Meet The New, “Safe” Synthetic CDO’s That Could Spell Disaster For The European Banking System

So what do you do if you’re a European banking regulator faced with the task of maintaining a safe, sustainable financial system amid a concerning growth in bank leverage.Well, if you said sell down risk assets then you’re just being silly or completely ignoring your implicit obligation to engineer higher banking profitability at all costs.

If we can get serious for a moment, like in the early 2000’s, when all else fails you turn to synthetic CDO’s which, courtesy of some magical, if completely incomprehensible, math, slashes the risk of bank balance sheets while having a negligible impact on profitability.It’s called the Synthetic Collateralized Loan Obligation and it’s all the rage in Europe.

Here’s how it works:

In a synthetic securitisation a bank buys credit protection on a portfolio of loans from an investor. This means that when a loan in the portfolio defaults, the investor reimburses the bank for the losses incurred on loans in that portfolio up to a maximum, which is the amount invested. This amount therefore provides credit protection for a slice of the portfolio, which is often called the ‘first loss tranche’. The size of this tranche is typically chosen in a way to cover at least the expected losses on the portfolio as well as a share of unexpected losses. The bank usually retains the rest of the risk, which is called the ‘senior tranche’.

Before closing, the bank and the investor agree on the terms of the transaction, such as the amount the investor is at risk for, the duration of the contract and the loans that are eligible for inclusion in the portfolio. Choosing which loans are eligible can be on a disclosed basis, where the investor knows the exact names of the borrowers of these loans, or on a blind pool basis, where the investor does not know the identities of the borrowers. In the latter case the loans are chosen based on criteria, such as the type of loans, sector, geography, credit risk, et cetera.

The term ‘synthetic’ comes from the fact that, unlike in a true sale transaction, the loans being securitised are not sold by the bank but are referenced, which means they remain on the bank’s balance sheet. This way, the bank reduces the credit risk on the securitised loans and remains in charge of managing the loans and the lending relationship with their client itself. Synthetic securitisations are often used for hedging the credit risk on loans that cannot easily be sold.