Financial institutions faced with growing inventories of unsold synthetic collateralized debt obligations and increasingly skittish investors are turning to ever more novel structures to entice buyers. The new twists structurers are putting on CDOs include kickers to the mezzanine tranche, adding structured products to the equity slice, securing ratings for deals that would previously have been placed without a rating and even putting tranches in other asset-backed products.
The ability to place CDOs has traditionally hinged on interest from equity investors, however at the moment mezzanine investors are in the driving seat. To entice the mezzanine investors, firms, including Bear Stearns, Deutsche Bank, CIBC, Merrill Lynch and Dresdner Kleinwort Wasserstein are planning to structure synthetic collateralized debt obligations with equity participation for mezzanine notes, or extra credit protection, to encourage mezzanine investors to part with their cash, according to officials at the firms. Over the past few months these structures--such as spread trapping or equity upside participation--have begun to appear in private synthetic CDOs for the first time in Europe, and bankers believe their use will increase.
Spread trapping is a technique in which income that usually goes to an equity investor is put into a reserve account to rebuild subordination after losses, but is returned to the equity investors if there are no losses, explained Andrew Jackson, director in European structured finance at Fitch Ratings. This means equity investors only lose out on the ability to reinvest the returns, he added. Participation in upside, however, involves giving mezzanine investors a percentage of the return usually given to investors in the equity tranche, Jackson said.
Robina Barker-Bennett, executive director in the credit structuring group at CIBC in London, said the key is making sure there continues to be a balance between returns for equity and mezzanine investors. Among firms that have already begun showing investors a wide variety of these type of deals is Deutsche Bank, noted Paul Czekalowski, head of European credit structuring in London.
Guaranteed Equity Notes
Similarly, several firms are pitching structured products referenced to the equity slice of synthetic CDOs in order to shift the equity component. JPMorgan, Deutsche Bank and Merrill have all pitched deals that would give investors a guaranteed note comprising a zero-coupon bond and a slither of CDO equity. John McLaughlin, head of structured investments at Schroder Investment Management in London, said one of the major drawbacks of these deals is they are hard for retail customers to understand.
It would be easier to structure the products on synthetic CDOs because issuers can create the single equity tranche without having to place the rest of the deal, according to McLaughlin. However, Schroder does not have any immediate plans to sell these notes because they would be difficult to explain to the typical retail client.
Even though CDO structurers are saying deals are increasingly difficult to shift, at least two rating agencies say they are seeing an increase in deal volumes. Fitch's Jackson said July was the group's busiest month so far this year. Ebo Coleman, v.p. and senior credit officer at Moody's Investors Service in London, predicted the rating agency would rate around 50% more CDOs, in terms of notional size, this year than the USD100 billion it rated last year. They attributed this to bankers getting ratings for deals that would previously have been placed without a rating.
