Synthetic CDOs (or “Bespoke CDOs”) are securities tied to the performance of a pool of credit default swaps. The credit default swaps can reference corporate entities, municipalities, or even ABS. Synthetic CDOs differ from “cash flow” CDOs in that they have counterparty risks in addition to credit risk.
In our experience, when contemplating a restructuring of a bespoke CDO tranche it is important to quantify whether the restructuring preserves the risk/reward value of the tranche. For example, investors should carefully consider whether the increase in subordination sufficiently compensates for the give-up in spread.