A managed synthetic collateralized debt obligation of municipal paper that passes through tax-exempt interests to all rated classes will soon hit the market. "It's the next generation of municipal CDOs," said Lary Stromfeld, head of the municipal capital markets division of Cadwalader, Wickersham & Taft, which has been working on the legal structure for a major Street player he declined to name.
Until now, managed muni CDOs have been unable to retain tax exemption. Static versions can retain tax exemption, but they do not enjoy the same cash flows as their managed counterparts. UBS issued a synthetic municipal CDO named Alpine III in August which did not pass through tax exemption. About four months later, Credit Suisse First Boston issued C-SyMBOL, a static synthetic deal.
"The trick is not turning gold to tin," Stromfeld said, explaining that Cadwalader figured out how to preserve all the benefits of a managed CDO to avoid taxation. "What investors buy is an ownership interest in the municipal bond opposed to a debt obligation issued by the trust structure," he said, adding the secret is to create a structure that can be characterized as equity, not debt. He declined to explain how that is achieved.
Estimations of the average principal issuance of municipal bonds typically range between USD350-400 billion annually. Stromfeld suspects the CDO market's value is but a small part because there is not enough economic incentive to invest in these products if they can't pass through tax exemption. But the size of the cash market suggests CDOs would take off given the right structure, he said.
The firm has held detailed discussions with two other banks concerning the product while interested dealers wait for the right market conditions, particularly wider credit spreads. Stromfeld explained banks need to sell tranches of credit risk that will make the deal worthwhile to investors.
"It could potentially be a popular product," said Elwyn Wong, a director in the structured finance collateralized debt obligations group of Standard & Poor's in New York. He has not rated any such CDO. "Sophisticated investors are having a closer look," he added, but warned traditional municipal investors, who are not used to buying leveraged products, need to be educated about CDOs before this product really takes off.
Stromfeld said the product would be another tool for diversifying risk. "It's for investors who want to take on municipal credit risk in the synthetic rather than cash market," he said. The municipal cash market's value is huge, but only a small percentage is using derivatives, he said, explaining many players in the market are unfamiliar with how to use derivatives.
