@article {Tavakoli48, author = {Janet Tavakoli}, title = {The Elusive Income of Synthetic CDOs}, volume = {11}, number = {4}, pages = {48--58}, year = {2006}, doi = {10.3905/jsf.2006.614082}, publisher = {Institutional Investor Journals Umbrella}, abstract = {Investment banks/arrangers sometimes increase the risk profiles of CDOs without receiving or paying investors commensurate increases in income. Arrangers created STCDOs so that they could still do business without developing a deeper investor base for those transactions, but the STCDO always leaves the arranger with residual credit risk and a huge position to hedge. Correlation trading has grown rapidly, but it is based on false analogies to the conventional options markets and unreliable data on factors such as relative spread movements and subordination required for desired credit quality. The models are unstable. Hedging should focus instead on default probability and recovery rates based on fundamental corporate balance sheet analysis. Arrangers of synthetic CDOs should report entire notional amounts, but they have been reporting only the amounts of tranches they have sold for fear that huge notional amounts will make bank managers and regulators uncomfortable. Investors in synthetic CDOs should insist on a cash flow analysis that shows the timing, magnitude, and probability of receipt of cash flows{\textemdash}and that requires knowledge of the full notional amount of the CDO. {\textquotedblleft}Delta{\textquotedblright} hedging strategies can be a source of moral hazard because the income produced by correlation-driven delta hedging is easily manipulated by fudging the hedge ratio. Arrangers can manipulate hedge ratios so that they sell more credit protection and increase their income without a perceived increase in risk.TOPICS: CLOs, CDOs, and other structured credit, information providers/credit ratings, credit risk management}, issn = {1551-9783}, URL = {https://jsf.pm-research.com/content/11/4/48}, eprint = {https://jsf.pm-research.com/content/11/4/48.full.pdf}, journal = {The Journal of Structured Finance} }