This is what I can imagine from the textbook:
Assuming a partially funded synthetic CDO:
An SPV is established on a notional amount of, say $100 million, but only $10 is actually raised from subordinate tranch, the senior trach does not contribute any fund to the SPV. This $10 million is then used to purchase high-quality securities.
Also, the SPV will enter into a short position in a CDS arrangement with the bank, in return receives periodic CDS fees.
CDS fees and income/principal streams from those high-quality securities will be used to pay off the tranches and how they are paid depends on the intitial specification of the SPV.
Since any losses (in the event of default of those loans) will be absorbed by the subordinate tranch, the senior tranch will only incur loss if the amount of defaulted loans exceed $10 million.
So the bank effectively transfer the credit risk of the loans to the SPV (by entering into a CDS), thus to the holders of different tranches, without selling the actual assets (loans).
Basically a synthetic CDO is a CDS within a structured fixed income security?
Am I correct?
