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Derivatives

SG, DRKW Ready Arbitrage CDOs On Spread Widening

Société Générale and Dresdner Kleinwort Wasserstein are both structuring arbitrage synthetic collateralized debt obligations as a result of accelerated credit spread widening following the Sept. 11 terrorist attacks. The SG deal will be EUR1 billion (USD904 million) and DrKW's will be USD1 billion, according to officials at the firms. Both deals will have a five-year maturity.

Several balance sheet transactions have reportedly been pulled recently because issuers are reluctant to pay wider spreads to investors taking on credit risk. An arbitrage CDO differs in that the structurer passes on credit risk both to the credit-default swap market and to investors. Frederic Monneret, structurer at SG in Paris, said the firm plans to take advantage of spread widening by offering investors a higher return for taking on exposure to a basket of names, while at the same time earning a higher premium on selling protection on the individual components of the basket. As a result of across the board spread widening, the firm is also able to eliminate or reduce exposure to credits that are usually used to boost the coupon, such as telecoms, thereby lowering the risk and spicing up the coupon.

For example a triple-B tranche of a European synthetic CDO would have paid approximately 200 basis points before the Sept. 11 terrorist attacks and would pay nearer 300bps today. Jeremy Vice, head of CDOs at DrKW in London, agreed that the wider spreads allow for larger coupons. For example the spreads on the equity tranche of arbitrage deals have increased from 10-15% to 15-20%. Both CDOs are expected to be priced in the coming weeks.

The DrKW deal will be the first in a program of so-called DISCs--Diversified Investment in Synthetic Credit deals. Vice said the firm plans to issue five of these deals a year with each being around the USD1 billion mark and referenced to a basket of credit-default swaps.

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