Is there a difference between a Total Return Swap and a Synthetic CDO?

Yes, a synthetic CDO gives you exposure to a CDO through a CDS. A total return swap is a contract set up to give you exposure to some underlying asset or index. Basically, a total return swap is more broad.

Caveat Emptor and One Buck put things very well.

In practice a TRS is generally long cash securities and used by a hedge fund like a margin account. From what I've seen TRS usually have some mark-to-market component, like a margin account. In my experience there is usually no tranching in a TRS and they are usually not rated or syndicated. One of the most common uses of TRS lines during the credit peak was in what were basically two-tranche market value CLOs.

A synthetic CDO is like a cash-flow CDO (multiple tranches paying higher coupons as you take more risk with the residual cash flows going to the equity tranche) except instead of buying securities, the CDO goes "long" the credit risk of the securities by selling default insurance (CDS) and pays the cash flows from these CDS down the waterfall instead of interest receipts. Synthetic CDOs can be syndicated just like a vanilla CDO and can be rated. Like a cash flow CDO, there's usually no mark-to-market component, so the deal keeps going till its indenture requires it to wind down (either from losses/covenant breaches or because it matures).

So to recap: TRS: usually cash long, usually untranched, usually not syndicated, usually not rated, usually have a market-value component.

Synthetic CDO: Long CDS contracts, usually tranched, often syndicated, can be rated, usually no market-value component (in my experience).

ok. so a synthetic CDO gains exposure to a certain asset by selling credit protection on the asset instead of buying the asset (cash flow CDO) itself. some follow up questions now.

1. From what you said, a synthetic CDO can sell CDS protection. Can it also sell TRS protection?

2. Why do investors use S CDOs to sell CDS/TRS. Cant they just sell CDS/TRS directly to the other party who wants to buy protection?. So instead of having Investors-CDO-CDS-Protection buyer, why cant you have investors-CDS-protection buyer? in other words, why have that CDO in the middle, if you can (???) sell credit protection in the form of a CDS/TRS to the protection buyer directly?

1) I have never seen a synthetic CDO in anything other than CDS; part of the reason behind this is that CDS are liquid/standardized. While there are in theory a lot of similarities to a CDS and a TRS, there are a few differences. A TRS includes market value adjustment language (ie if the swap terminates and the market value has changed, the difference has to be settled) which makes it less practical for a CDO. A good primer on how TRS are used in practice: www.tavakolistructuredfinance.com/TRS.pdf In practice they are used to finance long positions in cash securities, rather than a CDS which is sold outright, contains embedded leverage, and is a synthetic long with cash flows that may not be identical to the cash position.

2) A few things: a) SCDOs are tranched like a vanilla CDO, so investors can select tranches according to their risk appetitie. b) An SCDO references a large portfolio of assets, depending on the investor it may not be practical to sell CDS on every reference asset c) CDO structures are designed in part to create stable investments that can ride out economic cycles. If you are an institutional investor and you sell some CDS contracts, you have to mark the contracts to market if credit improves and their resale value drops even though your cash flows haven't changed (just like a cash investment). CDOs (vanilla or synthetic) generally don't mark their portfolios to market. d) Ratings: Synthetic CDOs can be rated by Moody's/S&P which is important for some institutional investors, a portfolio of CDS is not rated.

1. Total return swaps are usually done strictly between two counterparties. So if Paulson & Co wants the returns of a bank loan without trying to purchase the bank loan itself they will go and purchase a Total Return Swap with that bank loan as a reference asset from Goldman Sachs.

Your question is asking if the synthetic CDO underwriter (let's say Citigroup in this case) could instead be the seller of TRS. You never see TRS transactions being done with an investment vehicle such as a CDO. A synthetic CDO managed by Citigroup cannot sell a Total Return Swap, only Citigroup itself could do such a thing.

2. You may be misunderstanding this. Or I may be misunderstanding your question. You do not need a synthetic CDO to sell CDS. A majority of the CDS transactions are transacted between parties who want to hedge/increase their exposure to the credit.

So if I'm Morgan Stanley and I'm worried about my exposure to Las Vegas Sands corporate bonds. I will go out to the market and try to buy protection on LVS bonds. I will call other brokers/use electronic networks to find the best price available.

ok. so both CDS and TRS can be done bilaterally but only a (pool of) CDS can be put in a SCDO. Now, how do I obtain leverage in a CDS? I know that in a TRS you basically have to put a small collateral of the swap notional. So if you enter in a 1bn TRS, you'll put say 10% as collateral (this can increase because the TRS is marked to market, so if the value of the asset goes down, you have a margin call from the bank, but for sake of simplicity let's just assume the value trades at par), but you get paid interest on the whole 1bn. So your leverage in this case is 10x. In a CDS, do you obtain leverage in the same way? so if I decide to sell a CDS on 1bn of loans, do I need to put a collateral on that? I assume you must cause it would be easy money without it. anyone can sell a CDS on 1bn of US sov debt and get paid 30-40bps or whatever it trades at, without putting any money down.

Just like a cash flow CDO, a synthetic CDO obtains leverage by selling tranches of bonds, with the equity tranche benefiting from the excess cash flows and absorbing the first loss.

So: TRS leverage comes from the counterparty; CDO (synthetic or otherwise) leverage comes from the bond buyers.

If you sell a CDS contract you will be required to maintain margin but that's not really relevant to your question.

The whole idea of leverage behind a CDS is such:

If you wanted to go long a bond, you would need to pay the market value of the bond. So if a 5mm par bond trades at 90. Then you would need to pay out 4.5mm.

With selling protection on a CDS you are instead paying a basis point spread on the notional amount. So if the CDS is 300bps on 5mm notional. Each year you are receiving $150,000 a year in payments. However, in the instance of a default you receive the bond and whatever it is worth at that time, and pay out the full notional amount.

Notice the difference in cash flows. In one you are paying money to establish a position. In another you are receiving money to establish the same credit exposure.