What is a synthetic CDO?
A synthetic CDO is a type of collateralised debt obligation that invests in credit derivatives such as options and swaps. It differs from a standard CDO, which is backed by assets such as bonds and loans.
Where have you heard about synthetic CDOs?
They were popular in the US prior to the financial crisis. According to the US government, banks sold $61 billion worth of synthetic CDOs in 2006 at the height of the credit bubble, but they crashed and burned during the global meltdown.
What you need to know about synthetic CDOs.
Synthetic CDOs are seen as a way of generating income from non-cash derivatives. Like other CDOs, they’re usually split into credit trenches based on how risky they are. The payments come from the cash flow associated with credit default swap premiums. In instances where there isn't enough cash to pay all the CDO investors, those in the lowest tranches are the first to lose out.
The potential for profits by investing in synthetic CDOs is very high, but investors in them take on all liability for any payment defaults.