Synthetic CDOs: Getting riskier, but how risky are they?

Creditflux magazine has some interesting numbers out about the synthetic CDO market, as reported by Paul Davies in the FT today:

Sales of public and private synthetic CDOs grew to $450bn in notional terms last year compared with $224bn in 2005, according to data from Creditflux, an information and news service that has the best access to the hard-to-track private deals...
On the risk-weighted basis - where the value of a CDO is calculated by multiplying the tranches by their risk weight - volumes grew from $648bn to $1,554bn.

I'll do the math so you don't have to: the risk weight on synthetic CDOs has increased from 2.89 last year to 3.45 this year. What do these numbers mean? According to Davies, they mean this:

Investors are increasingly purchasing ultra-risky slices of complex derivatives known as "synthetic" collateralised debt obligations (CDOs)

"Ultra-risky"? Is that, you know, well-defined? Besides, are synthetic CDOs particularly complex? Really, they're just pools of assets which have a fixed income, only the assets are CDSs rather than bonds.

It's easy to look at skyrocketing risk-weighted exposure to synthetic CDOs and get worried. But it's also worth remembering that every dollar an investor in these instruments receives is a dollar spent by somebody insuring himself against a credit event. I'm going to try to find out what those 2.89 and 3.45 numbers actually refer to, but in the mean time I'll remain a bit more sanguine than Paul Davies.

Posted by Felix at 12:26 EST