The synthetic collateralized debt obligation is well-established as a vehicle used to facilitate balance sheet capital management, credit risk transfer and credit trading. In this Learning Curve, we describe an innovative structure, which combines a multi-Special Purpose Vehicle (SPV) arrangement, together with a hybrid cash and synthetic element that splits the vehicle into stand-alone pieces to suit specific investor requirements. The structure uses existing technology, packaged together in a way that integrates cash and synthetic markets. This results in a product offering greater flexibility than has been issued before and enables financial institutions already originating cash or synthetic CDOs to benefit from this flexibility.
The new structure may be used to achieve one or a combination of the following:
* credit risk transfer and/or regulatory capital management of assets already on the balance sheet;
* exploiting arbitrage opportunities between cash and synthetic credits;
* obtaining funding for acquiring assets subsequently used in an arbitrage synthetic transaction;
* a significant increase in potential deal size, due to the benefits arising from the multi-SPV structure;
* any combination of conventional bonds, structured financial products (ABS, MBS and CDO), loans and synthetic assets such as credit-default swaps in the reference portfolio;
* leveraging the credit expertise of a fund manager to deliver gains for the equity participants in the vehicle;
* meeting the requirements of a varied class of investors by means of the multi-SPV structure, including multi-currency requirements and specific fund management styles.
The proposed multi-SPV may be considered the fourth-generation of such products. This is illustrated in Figure 1.
By arranging a CDO deal in this way, originators will be able to attract wider investor interest. The vehicle we describe combines a cash funded element as well as a synthetic element, hence the term hybrid.
Deal Structure
The structure diagram is shown at Figure 2, with illustrative terms in Figure 3. The note tranching and funding is shown at Figure 4.
The structure is comprised of the following:
* a reference portfolio sourced in the market or on originator's balance sheet;
* a total return swap (TRS) set up for funding purposes;
* a back-to-back TRS;
* a second-loss credit protection credit-default swap;
* a funded element of credit-linked notes issued by SPV 2;
* if required, a managed arbitrage-element of credit-default swap trading undertaken via SPV 1.
The TRS is a funded total rate-of-return swap, rather than the unfunded credit transfer TRS normally associated with the credit derivatives market.
Deal Arrangement
The reference portfolio may be comprised of conventional bonds, asset-backed securities (ABS), loans or synthetic assets such as credit-default swaps. The type of assets that can be placed in the portfolio are dictated by the deal terms and conditions. The portfolio is actively managed by the fund manager, which retains an equity participation in the deal. Assets can be substituted by the fund manager acting under portfolio guidelines.
The funding stage of the transaction, indicated by SPV 3 in figure 1, is executed first. This enables the deal to acquire assets. This SPV enters into a back-to-back TRS with the originator that transfers the total return of assets to the originator and eventually on to a swap counterparty via SPV 1. The fund manager can execute credit derivatives in the market via SPV 1, and a multi-dealer arrangement that would be conducted in a managed arbitrage synthetic deal.
The cash CDO element of the structure is executed by SPV 2, which issues credit-linked notes. This SPV provides the second-loss protection for the originator. Proceeds of the note issue are invested in risk-free assets such as Treasury bills, or placed in a reserve cash account or structured deposit. If proceeds are invested in eligible investments, these are placed in a repo with a counterparty bank. The return on the issued notes is linked to the return from the collateral pool and the premium payments received by the SPV from the originator for taking on the second-loss risk protection.
The originator retains equity participation in the structure to benefit from gains made by the fund manager in running the portfolio and in entering into credit-default swap trading.
Deal Highlights
For a balance-sheet transaction, the originator is able to transfer the credit risk of assets held on its balance sheet. It can also benefit from the arbitrage gain from sourcing credit protection on these assets in the credit-default swap market compared to the return received on these assets in the cash market. There is also a significant saving in the regulatory capital charge from the partially-funded structure. In addition, the managed element of the deal, which is undertaken via SPV 1 and a multi-dealer counterparty arrangement, will allow the originator to undertake credit trading.
The multi-SPV structure enables the originator to benefit from being able to undertake the following:
* Structure and close large volume deals by placing risk across a wide range of investors, both cash bond investors and credit derivative counterparties;
* Provide a vehicle that enables each investor an opportunity to tailor the SPV to meet their specific investment requirements and criteria; for instance, specific requirements in terms of currency requirements, market sector and particular fund management style;
* Allows the Portfolio Manager to leverage experience from different areas of their firm to blend skills into the management of the overall deal;
* Using existing market familiarity with credit derivatives, cash and synthetic CDOs and managed arbitrage synthetic CDOs to introduce a more complex product across a wider range of investors and markets;
* Retain flexibility in the deal structure so that risk exposure of any asset class can be transferred and any asset class targeted in the market for credit trading;
* Securitise both cash and synthetic assets as required.
Due to the familiarity with existing CDO product across the U.S. and European legal jurisdictions, it will be possible to bring the new structure to the market under existing legislation.
Summary
The synthetic CDO is well-established in the debt capital markets. In its different variants, financial institutions have employed the product for balance sheet management, credit risk transfer and credit trading. We have shown how the deal mechanics can be advantageous for commercial banks wishing to effectively control regulatory capital. The greater liquidity of the synthetic credit market, compared to the cash market, has made synthetic CDOs accessible for investors.
The latest generation of this product has been designed to integrate the cash and synthetic markets. By engineering one transaction, which can generate interest across a wider range of investors, the originator will benefit from greater deal flexibility. This has significant implications for efficient balance sheet management.
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This week´s Learning Curve was written by Moorad Choudhry, a visiting professor in the department of economics at the London Metropolitan University. This article is taken from Chapter 11 of his book Structured Credit Products: Credit Derivatives and Synthetic Securitisation (John Wiley & Sons 2004) and is reproduced with permission
