Structured Finance. Synthetic CDOs: A Growing Market for Credit Derivatives. Loan Products Special Report. Analysts

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1 Loan Products Special Report Synthetic CDOs: A Growing Market for Credit Derivatives Analysts New York Roger Merritt roger.merritt@fitchratings.com Michael Gerity michael.gerity@fitchratings.com Alyssa Irving alyssa.irving@fitchratings.com London Mitchell Lench mitchell.lench@fitchratings.com Synthetic CDOs: Key Attributes Cost of funding advantage Regulatory/economic capital relief No borrower notification Administratively efficient Customized exposures Efficiency vis-a-vis market risks Summary The market for collateralized debt obligations (CDOs) continues to show healthy growth despite a notable rise in corporate defaults and negative rating actions related to poorly performing 1997 and 1998 vintages. Exceptionally wide arbitrage opportunities, as well as increased market acceptance of CDO technology and credit derivatives to manage portfolio risk and diversify funding, continue to drive issuance activity. One of the more interesting developments in the market is the growing popularity of synthetic CDO structures. By some estimates, synthetic CDOs now comprise in excess of 50% of total CDO issuance and are the preferred structure for the expanding European CDO market. Synthetic structures differ from more traditional cash-funded CDOs in a number of important ways. Cash-funded CDOs are typically structured as securitizations, whereby ownership of the assets is legally transferred to a bankruptcy-remote trust or special purpose vehicle (SPV). The assets are fully cash funded with the proceeds of debt and equity issued by the SPV, with repayment of the obligations directly tied to the cash flow of the assets. Conversely, synthetic CDOs simulate the risk transference benefits of cash-funded CDOs, without a legal change in the ownership of the assets, by utilizing credit derivatives to transfer credit risk related to a portfolio of reference assets. In a synthetic CDO, the sponsoring institution transfers the total return profile or default risk of a reference portfolio via a credit derivative agreement (total return swap [TRS] or credit default swap [CDS]) or a credit-linked note. Correspondingly, the SPV issues one or more tranches of securities with repayment contingent upon the actual loss experience relative to expectations. Proceeds may be held by the SPV and invested in highly rated, liquid collateral, or the funds may be passed through to the sponsor as an investment in a credit-linked note. Broadly speaking, there are two types of synthetic CDOs arbitrage and balance sheet. Arbitrage CDOs are used by asset management complexes, insurance companies, and other investment boutiques with the intent of exploiting a yield mismatch between the yield on the underlying assets and the lower cost of servicing the CDO securities. Alternatively, balance sheet CDOs are utilized primarily by banks for managing regulatory and risk-based capital. Motivating Factors for Synthetic Structures There are a number of reasons for the growing popularity of synthetic CDOs, although the motivations will differ somewhat between arbitrage and balance sheet transactions. As previously mentioned, the primary motivation for entering into an arbitrage CDO is to exploit the yield mismatch between a pool of assets and the CDO liabilities. The February 6,

2 motivations for using a balance sheet CDO are typically driven by regulatory or risk-based capital considerations. Because the reference assets, for the most part, are not actually removed from the sponsoring financial institution s balance sheet, synthetic CDOs are typically easier to execute than cash-funded structures. This is particularly the case with bank loans, which may require borrower notification and consent or have other restrictions on loan sales that can interfere with borrower relations. Synthetic structures are less administratively burdensome when compared with cash-funded transactions and are superior to cashfunded CDOs in their ability to transfer partial claims on a particular credit. Finally, issues related to interest rate and currency hedging are efficiently addressed in synthetic balance sheet CDOs. For example, currency risk can be neutralized by setting the exchange rate at the outset for purposes of establishing the loss amount on a defaulted asset. Synthetic CDOs generally accomplish risk transfer at a lower cost, since the amount of issuance is typically small relative to the reference portfolio, reflecting some multiple of losses. In these partially funded structures, funding is largely provided by the sponsoring financial institution at a cost that is lower than fully funded CDO structures. Synthetic structures also can facilitate exposure to assets that may be relatively scarce and, therefore, difficult to acquire via the cash market. Finally, synthetic structures allow banks to create more customized transfers of balance sheet risk. For example, losses may be subject to a threshold, and mechanisms can be employed to reimburse carrying costs for nonperforming assets during a predefined workout period. Contingent exposures, including undrawn revolving facilities, and counterparty credit exposures also can be accommodated with relative ease. The primary motivation for European banks, in particular, to issue synthetic CDOs is to take advantage of the fact that the risk weightings used to determine a bank s minimum capital adequacy requirements do not differentiate between various levels of risk. Currently, the amount of capital that international banks are required to hold against any corporate exposure is 100% of the capital adequacy ratio. The requirements for a synthetic CDO, however, are much less than this Cash vs. Synthetic Balance Sheet CDOs: Comparative Benefits Degree of Importance Benefit Provided Cash-Funded Synthetic Transfer Credit Risk High High Regulatory/Economic Capital Relief High High Funding Diversification High Low Customization/Flexibility Medium High Ease of Execution Low/Medium High CDOs Collateralized debt obligations. 2

3 since the funded portion of the structure is backed by government securities, which have a 0% risk weighting (if the collateral is pfandebriefe, it is 10%). The equity tranche, which is typically retained by the bank, will receive a one-for-one capital charge. When the proposed Basle requirements are implemented, however, the new risk weightings will be scaled to more closely match the risk of the asset. Synthetic Arbitrage CDOs Synthetic arbitrage CDOs replicate a leveraged exposure (generally five to seven times [x] levered depending on the portfolio characteristics) to a reference portfolio of assets, most frequently syndicated loans or bonds. Investors and the collateral manager have the potential for attractive returns on a leveraged basis, while the sponsoring financial institution (typically a bank) generates fee income and an additional distribution outlet for origination/lending activities. Examples of these programs include but by no means are restricted to Chase s CSLT, J.P. Morgan s SEQUILS/MINCs, Bank of America s SERVES and Citibank s ECLIPSE programs. In a typical structure, an SPV enters into a series of TRS on a portfolio of credits that is diversified by obligor and industry. The portfolio may be fully or partially rampedup at the outset, at the discretion of the investment manager, and is actively managed over the transaction s life, subject to established investment guidelines. In accordance with the terms of the TRS, the SPV receives the total realized return on the reference portfolio and pays the sponsoring bank the London Interbank Offered Rate (LIBOR) plus a spread, which generally corresponds to the bank s funding/administrative costs with respect to the reference portfolio. The SPV, in turn, issues a combination of notes and equity, which serve to fund the first loss exposure to the reference portfolio. The reference portfolio is funded on-balance sheet by the sponsoring institution. The TRS generally is marked to market on a periodic basis, and these structures may be subject to one or more market value triggers. If so, a degree of market risk exists that is not present in cash flow CDOs. J.P. Morgan s SEQUILS/MINCS vehicles provide synthetic exposure to a reference portfolio of leveraged bank loans through a CDS, rather than a TRS. There is no mark-to-market component, and the transaction triggers are based purely on realized losses under the CDS. The reference portfolio is funded off-balance sheet by the SEQUILS portion of the transaction, which is senior in priority to the MINCS notes. These structures invest the proceeds from the note and equity issuance in high-quality, liquid eligible collateral, which generally earns a rate approximating LIBOR and serves to defray the coupon on the notes. This collateral is pledged on a primary basis to cover losses, if necessary. Provided losses do not exceed Foundation Built on Credit Derivatives Credit Default Swap A credit default swap is a bilateral contract in which the credit protection buyer pays a periodic premium on a predetermined amount (notional amount) in exchange for a contingent payment from the credit protection seller to cover losses following a specified credit event on a specific asset (reference asset). Credit events generally follow the definitions promulgated by the International Swaps and Derivatives Association. Market convention, to date, has defined a credit event as failure to pay, bankruptcy, restructuring, repudiation or moratorium, and acceleration. The premium, notional amount, reference asset, credit instrument, and credit events, as well as other terms of the contract, are negotiated between the protection buyer and seller (counterparties) at inception. Total Return Swap A total return swap is also a bilateral contract, but, in this case, the protection buyer exchanges the entire economic performance (interest, fees, and realized gains/losses) of a reference asset in exchange for a payments tied to the London Interbank Offered Rate (LIBOR) (or some other index) plus a spread. Total return swaps closely resemble asset-based swaps in substance, effectively allowing the total return receiver to create a synthetic leveraged position in the reference asset. 3

4 expectations, commensurate with the assigned rating, the collateral is available at maturity to repay the obligations. Fitch s analytical framework for evaluating synthetic arbitrage CDOs corresponds closely to the published criteria for rating any cash flow CDO (see Fitch Research on Rating Criteria for Cash Flow Collateralized Debt Obligations, dated Nov. 30, 2000, available on Fitch s web site at Key inputs include level and timing of stressed defaults, recovery expectations, and asset-liability management. Additionally, these transactions have distinctive features that may warrant additional analytical emphasis, including the use of leverage, buildup and release of excess spread, and mark-to-market triggers that may necessitate a hybrid cash flow/market value analysis. The eligible collateral also must conform to certain criteria in order to mitigate market and liquidity risk, which would arise in the event there is a liquidation prior to the transaction s maturity date, in order to satisfy payments by the trust under the TRS. Synthetic Balance Sheet CDOs Increasingly, banks have embraced synthetic structures to execute balance sheet CDOs for purposes of managing credit exposures and improving returns on risk/regulatory capital. Synthetic structures, which can be structured using either a CDS or a credit-linked note, allow banks to achieve risk/regulatory capital relief at lower all-in funding and administrative costs when compared with fully cash-funded CDOs. Europe, in particular, has been quick to embrace the use of synthetic balance sheet CDOs. Synthetic structures are especially well suited for European CDOs because of the ability to reference exposures across multiple legal and regulatory regimes. ABN AMRO s Amstel and , a EUR8.5 billion synthetic CDO issued in December 2000, is an example of a typical, albeit large, synthetic structure that transfers the credit risk of a portfolio of large European corporates originated by ABN AMRO. Proceeds from the notes were deposited into an account in the name of the SPV at ABN AMRO (rated F1+ by Fitch) and will be used to cover any losses (over and above the amount in the reserve account) and to redeem the notes at maturity. One of the current growth areas in the European CDO market is the securitization of small and medium-sized enterprise (SME) portfolios via synthetic structures. One of the primary roles of state development banks, such as Kreditanstalt fuer Wiederaufbau (KfW) of Germany and Instituto de Credito Oficial (ICO) of Spain, is to assist in the growth of SMEs. By securitizing their SME loans these banks are transferring a significant portion of the risk associated with these loans to the capital markets and, therefore, are able to originate additional loans to help expand this market. Another emerging asset class for European CDOs is the repackaging of asset-backed, residential mortgage-backed, and commercial mortgage-backed securities. Banks are now transferring the risk of referenced portfolios of structured securities, largely via unfunded structures. This is useful for banks both 4

5 in terms of managing their own credit exposure and, for German banks in particular, by enabling them to use the repackaged asset-backed portfolio as collateral for their own pfandebriefe issuance. In synthetic structures involving a CDS, the issuing bank establishes an SPV and enters into a CDS that references a portfolio of loans, bonds, commitments, or other credit instruments. Alternatively, the bank may execute the transaction through a third-party intermediary, such as in J.P. Morgan s BISTRO program. The bank normally will retain a relatively small first loss piece that serves to align its interests with the noteholders. The SPV issues one or more tranches of notes whose ultimate performance is linked to the actual default and recovery experience of the reference portfolio. Any losses arising from defaults are allocated to the noteholders, according to their priority in the capital structure. Losses are determined by specific credit events and settlement mechanisms, which are set forth in the CDS confirmation. Note proceeds are invested in high-quality, liquid collateral. This eligible collateral is pledged, on first priority basis, to the sponsor in order to satisfy loss claims under the CDS during the transaction s life and, secondarily, to the investors for repayment of the notes at maturity. In European synthetic transactions, the collateral used to delink the rating of the bank from the notes initially took the form of the sponsoring bank s AAA rated pfandebriefe; however, the market has now evolved to include other highly rated securities, with overcollateralization sized to cover market risk. To mitigate market and credit risk, some structures also may allow for delivery of the eligible collateral at par to satisfy loss claims under the CDS. The transaction remains linked to the senior debt rating of the sponsoring bank in the form of ongoing premium payments on the CDS, which serve to cover shortfalls on coupon payments, losses, and other miscellaneous expenses. In these structures, it is possible to de-link the transaction and achieve a higher rating than that of the bank on the basis of the collateral s rating, as well as structural mechanisms that include defeasance triggers, substitution rights, early termination, and other provisions. In credit-linked note structures, note proceeds are invested in a credit-linked note issued by the bank. As a result, proceeds from the CDO issuance are available to the bank for general corporate purposes, and the most senior tranche of the CDO typically will be subject to a rating cap equal to the sponsoring bank s senior debt rating. The rating cap underscores the position of CDO investors as senior unsecured creditors of the bank with respect to timely debt service and ultimate repayment. For either structure, the amount of issued notes typically is a fraction of the notional amount of the reference portfolio. The partially funded nature of the more recent synthetic balance sheet CDOs is a 5

6 Loss Recognition for Synthetic CDOs Loss Recognition Cash or physical settlement Immediate or deferred settlement With or without cost of carry Loss thresholds may apply Credit Events* Failure to pay (modified for structured securities) Bankruptcy Acceleration Repudiation or moratorium Restructuring *See 1999 International Swaps and Derivatives Association Credit Derivatives Definitions. distinctive feature and underscores that the main motivation is regulatory and economic capital management rather than funding driven. The bank is able to achieve maximum regulatory capital relief through the combination of the synthetic CDO, as well as through a super senior CDS transacted with an OECD bank. The super senior CDS is sized to provide credit protection for the balance of the reference portfolio in excess of the most senior tranche of the synthetic CDO. Alternatively, it may be possible, at least for U.S. banks, to gain full regulatory capital without the super senior CDS, as per guidelines issued by the Federal Reserve. Loss Recognition The mechanisms for determining and settling losses are interesting and unique features of synthetic balance sheet CDOs that merit some discussion. Loss indemnification can occur immediately following a credit event or can be deferred in order to allow for higher recoveries through active workout. In the latter case, there may be a mechanism to compensate the bank for its negative carry cost on the nonperforming asset. Protection payments on defaulted assets may be under a cash settlement method, in which the protection payment is based on the difference between the par value of the asset and its post-default market value. Alternatively, the CDO may provide for physical settlement, in which case the SPV is required to make a payment based on the full par value of the asset, and ends up owning the defaulted asset. Immediate cash settlement may prove to be more costly for CDO investors since technical trading factors immediately following a credit event can depress asset prices below their intrinsic recovery value. This is particularly true for senior secured bank loans, due to their superior creditor status, which positively influences ultimate recovery in bankruptcy proceedings. Definitions of credit events also play a role in synthetic structures that are not present in traditional CDOs. Credit event definitions conform to 1999 International Swap Dealers Association (ISDA) Credit Derivatives Definitions. Market convention generally defines a credit event as failure to pay, bankruptcy, restructuring, repudiation or moratorium, and obligation acceleration. Restructuring, in particular, has become a hot button issue, and this definition may be subject to substantial revision or excluded altogether as a standard credit event by market participants (see Fitch Research on Restructuring: A Defining Event for Synthetic CDOs, dated Jan. 8, 2001, available on Fitch s web site at For synthetic CDOs referencing asset-backed and other structured securities portfolios, the standard credit event definitions require modification. Because many structured securities are contractually permitted to defer interest payments without being in default, the definition of failure to pay is modified to ensure consistency with the underlying reference assets. Again, the analytical framework for synthetic balance sheet CDOs mirrors Fitch s published CDO criteria. These transactions, however, do have a number of features that are unique, including mechanisms to ensure de-linkage from the issuing bank s rating, timing and procedures for making protection payments on defaulted assets, and investment restrictions in collateralized structures designed to minimize or offset market and liquidity risk. Additionally, these transactions may have early redemption features that permit the issuer to call the transaction in the event of changes in the regulatory capital framework. On the other hand, these structures can offer greater simplicity with respect to asset/liability management and cash flow modeling. Credit Default Swaps Increasingly, Fitch is asked to evaluate more customized synthetic exposures in the form of portfolio CDSs. These transactions closely resemble synthetic balance sheet CDOs in so much as a CDS is used to transfer credit risk on a well defined reference portfolio of 6

7 terms of the number of obligors. It is possible for a portfolio CDS to reference as few as obligors, although obligors is more normal. This would not be the case in a well diversified CDO. Moreover, there will be no upfront credit enhancement in the case of first loss exposures, although there may be mechanisms to capture and accumulate excess cash derived from the CDS premium payments. Fitch s analytical approach will be based on the reference portfolio s credit profile, with particular emphasis on the expected default probability of the weaker credits, the degree of diversification and its impact on expected defaults, and an assessment of recovery values. credits. That said, there are important differences that make these transactions more akin to synthetic CDOslite (all the benefits, but half the credits). In a typical portfolio CDS, the arranger seeks to transfer first loss or second loss exposure on a predetermined percentage of the reference portfolio in return for an annual premium. The seller of credit protection effectively is taking a levered position in the reference portfolio, with the leverage inversely related to the loss percentage. For example, a 5% first loss exposure is equivalent to a 20x levered position in the underlying reference portfolio. This has important analytical implications since a single default, however low the statistical probability, can result in a high loss severity depending on the size of the first loss position and the corresponding leverage. As compared to synthetic CDOs, portfolio CDS tend to be more customized with respect to the structure and the reference portfolio characteristics. Protection buyers may use portfolio CDS to rebalance their portfolios and synthetically transfer excessive concentrations. Similarly, protection sellers are able to take on name-specific risk on the basis of their investment parameters and risk-reward appetite. Portfolio CDS can be transacted as a pure credit derivative or, alternatively, in funded form as a creditlinked note. A funded format may be more attractive to some buyers of credit risk who operate under specific investment guidelines, want a cash instrument that pays a stated coupon, and desire to limit counterparty credit risk through the use of collateral. Fitch s rating methodology for portfolio CDS has some fundamental differences when compared with traditional CDOs or synthetic CDOs. First, the reference portfolio may be significantly less diverse in Conclusion Growth in synthetic CDOs directly corresponds to the rapid growth and innovations in traditional credit derivative markets. The fact that credit derivatives and CDOs are still relatively new indicates that more innovations and further acceptance is likely. Underscoring this trend is the application of synthetic structures to an ever wider range of asset types, including investment-grade and leveraged loans, corporate bonds, asset-backed securities, commercial and residential mortgage-backed securities, and, even, counterparty risk from derivatives and other activities. Synthetic CDOs have a number of features that are unique and distinctive. Fitch s analysis of synthetic CDOs is fundamentally based on the methodology used to rate cash-funded CDOs. A number of additional analytical factors, however, come into play when rating synthetic CDOs. To summarize, these include a review of the underlying credit derivative instrument, including definitions of credit events, loss recognition, market value triggers, and counterparty and collateralization requirements. Related Fitch Research For more information on Fitch s rating criteria for CDOs, see the following Fitch Research, available on Fitch s web site at Restructuring: A Defining Event for Synthetic CDOs, dated Jan. 8, Rating Criteria for Cash Flow Collateralized Debt Obligations, dated Nov. 30, Rating Criteria for Cash Flow ABS/MBS CDOs, dated Nov. 9, Rating Criteria for European Arbitrage Collateralised Debt Obligations, dated June 5, Market Value CBO/CLO Rating Criteria, dated June 1,

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