"Synthetic CDOs do not own cash assets like bonds or loans. Instead, synthetic CDOs gain credit exposure to a portfolio of fixed income assets without owning those assets through the use of credit default swaps, a derivatives instrument. (Under such a swap, the credit protection seller, the CDO, receives periodic cash payments, called premiums, in exchange for agreeing to assume the risk of loss on a specific asset in the event that asset experiences a default or other credit event.) Like a cash CDO, the risk of loss on the CDO's portfolio is divided into tranches. Losses will first affect the equity tranche, next the mezzanine tranches, and finally the senior tranche. Each tranche receives a periodic payment (the swap premium), with the junior tranches offering higher premiums."

(from http://en.wikipedia.org/wiki/Collateralized_debt_obligation)

Fixed maximum gain, potentially unlimited loss, and they don't even own anything. Who ever thought of this needs to be slapped back to 1929.

Just read this, from Bloomberg, today (excerpt, thanks Yves Smith):

"Recent CLO deals have been ``eating into the massive overhang of leveraged bank loans and alleviating some of the stress in the capital markets,'' said Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York.They're also ``an easy way for banks to reduce balance sheet risk, which indirectly helps reduce capital requirements, by funding the AAA through the Fed and selling the equity, which provides high yield to investors,'' Plaut said." (my bold)

High yield because they're high risk. So lets see: Banks/etc can't sell their sketchy loans, so they transfer said loans to what essentially amounts to a shell company (a CLO), buy the sketchy loans off themselves using money from bonds sold to the Fed, and sell stock in their new shell company to investors for a quick profit.

*Head in hands*