The Ethics of Banking: Conclusions from the Financial Crisis (Issues ...

Variants of Derivatives 91
CDO synthetically – artificially – replicates a cash CDO. We talk about synthetic
securitization when the claims of one or more banks are combined into a package
(bundle, pool, special fund, portfolio) and a credit derivative is used to split off the
credit risk, which is sold to a special purpose vehicle; however, the credit claim
continues to figure on the bank’s balance sheet (which differentiates it from a truesale
securitization). 13 The synthetic CDO, despite its synthetic, artificial nature, is
easier and cheaper to create than the “true sale CDO” because it requires less legal
expense. It hives off the loan but leaves the asset on which the loan is secured as a
bank asset, and thus enhances the bank’s equity and, therefore, its lending capacity.
Since only the credit risk is sold but not the asset, the synthetic CDO is the
same thing as a credit-default swap. The different names for the same financial
instrument can be explained by the different origins of each, and by the efforts of
banks to remove lending risks from their balance sheets. The synthetic CDO is a
credit-default swap issued by banks that want to reduce their equity requirement and
maintain or even expand their capital base, whereas general credit-default swaps are
agreed for the most diverse reasons by the protection buyer and seller.
Finally, there are also hybrid CDOs which are combinations of cash CDOs and
synthetic CDOs. They are structured in such a way that in part they sell the loan
collaterals to the CDO buyer and in part they sell the risk only.
The interest payments or bond coupons to the investors are settled out of the
interest payments on the loan and the fees received by the bank that transfers the
bond to a special purpose vehicle, and out of the enhanced credit made possible
by the CDO. All three components of income must be higher than the costs of the
CDO. The fees to be paid by the investor/buyer of the CDO to the issuer of the CDO,
the originator, can be substantial. The expense of securitization is, as in many other
areas of structured finance, high. This indicates a fundamental problem concerning
the structuring of financial instruments: the fees for intermediation are high, whereas
the actual value created by the intermediation, especially by multiple repetition of
the same financial operation, is dubious.
Why do banks have an interest in transforming their loans into CDOs? The
following reasons can be cited:
– Arbitrage gains from switching to another system of regulation (regulatory
arbitrage)
– Individual adaptation of financing to customer needs (customization)
– Credit enhancement (enhanced credit creation)
– Adjustment of bond denominations to the customer’s needs for retail denominations.
13 Cf. Monatsbericht der Deutschen Bundesbank [Monthly Report of the German Bundesbank] of
April 2004, p. 29, Monthly Report of the German Bundesbank of March 2006, p. 57 (clear example
calculations), Monthly Bulletin of the European Central Bank of February 2008, pp. 92 ff.
(schematic representation; explanations on particular forms of synthetic securitization; charts),
page numbers refer to the German editions consulted. (Source: Gerhard Merk, University of
Siegen).