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Treasury Desk Applications Of Credit Derivatives & Synthetic Securitisations - Part I

In this Learning Curve we describe the latest developments in credit derivative-based synthetic funding structures, which are now being used for liquidity and balance sheet asset-liability management by banks and other financial institutions.

In this Learning Curve we describe the latest developments in credit derivative-based synthetic funding structures, which are now being used for liquidity and balance sheet asset-liability management by banks and other financial institutions. The structures combine credit derivatives, such as total-return swaps, with commercial paper and medium-term note issuance vehicles and enable originators to raise LIBOR-based funding from the wholesale inter-bank market. To begin with we consider the simplest arrangement, the funded basket total-return swap.  

Total-Return Swaps: The Essential Building Blocks

The TRS is the essential building block used in the arrangement of synthetic funding structures, which we consider shortly. First though we look at how it can be used as a plain vanilla funding and liquidity instrument.

When used for funding purposes, a TRS is more akin to a synthetic repo contract. To illustrate this application, we describe here the use of TRS to fund a portfolio of bonds, as a substitute for a repo trade.

Consider a financial institution such as a regulated broker-dealer that has a portfolio of assets on its balance sheet for which it needs to obtain funding. These assets are investment-grade structured finance bonds, such as credit card ABS, residential MBS and CDO notes, and investment-grade rated convertible bonds. In the repo market, it is able to fund these at LIBOR plus 16 basis points. That is, it can repo the bonds out to a bank and will pay LIBOR plus 16bps on the funds it receives.

Assume that for operational reasons the bank can no longer fund these assets using repos. Instead it can fund them using a basket TRS contract, providing a suitable counterparty can be found. Under this contract, the portfolio of assets is passed to the TRS counterparty and cash is received. The assets are therefore sold off the balance sheet to the counterparty, an investment bank. The investment bank will need to fund this itself--it may have a line of credit from a parent bank or it may enter a further swap. The funding rate it charges the broker-dealer will depend to as large extent on what rate the bank can fund the assets itself. Assume the TRS rate charged is LIBOR plus 22 bps--the higher rate reflects the lower liquidity in the basket TRS market for non-vanilla bonds. At first this trade may appear illogical, because of the higher funding rate the broker-dealer will be paying to fund its book with the TRS. However we assume there are reasons, connected with funding diversity and balance sheet requirements, why the trade makes sense.

The portfolio is shown at Figure 1. At the start of the trade, the portfolio consists of five (hypothetical) euro-denominated convertible bonds. The broker-dealer enters into a three-month TRS with the investment bank counterparty, with a one-week interest rate reset. This means at each one-week interval, the basket is revalued. The difference in value from the last valuation is paid (if higher) or received (if lower) by the investment bank to the broker-dealer; in return the broker-dealer also pays one-week interest on the funds it received at the start of the trade. It can be broken at one-week intervals and bonds in the reference basket can be returned, added to or substituted. So if any stocks have been sold or bought, they can be removed or added to the basket on the reset date. If the bonds have not moved in price between the reset dates, then there is no performance for the investment bank to make.

The terms of the trade are shown below. 
Trade date 24-Mar-04
Value date 26-Mar-04
Maturity date 28-Jun-04
Rate reset 31-Mar-04
Interest rate 2.2970% (this is one-week euro LIBOR fix of 2.077% plus 16bps)
The combined market value of the entire portfolio is taken to be EUR102,477,023.48. There is no haircut.
At the start of the trade, the five bonds are swapped out to the investment bank, which pays the portfolio value for them. On the first reset date, the portfolio is re-valued and the following calculations confirmed:
Old portfolio value EUR102,477,023.48
Interest rate 2.30%
Interest payable by broker-dealer EUR45,770.22.
New portfolio value EUR107,532,194.64
Portfolio performance  5,055,171.16
Net payment: broker-dealer receives EUR5,009,400.94

These values are shown in Figure 1. We assume there has been no change in the prices of the five convertible bonds, but the broker-dealer has added a new security to the portfolio. In addition, there has been one week's accrued interest on the original portfolio. This makes up the new portfolio value.

The rate is reset for value April 2 for the period to April 9. The new rate is 22bps over the one-week euro LIBOR fix on March 31, an all-in rate of 2.252880%. This interest rate is payable on the new loan amount of EUR107,532,194.64.

This trade has the same goals and produced the same economic effect as a classic repo transaction.

Figure 1: Basket TRS Trade On March 24, Undertaken For Funding Purposes
TRS ticket
EUR€ 1W Libor 2.077
Name Currency Nominal Price Accrued Pool factor Consideration (€) ISIN Code ---------------
ABC Telecoms 6.25% EUR 11,000,000 113.5 0.024658 N/a 12,487,712.38 XS—————
SAD Bros 7.50% EUR 10,000,000 136.29 0.519444 N/a 13,680,944.40 XS—————
KFC / DTI 5.875% EUR 35,000,000 104.63 0.469262 N/a 36,784,741.70 XS—————
Bigenddi 8.25% EUR 15,000,000 122.48 0 N/a 18,372,000.00 XS—————
Bangla 9% EUR 50,000,000 41.95 1.471875 N/a 21,151,625.00 XS—————
Jackfruit Funding  EUR 5,000,000 99.95 0 1 4,997,500.00 XS—————
[addition to basket 
at roll-over]
102,477,023.48 Portfolio value at start
107,474,523.48 Portfolio value at rollover


The Synthetic ABCP Conduit

The latest development in asset-backed commercial paper (ABCP) conduits is the synthetic structure. Exactly as with synthetic structured credit products, this uses credit derivatives to affect an economic transfer of risk and exposure between the originator and the issuer, so there is not necessarily a sale of assets from the originator to the issuer. We describe synthetic conduits by means of a hypothetical transaction, called Golden Claw Funding, which is a total return swap-backed ABCP structure.


Hypothetical Case Study: Golden Claw Funding

Figure 2 is a structure diagram for a synthetic ABCP vehicle that uses total return swaps (TRS) in its structure. It illustrates a hypothetical conduit, Golden Claw Funding Ltd, which issues paper into both the U.S. commercial paper market and the euro CP market. It has been set up as a funding vehicle, with the originator accessing the CP market to fund assets it holds on its balance sheet. The originator can be a bank or a non-bank financial institution, such as a hedge fund or corporate. In our case study the originator is a hedge fund called ABC Fund Ltd.


The structure shown at figure 2 has the following features:

* the CP issuance vehicle and the Purchase Company (PC) are based offshore;

* the conduit issues CP in the dollar market via a co-issuer based in Delaware. It also issues euro-CP via an offshore SPV;

* proceeds of the CP issue are loaned to the PC, which uses these funds to purchase assets from the originator. As well as purchasing assets directly, the vehicle may acquire an interest in assets held by ABC Fund Ltd via a note referenced to a basket of assets. If assets are purchased directly onto the balance sheet of the PC, this is akin to what happens in a conventional ABCP structure. If interests in the assets are acquired via referenced Note, then they are not actually sold to the PC and remain on the balance sheet of ABC Fund. Assets can be bonds, structured finance bonds, equities, mutual funds, hedge fund shares, convertible bonds, synthetic products and private equity;

* simultaneously as it purchases assets or a note linked to assets, the PC enters a TRS contract with ABC Fund, under which it pays the performance on the assets and receives interest on the CP proceeds it has used to purchase assets and referenced notes. The TRS is the means by which ABC Fund retains the economic interest in the assets it is funding and the means by which PC receives the interest it needs to pay back to Golden Claw as the CP matures.

* the issue vehicle itself may also purchase assets and referenced notes, so we show at Figure 2 it also has a TRS between itself and ABC Fund.

The Golden Claw structure is a means by which funds can be raised without a true sale structure. The TRS is guaranteed by the sponsor bank, so will ensure the conduit is rated at the short-term rating of the sponsor bank. As CP matures, it will be repaid with a roll-over issue of CP, with interest received via the TRS contract. If the CP cannot be rolled over, then the CP or the issuer will need to sell assets or referenced notes to repay principal, or the TRS guarantor will need to cover the repayment.

Essentially, the TRS is the means by which the conduit can be used to secure LIBOR-flat based funding for the originator, as long as payments under it are guaranteed by a sponsor or guarantor bank. Alternatively, the originator can arrange for a banking institution to provide a stand-by liquidity back-up for the TRS in the event it cannot roll over maturing CP. This service would be provided for a fee.


Example: Golden Claw Synthetic ABCP Conduit Cashflow Mechanics

Assume the first issue of CP by the Golden Claw structure. The vehicle issues $100 nominal of one-month CP at an all-in price of $99.50. These funds are lent by the vehicle to its purchase company, which uses these funds to buy $99.50 worth of assets synthetically from ABC Fund, in the form of par-priced options referenced to these assets. Simultaneously it enters into a TRS with ABC Fund, for a nominal amount of $100.

At CP maturity, assume the reference assets are valued at $103. This represents an increase in value of $3. ABC Fund will pay this increase in value to the purchase company, which would then pay this, under the terms of the TRS, back to ABC Fund (in practice, this cashflow nets to zero so money doesn't actually move). Also under the terms of the TRS, ABC Fund pays the maturing CP interest of $0.50, plus any expenses and costs of Golden Claw itself, to the purchase company, which in turn pays this to Golden Claw, enabling it to repay the CP interest to investors. The actual nominal amount of the CP issue is repaid by rolling it over.

If for any reason CP cannot be rolled over on maturity, the full nominal value of the CP must be paid under the terms of the TRS by ABC Fund to the purchase company.


This week's Learning Curve was written by Moorad Choudhry, a visiting professor in the Department of Economics at London Metropolitan University and co-founder of



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