Market players expect growth in synthetic arbitrage structures to bypass the default risk and the need for equity investors associated with traditional cash flow collateralized debt obligations. Typical cash flow deals contain an equity component of 12%, but commitments of that size have been difficult to come by. Additionally, rising default rates have hammered many traditional collateralized debt obligation structures. A synthetic piece in a deal allows managers to dodge those bullets by either reducing required equity or providing credit protection on collateral.
"We've witnessed in the last year an uptick in the number of managers interested in synthetic arbitrage structures," said Roger Merritt, managing director of loan products at Fitch. He noted that the rating agency expects to review more synthetic deals by the end of the year as the investor base has expanded. Merritt said more managers who have historically worked on traditional cash flow arbitrage structures are incorporating synthetic arbitrage deals as part of their broader CDO effort.
Dan Smith, portfolio manager at Indosuez Capital, used Bank of America to execute a $400 million synthetic arbitrage structure for a deal in March--SERVES 2001 Ltd.--to reduce necessary equity needed for the deal in a tough equity environment. "I only had to raise $67 million in capital for my deal rather than $400 million," said Smith. Indosuez set aside $67 million in a trust, tranched out to a single-A, triple-B, and an equity class. This trust served as the first loss position on the deal and as the margin collateral for a swap provided by B of A. Through B of A's total return swap, Indosuez is essentially provided with a $400 million loan to go out and shore up collateral. On a typical traditional deal, the bank would issue tranches of subordinated debt for the manager and the manager would have to find $48 million in equity investment.
This trust reduces the equity piece on the deal and liability funding required. Smith explained that he also chose a synthetic structure because it diminishes rating agency requirements and allowed for a faster marketing period. One potential negative on the deal is the mark-to-market nature of the structure. "If collateral deteriorates to a certain level than the total return provider wants you to dip into the $67 million to true up market value," he said. In response, Smith said, in today's environment credit quality is good and managers are paid for risks, so future losses are expected to be a lot less.
David Hinman, executive v.p. and portfolio manager at PIMCO, explained that PIMCO had different motivations behind its recent use of a synthetic structure for its Sequils-Mincs CLO 1. Last week, the fund closed a roughly $475 million synthetic arbitrage deal not to reduce equity, but rather to protect against default possibilities. "Our motivation is not to raise less equity but to have the flexibility to manage the structure against defaults," said Hinman, explaining that the recovery time on credits has increased 50% over the last three years and bankruptcy proceedings seem to be taking longer and longer. "This way two or three isolated defaults don't impact the whole structure," he said. On PIMCO's deal, a trust isn't set up as a first loss position, but rather several swaps are worked into the deal to protect against potential non-performing assets as J.P. Morgan, the underwriter on the deal, advances money against defaulting securities.