Tighter spreads, lower subordination levels and a huge influx of cash have prompted interest in both sides of synthetic structure trades in the commercial mortgage-backed securities market, according to DW sister publication Real Estate Finance & Investment. The structures, which primarily consist of credit default swap and total return swap formats, are gaining interest from investors, said Precilla Torres, who spearheaded the development of the synthetic CMBS structure with Jeffrey Mudrick at Lehman Brothers. "We feel synthetics are the next natural development of the CMBS market," Torres said. "It seems to be a pattern in other securitized markets and in ABS."
There have been a handful of trades done, investors said, noting that few details of the transaction were available. Likely parties would be hedge funds, portfolio managers and certain broker deals, some of whom have been hedging their loan portfolios with total return swaps on CMBS indices for several years. Each swap needs a party to take long and short positions.
A credit default swap, common in the corporate bond market, allows the owner of a bond to transfer the credit risk of the security to another party. A bondholder pays another party a fee to assume the credit risk. The bondholder's return is the yield minus the fee. If there is a default, the counterparty will make a payment to the bondholder, which allows the first party to hedge their credit risk.
In a total return swap, an investor can exchange one set of cash flows for another. This allows an investor to get the principal and interest payments on a referenced bond without owning the bond.
Total return swaps are already a very active market, said Brian Lancaster, head of CMBS research at Wachovia Securities. "Receiving fixed on CMBS total return swaps has been on occasion one of the best relative value trades in the CMBS market. Counterparties can receive fixed based on a CMBS index and pay as much as 45, 50 or even 60 basis points below LIBOR for an incredibly cheap source of financing," he said. This stems from the natural imbalance created by an excess of fixed-rate payers--the Wall Street conduits hedging long positions before they can do a deal--and a shortage of receivers because many cannot invest in derivatives for tax, accounting or either reasons.
Lancaster said that there are some issues to work out given the nature of the CMBS. A corporate bond is much more standard than CMBS and there are usually many parties who are willing to take long or short positions. But with a CMBS deal, mezzanine tranches can be small, making it more difficult to find another reference security, or a particular deal could have a high concentration of large loans, making it more difficult to find other bonds to reference. "It's hard to short the GM Building," Lancaster said. "That is not to say that this market won't develop. It is inevitable."
Synthetics can also provide investors with a way to hedge credit risk in their portfolio or help to reduce exposure to a particular sector or property type without having to sell a bond. This could also work with investors who want to reduce exposure to a particular property that has been included in several transactions through the pari passu structure. Torres added that with lower subordination levels, there has been less higher-yielding mezzanine and lower-rated CMBS. Synthetic structures will enable investors to access higher-yielding pieces of a deal. For CDO issuers, synthetics are a way to shorten the ramp up period for their CDOs. For B-piece buyers, this will allow them to leverage the due diligence they have done, she added.
"Last year when we spoke with investors, many of them didn't really have much interest in the synthetic structure but now there is a real growth, interest and awareness," Torres said. She noted that the product still has structuring challenges, including aligning the interests of both counterparties. "I think that is the greatest challenge, to streamline the structure so that it can address both sets of requirements.
