Merrill Lynch was putting the finishing touches to a JPY40 billion (USD304 million) synthetic collateralized debt obligation referenced to a pool of unrated and high-yield assets last week.
The deal is unusual as most synthetic CDOs are referenced to investment-grade assets. The CDO is designed to reduce credit risk on a domestic bank's loan portfolio and needed to be issued before the Japanese fiscal year-end last Sunday to reduce the firm's credit exposure, according to officials familiar with the deal. Officials at Merrill declined comment.
"Merrill [is] negotiating with the client and investors," an official added. He continued that the structure will only have two tranches, a rated tranche which is expected to be rated single A, and an equity tranche. The issuing firm will keep the entire equity tranche, which will be JPY20 billion and the remaining JPY20 billion will be sold to investors in the form of credit-linked notes. "From an economic standpoint, this frees up capital while controlling the potential maximum loss on the bank's portfolio," added the official.
It has a larger than usual equity tranche to absorb the first loss in order for a rated tranche to be structured because the reference portfolio consists of unrated and high-yield assets. "This is unique for Japan but it's been done in Europe," noted a structurer at a rival firm in Tokyo. "The issuing bank still keeps the risk/return profile on the portfolio and also gets a funding injection," he added. The structurer continued that the underlying credits are likely near-distressed level and rather than selling off the portfolio at a loss, the bank keeps the assets for a potential upside gain if the credit quality improves while receiving cash for selling the rated tranche.
The market official continued that the structure will likely be rated by Moody's Investors Service. An official at Moody's in Tokyo declined comment.
