How does synthetic securitization work, and how does it differ from traditional (cash) securitization?

Question

AcadiFi · Accepted Answer

Synthetic securitization transfers credit risk without transferring ownership of the underlying assets. It uses credit derivatives — typically credit default swaps — to achieve economic risk transfer while keeping the assets on the originator's balance sheet.

**Traditional vs. Synthetic**

| Feature | Traditional (Cash) | Synthetic |
|---|---|---|
| Asset transfer | Yes — assets sold to SPV | No — assets stay on originator's B/S |
| Funding | SPV issues notes, proceeds fund asset purchase | Little or no funding (unfunded CDS) |
| Risk transfer mechanism | True sale | Credit default swaps |
| Originator's balance sheet | Assets removed | Assets remain |
| Regulatory capital relief | Yes | Yes (if risk transfer is recognized) |

**How a Synthetic CLO Works**

The originator (typically a bank) enters into CDS contracts with investors who sell protection on a reference portfolio of loans. Investors receive premium payments and bear credit losses in order of subordination.

**Worked Example — Thornfield Bank's Synthetic Securitization:**

Thornfield holds a $2 billion corporate loan portfolio. Rather than selling the loans, it enters into CDS contracts referencing the portfolio:

| Tranche | Attachment | Detachment | Notional | Funded? |
|---|---|---|---|---|
| Super senior | 12% | 100% | $1,760M | Unfunded (bank retains or buys protection from dealer) |
| Senior | 7% | 12% | $100M | Funded (notes issued) |
| Mezzanine | 3% | 7% | $80M | Funded |
| **First loss / Equity** | **0%** | **3%** | **$60M** | **Retained by Thornfield** |

Portfolio losses hit the equity tranche first. After 3% cumulative losses ($60M), the mezzanine absorbs losses. Thornfield retains the first-loss piece to maintain skin in the game and to satisfy regulatory requirements.

**Why Banks Choose Synthetic:**

1. **No need to notify borrowers** — the bank-borrower relationship is undisturbed
2. **Faster execution** — no true sale legal work, no SPV setup
3. **Capital relief** — regulatory capital is freed up for new lending
4. **Selective risk transfer** — the bank can choose exactly which risks to transfer
5. **Confidentiality** — the reference portfolio is not publicly disclosed in the same way as cash deals

**Investor Considerations:**

1. **Counterparty risk** — investors bear the risk that the originator bank fails to pay CDS premiums (mitigated by funded tranches)
2. **Basis risk** — CDS payout terms may not perfectly match actual loss experience
3. **Transparency** — less visibility into the reference portfolio compared to cash deals
4. **Moral hazard** — if the originator retains little risk, monitoring incentives diminish

Explore securitization structures in our CFA Level II fixed income course.

How does synthetic securitization work, and how does it differ from traditional (cash) securitization?

Master Level II with our CFA Course

Related Questions

Practice Questions