writedowns on those. The CDO arranger seller now has a bigger obligation on the CDS insurance to pay than the cashflow coming in so its super senior tranches also get written down as the losses on the insured pool owned by the CDS buyer continue to grow. I suspect the provider of credit default insurance (the CDO in this case), upon paying off the insurance claim, gets the asset that it insured (similar to your auto insurance company getting your crashed car after you total it) which they can then use to mitigate the claim that they paid out. But in this case, the losses were probably much worse than predicted (and priced for). If the asset backed deal included pay option ARM mortgage loans that allowed borrowers to defer their payments until their balance equaled 125% of the home value, then the losses probably multiplied.So what you have is the mispricing of insurance in at least three compounding ways. The losses on the underlying pools were greater and more widespread. The CDS premiums were not high enough to compensate for the loss potential and loss amount on the asset-backed securities and the CDS arranger mispriced the value of its super senior since the losses worked their way up to hit it.

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