A synthetic CDO is really an insurance contract ? not an investment.
The ?investor? deposits a sum of money with an issuing company that typically has an issued capital of $1, and is not actually owned by the bank or investment bank promoting it.
According to the paperwork, the issuing company is ?connected? to the bank, but in reality the shares in the issuing company are typically held ?in trust for selected charities? which are not disclosed, and the prospectuses usually specifically state that the issuer is not a subsidiary of the bank or investment bank.
The twist in a synthetic CDO prospectus is that it includes a list of several dozen companies. If a certain number of these companies go into default, then the investor in the CDO loses all of its money.
There is no actual connection between the investor?s money and the companies listed ? it is merely a theoretical exercise that raises the risk level of the investment and provides the issuing bank with ?insurance? in the event of corporate defaults.
An Ozzie lawyer shows how it works:
In September 2003, Hy-FI Securities Ltd issued a prospectus for what it called high-yield fixed-interest securities. The prospectus offered $40 million of ?series 3? securities and $30 million of ?series 4?. The offer was so successful that investors put $58 million into Series
3 and $7 million into Series 4.The money was then placed on deposit with ABN Amro, which undertook to pay the 90 day bank bill rate to the issuer (HY FI Securities). The issuer then undertook to pay the investors the 90 day bank bill rate plus 1.35 per cent.
So where did that extra payment come from?
In relation to Series 3, a ?portfolio size? of $1.6 billion was artificially constructed on the $40 million proposed investment and 70 companies were listed in the prospectus as the synthetic ?investments?. Each company was to be allocated $22.9 million.
The companies listed includes the monoline insurer MBIA Inc, XL Capital Ltd, Radian Group Inc, PMI Group Inc ? in other words companies that have now become notoriously exposed to the sub-prime crisis.
The rating agencies, Moody?s and Standard & Poor?s, gave these securities high ratings as long as the companies listed were ?diversified?. It is this behaviour by the rating agencies that has become so controversial, since in many cases they advised the issuers on how to construct the CDOs to get the highest rastings.
In the event, because of the over-subscription to Series 3, each company on the HY FI list was ?allocated? $33.1 million, and a ?protection amount? ? a sort of buffer for investors ? was set at $1
29 million.If one of the 70 companies on the list defaulted on its debt obligations during the five years of the agreement, the protection value would be reduced by the amount allocated to that company ($33.1 million).
After four such defaults, the reductions start to eat into the investors? principal. After six defaults the investors? money is all gone.
According to McLernon?s paper, it is in return for carrying this risk that the investors get 1.35 per cent over the 90 day bank bill rate ? that is, $783,000 per annum, at most.
These so-called ?fixed interest? synthetic CDO products are extremely widespread, and not just in Australia, and the companies whose defaults would trigger a loss of capital in them are front and centre in the sub-prime crisis in the United States.
The issuing banks are paying a premium over the bank bill rate to gain a form of insurance in the event of defaults ? to spread the risk among other investors.
The investors on the other hand are receiving what is arguably a low fixed interest type of return for taking an equity risk ? that is, the risk of losing all of their money.