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Derivatives

Cash-Like Structures Surface To Woo Mezz Investors

Features traditionally associated with cash structures are being added to synthetic collateralized debt obligations in order to attract mezzanine-level cash investors.

Features traditionally associated with cash structures are being added to synthetic collateralized debt obligations in order to attract mezzanine-level cash investors. Investors said turbo features, interest-coverage or over-collateralization tests and other so-called replenishment twists have started appearing on asset-backed securities and corporate full capital structure CDOs in the past few months. More are expected as a way to soup up returns given record tight spreads.

Underscoring the move, Credit Suisse closed its Adams Square offering two weeks ago with four or five cash traps in the mezzanine part of the stack in favor of a hybrid structure backed by cash and synthetic ABS. Lehman Brothers' recent Exum Ridge deal and the Lacerta offering from Citigroup caught the market's attention by using cash-flow triggers and tests. Citi is marketing several additional deals and Goldman Sachs is also said to have recently printed a cash-like synthetic deal backed by corporate credit.

"Single-tranche synthetic CDOs were not building a base. You were going to the same three or four investors over and over again," said one CDO trader at U.S. firm.

In response, structurers have added cash-like waterfalls and covenants to deals that source risk via CDS. The shift has also brought what used to be pure cash and synthetic CDO desks together to price and distribute deals. In general, these deals enable more leverage than static synthetic structures by using trapped excess interest as additional capital. This has proven popular for equity investors as well.

One benefit of cash traps is that they appeal to an equity buyer's internal rate of return on day one, said Kareem Sergaldim, head of synthetic CDOs at Credit Suisse. This is because the equity piece becomes smaller and the interest-coverage and over-collateralization tests allow the deal to leverage the cash.

With a turbo structure, interest above a certain running return on the equity tranche, usually about 12%, is used to pay back around 6% of principal a year to BBB investors. This is done in order to entice them into a deal.

"Any excess spread can then be captured through these features to provide some structural subordination, thereby increasing leverage and reducing your cost of funds," Sergaldim added.

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