Faced with growing inventories of unsold synthetic collateralized debt obligation, dealers and increasingly skittish investors are turning to more novel structures to entice buyers, according to BW sister publication Derivatives Week. The new twists structurers are putting on CDOs include kickers to the mezzanine tranche, adding structured products to the equity slice, securing ratings for deals that would previously have been placed without a rating and even putting tranches in other asset-backed products.
The ability to place CDOs has traditionally hinged on interest from equity investors, however, at the moment mezzanine investors are in the driving seat. To entice the mezzanine investors, firms, including Bear Stearns, Deutsche Bank, CIBC, Merrill Lynch and Dresdner Kleinwort Wasserstein are planning to structure synthetic collateralized debt obligations with equity participation for mezzanine notes, or extra credit protection, to encourage mezzanine investors to part with their cash, according to officials at the firms. Over the past few months these structures-such as spread trapping or equity upside participation-have begun to appear in private synthetic CDOs for the first time in Europe, and bankers believe their use will increase.
Spread trapping is a technique in which income that usually goes to an equity investor is put into a reserve account to rebuild subordination after losses, but is returned to the equity investors if there are no losses, explained Andrew Jackson, director in European structured finance at Fitch Ratings. This means equity investors only lose out on the ability to reinvest the returns, he added. Participation in upside, however, involves giving mezzanine investors a percentage of the return usually given to investors in the equity tranche, Jackson said.
Several firms are pitching structured products referenced to the equity slice of synthetic CDOs in order to shift the equity component. J.P. Morgan Securities, Deutsche Bank and Merrill have all pitched deals that would give investors a guaranteed note comprising a zero-coupon bond and a slither of CDO equity. John McLaughlin, head of structured investments at Schroder Investment Management in London, said one of the major drawbacks of these deals is they are hard for retail customers to understand.