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Combining Securitization Technology & Trading In Credit Derivatives

A synthetic arbitrage collateralized debt obligation is originated by collateral managers wanting to exploit differences in yield between the underlying assets and that payable on the CDO. The generic structure is as follows: a specially-created special-purpose vehicle enters into a total-return swap with the originating bank or financial institution, referencing the bank's underlying portfolio. The portfolio is actively managed and is funded on the balance sheet by the originating bank. The spv receives the total return from the portfolio and in return it pays LIBOR plus a spread to the originating bank. The spv also issues notes that are sold to CDO investors.

A balance sheet synthetic CDO is employed by banks that wish to manage regulatory capital. The underlying assets are bonds, loans and credit facilities originated by the issuing bank. There are three types of CDO within this structure. A fully synthetic CDO is a completely unfunded structure which uses credit default swaps to transfer the entire credit risk of the reference assets to protection sellers. In a partially funded CDO, only the highest credit risk segment of the portfolio is transferred. The cash flow that would be needed to service the synthetic CDO overlying liability is received from the AAA rated collateral that is purchased by the spv with the proceeds of an overlying note issue. An originating bank obtains maximum regulatory capital relief by means of a partially funded structure, through a combination of the synthetic CDO and what is known as a super senior swap arrangement with an Organisation for Economic Co-operation and Development-based bank. A super senior swap provides additional protection to that part of the portfolio, the senior segment, that is already protected by the funded portion of the transaction.

A generic partially funded synthetic transaction is shown above. It shows an arrangement whereby the issuer enters into two credit default swaps; the first with an spv that provides protection for losses up to a specified amount, while the second swap is set up with the OECD bank or, occasionally, an insurance company.

In a fully funded CDO the entire credit risk is transferred to the spv via a default swap. The issuer enters into the default swap with the spv, which itself issues credit-linked notes to the entire value of the assets. The proceeds from the notes are invested in risk-free government, agency or senior unsecured bank debt. Should there be a default on one or more of the underlying assets, the required amount of the collateral is sold and the proceeds from the sale paid to the issuer to recompense for the losses. The premium paid on the swap must be sufficiently high to ensure it covers the difference in yield between the collateral and the notes.

Fully funded CDOs are relatively uncommon. One of the advantages of the partially funded arrangement is the issuer will pay a lower premium compared to a fully funded synthetic CDO, because it is not required to pay the difference between the yield on the collateral and the coupon on the note. The downside is the issuer will receive a reduction in risk weighting for capital purposes to 20% for the risk transferred via the super senior tranche.

The fully unfunded CDO uses only credit derivatives in its structure. The swaps are rated in a similar fashion to notes, and there is usually an "equity" piece that is retained by the originator. The credit rating of the tranches is based on the rating of the reference assets, as well as other factors such as the diversity of the assets and ratings performance correlation. The typical structure is illustrated below. The senior tranches are sold to AAA rated banks as a portfolio default swap, while the junior tranche is usually sold to an OECD bank.

The default swaps are not single-name swaps, but are written on a class of debt. The advantage for the originator is it can name the reference asset class to investors without having to disclose the name of specific loans. Default swaps are usually cash-settled rather than physically settled, so the reference assets can be replaced with other assets if desired by the sponsor.

Synthetic deals may be either static or managed. Static deals hold the following advantages:

* there are no on-going management fees;

* the investor can review and grant approval to credits that

make up the portfolio.

The disadvantage is that if there is a deterioration in credit quality of one or more names, there is no ability to remove or offset this name from the pool and the vehicle continues to suffer. Last year a number of high profile defaults meant static pool CDOs performed below expectation. This partly explains the rise in popularity of the managed synthetic deal.


The Managed Synthetic CDO

Managed synthetic CDOs are the latest variant of the synthetic CDO structure. They are similar to the partially funded deals except the reference pool of credit derivatives is actively traded. With this structure, originators can use credit derivatives to arbitrage cash and synthetic liabilities, as well as leverage their expertise in credit trading to generate profit. The credit derivatives are actively traded, under specified guidelines. Thus, there is greater flexibility afforded to the sponsor and the vehicle will record trading gains or losses as a result. In most structures, the investment manager can only buy protection in order to offset an existing swap. For some deals, such as the Jazz CDO, this restriction has been removed.


The structure of the managed synthetic is similar to the partially funded synthetic CDO. On the liability side there is an issue of notes, with the proceeds invested in risk free debt.

On the asset side the spv enters into default swaps and/or total return swaps, selling protection to the sponsor. The investment manager can trade after the transaction has closed. The spv enters into credit derivatives via a single basket default swap to one swap counterparty, written on a portfolio of reference assets, or via multiple single-name credit swaps with a number of swap counterparties. The latter arrangement is more common and is referred to as a multiple dealer CDO. A percentage of the reference portfolio will be identified at the start of work on the transaction, with the remainder of the entities being selected before closing. The spv enters into the other side of the default swaps by selling protection to one of the swap counterparties on specific reference entities. Thereafter the investment manager can trade out of this exposure in the following ways:

* buying credit protection from another swap counterparty on the

same reference entity. This offsets the existing exposure, but there

may be residual risk exposure unless premium dates are matched

exactly or if there is a default in both the reference entity and the

swap counterparty;

* unwinding or terminating the swap with the counterparty;

* buying credit protection on a reference asset that is outside the

portfolio. This is uncommon as it will leave residual exposures

and may affect premium spread gains.

Initially the manager's opportunity to trade may be extensive, but this will be curtailed if there are losses. The trading guidelines will extend to both individual default swaps and the portfolio. They may include:

* parameters under which the investment manager may actively

close out, hedge or substitute reference assets;

* guidelines under which the manager can trade credit derivatives

to maximise gains or minimise losses on reference assets that have

improved or worsened in credit quality or outlook.

Default swaps may be cash settled or physically settled, with cash settlement being more common in a managed synthetic deal. In a multiple dealer CDO the legal documentation must be in place with all names on the counterparty dealer list, which may add to legal costs as standardization may be difficult.

Investors who are interested in this structure are seeking to benefit from the following advantages compared to vanilla synthetic deals:

* active management of the reference portfolio and the trading

expertise of the investment manager;

* a multiple dealer arrangement, so the investment manager can

obtain the most competitive prices for default swaps;

* under physical settlement, the investment manager has the ability

to obtain the highest recovery value for the

reference asset.

A generic managed synthetic CDO is illustrated above.


This week's Learning Curve was written by Moorad Choudhry at the department of management at Birkbeck, University of London.

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