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Structured Finance
F
Loan ProductsSpecial Report Synthetic CDOs: A Growing
Market for Credit Derivatives
AnalystsNew YorkRoger Merritt1 212 [email protected]
Michael Gerity1 212 [email protected]
Alyssa Irving1 212 908 [email protected]
LondonMitchell Lench44 20 7417 [email protected]
� SummaryThe market for collateralized debt obligations (CDOs) continues toshow healthy growth despite a notable rise in corporate defaults andnegative rating actions related to poorly performing 1997 and 1998vintages. Exceptionally wide arbitrage opportunities, as well asincreased market acceptance of CDO technology and credit derivativesto manage portfolio risk and diversify funding, continue to driveissuance activity. One of the more interesting developments in themarket is the growing popularity of synthetic CDO structures. By someestimates, synthetic CDOs now comprise in excess of 50% of totalCDO issuance and are the preferred structure for the expandingEuropean CDO market.
Synthetic structures differ from more traditional cash-funded CDOs in anumber of important ways. Cash-funded CDOs are typically structuredas securitizations, whereby ownership of the assets is legally transferredto a bankruptcy-remote trust or special purpose vehicle (SPV). Theassets are fully cash funded with the proceeds of debt and equity issuedby the SPV, with repayment of the obligations directly tied to the cashflow of the assets. Conversely, synthetic CDOs simulate the risktransference benefits of cash-funded CDOs, without a legal change in theownership of the assets, by utilizing credit derivatives to transfer creditrisk related to a portfolio of reference assets.
In a synthetic CDO, the sponsoring institution transfers the total returnprofile or default risk of a reference portfolio via a credit derivativeagreement (total return swap [TRS] or credit default swap [CDS]) or acredit-linked note. Correspondingly, the SPV issues one or moretranches of securities with repayment contingent upon the actual loss
Synthetic CDOs: KeyAttributes
• Cost of funding advantage• Regulatory/economic capital relief• No borrower notification• Administratively efficient• Customized exposures• Efficiency vis-a-vis market risks
ebruary 6, 2001
www.fitchratings.com
experience relative to expectations. Proceeds may be held by the SPVand invested in highly rated, liquid collateral, or the funds may bepassed through to the sponsor as an investment in a credit-linked note.
Broadly speaking, there are two types of synthetic CDOs � arbitrageand balance sheet. Arbitrage CDOs are used by asset managementcomplexes, insurance companies, and other investment boutiques withthe intent of exploiting a yield mismatch between the yield on theunderlying assets and the lower cost of servicing the CDO securities.Alternatively, balance sheet CDOs are utilized primarily by banks formanaging regulatory and risk-based capital.
� Motivating Factors for Synthetic StructuresThere are a number of reasons for the growing popularity of syntheticCDOs, although the motivations will differ somewhat betweenarbitrage and balance sheet transactions. As previously mentioned, theprimary motivation for entering into an arbitrage CDO is to exploit theyield mismatch between a pool of assets and the CDO liabilities. The
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motivations for using a balance sheet CDO aretypically driven by regulatory or risk-based capitalconsiderations.
Because the reference assets, for the most part, are notactually removed from the sponsoring financialinstitution�s balance sheet, synthetic CDOs aretypically easier to execute than cash-funded structures.This is particularly the case with bank loans, whichmay require borrower notification and consent or haveother restrictions on loan sales that can interfere withborrower relations. Synthetic structures are lessadministratively burdensome when compared withcash-funded transactions and are superior to cash-funded CDOs in their ability to transfer partial claimson a particular credit. Finally, issues related to interestrate and currency hedging are efficiently addressed insynthetic balance sheet CDOs. For example, currencyrisk can be neutralized by setting the exchange rate atthe outset for purposes of establishing the loss amounton a defaulted asset.
Synthetic CDOs generally accomplish risk transfer ata lower cost, since the amount of issuance is typicallysmall relative to the reference portfolio, reflecting
some multiple of losses. In these �partially funded�structures, funding is largely provided by thesponsoring financial institution at a cost that is lowerthan fully funded CDO structures. Syntheticstructures also can facilitate exposure to assets thatmay be relatively scarce and, therefore, difficult toacquire via the cash market. Finally, syntheticstructures allow banks to create more customizedtransfers of balance sheet risk. For example, lossesmay be subject to a threshold, and mechanisms canbe employed to reimburse carrying costs for non-performing assets during a predefined workoutperiod. Contingent exposures, including undrawnrevolving facilities, and counterparty credit exposuresalso can be accommodated with relative ease.
The primary motivation for European banks, inparticular, to issue synthetic CDOs is to take advantageof the fact that the risk weightings used to determine abank�s minimum capital adequacy requirements do notdifferentiate between various levels of risk. Currently,the amount of capital that international banks arerequired to hold against any corporate exposure is100% of the capital adequacy ratio. The requirementsfor a synthetic CDO, however, are much less than this
Cash vs. Synthetic Balance Sheet CDOs: Comparative Benefits������� Degree of Importance �������
Benefit Provided Cash-Funded SyntheticTransfer Credit Risk High HighRegulatory/Economic Capital Relief High HighFunding Diversification High LowCustomization/Flexibility Medium HighEase of Execution Low/Medium HighCDOs � Collateralized debt obligations.
Synthetic CDOs: A Growing Market for Credit Derivatives
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since the funded portion of the structure is backed bygovernment securities, which have a 0% riskweighting (if the collateral is pfandebriefe, it is 10%).The equity tranche, which is typically retained by thebank, will receive a one-for-one capital charge. Whenthe proposed Basle requirements are implemented,however, the new risk weightings will be scaled tomore closely match the risk of the asset.
� Synthetic Arbitrage CDOsSynthetic arbitrage CDOs replicate a leveragedexposure (generally five to seven times [x] levereddepending on the portfolio characteristics) to areference portfolio of assets, most frequentlysyndicated loans or bonds. Investors and the collateralmanager have the potential for attractive returns on aleveraged basis, while the sponsoring financialinstitution (typically a bank) generates fee income andan additional distribution outlet for origination/lendingactivities. Examples of these programs include but byno means are restricted to Chase�s CSLT, J.P.Morgan�s SEQUILS/MINCs, Bank of America�sSERVES and Citibank�s ECLIPSE programs.
In a typical structure, an SPV enters into a series of TRSon a portfolio of credits that is diversified by obligor andindustry. The portfolio may be fully or partially ramped-up at the outset, at the discretion of the investmentmanager, and is actively managed over the transaction�slife, subject to established investment guidelines. Inaccordance with the terms of the TRS, the SPV receivesthe total realized return on the reference portfolio andpays the sponsoring bank the London Interbank OfferedRate (LIBOR) plus a spread, which generallycorresponds to the bank�s funding/administrative costswith respect to the reference portfolio. The SPV, in turn,issues a combination of notes and equity, which serve tofund the first loss exposure to the reference portfolio.The reference portfolio is funded on-balance sheet bythe sponsoring institution. The TRS generally is markedto market on a periodic basis, and these structures maybe subject to one or more market value triggers. If so, adegree of market risk exists that is not present in cashflow CDOs.
J.P. Morgan�s SEQUILS/MINCS vehicles providesynthetic exposure to a reference portfolio of leveragedbank loans through a CDS, rather than a TRS. There isno mark-to-market component, and the transactiontriggers are based purely on realized losses under theCDS. The reference portfolio is funded off-balancesheet by the SEQUILS portion of the transaction,which is senior in priority to the MINCS notes.
These structures invest the proceeds from the noteand equity issuance in high-quality, liquid �eligible�collateral, which generally earns a rate approximatingLIBOR and serves to defray the coupon on the notes.This collateral is pledged on a primary basis to coverlosses, if necessary. Provided losses do not exceed
Foundation Built on Credit Derivatives
Credit Default SwapA credit default swap is a bilateral contract in whichthe credit protection buyer pays a periodic premiumon a predetermined amount (notional amount) inexchange for a contingent payment from the creditprotection seller to cover losses following aspecified �credit event� on a specific asset(reference asset). Credit events generally follow thedefinitions promulgated by the International Swapsand Derivatives Association. Market convention, todate, has defined a credit event as failure to pay,bankruptcy, restructuring, repudiation ormoratorium, and acceleration. The premium,notional amount, reference asset, credit instrument,and credit events, as well as other terms of thecontract, are negotiated between the protectionbuyer and seller (counterparties) at inception.
Total Return SwapA total return swap is also a bilateral contract, but, inthis case, the protection buyer exchanges the entireeconomic performance (interest, fees, and realizedgains/losses) of a reference asset in exchange for apayments tied to the London Interbank Offered Rate(LIBOR) (or some other index) plus a spread. Totalreturn swaps closely resemble asset-based swaps insubstance, effectively allowing the total returnreceiver to create a synthetic leveraged position inthe reference asset.
Synthetic CDOs: A Growing Market for Credit Derivatives
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Synthetic CDOs: A Growing Market for Credit Derivatives
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expectations, commensurate with the assigned rating,the collateral is available at maturity to repay theobligations.
Fitch�s analytical framework for evaluating syntheticarbitrage CDOs corresponds closely to the publishedcriteria for rating any cash flow CDO (see FitchResearch on �Rating Criteria for Cash FlowCollateralized Debt Obligations,� dated Nov. 30,2000, available on Fitch�s web site atwww.fitchratings.com). Key inputs include level andtiming of stressed defaults, recovery expectations,and asset-liability management. Additionally, thesetransactions have distinctive features that maywarrant additional analytical emphasis, including theuse of leverage, buildup and release of excess spread,and mark-to-market triggers that may necessitate ahybrid cash flow/market value analysis. The eligiblecollateral also must conform to certain criteria inorder to mitigate market and liquidity risk, whichwould arise in the event there is a liquidation prior tothe transaction�s maturity date, in order to satisfypayments by the trust under the TRS.
� Synthetic Balance Sheet CDOsIncreasingly, banks have embraced synthetic structuresto execute balance sheet CDOs for purposes ofmanaging credit exposures and improving returns onrisk/regulatory capital. Synthetic structures, which canbe structured using either a CDS or a credit-linkednote, allow banks to achieve risk/regulatory capitalrelief at lower all-in funding and administrative costswhen compared with fully cash-funded CDOs.
Europe, in particular, has been quick to embrace theuse of synthetic balance sheet CDOs. Syntheticstructures are especially well suited for EuropeanCDOs because of the ability to reference exposuresacross multiple legal and regulatory regimes. ABNAMRO�s Amstel 2000-1 and 2000-2, aEUR8.5 billion synthetic CDO issued in December2000, is an example of a typical, albeit large,synthetic structure that transfers the credit risk of aportfolio of large European corporates originated byABN AMRO. Proceeds from the notes weredeposited into an account in the name of the SPV atABN AMRO (rated �F1+� by Fitch) and will be usedto cover any losses (over and above the amount in thereserve account) and to redeem the notes at maturity.
One of the current growth areas in the EuropeanCDO market is the securitization of small andmedium-sized enterprise (SME) portfolios viasynthetic structures. One of the primary roles of statedevelopment banks, such as Kreditanstalt fuerWiederaufbau (KfW) of Germany and Instituto deCredito Oficial (ICO) of Spain, is to assist in thegrowth of SMEs. By securitizing their SME loansthese banks are transferring a significant portion ofthe risk associated with these loans to the capitalmarkets and, therefore, are able to originateadditional loans to help expand this market.
Another emerging asset class for European CDOs isthe repackaging of asset-backed, residentialmortgage-backed, and commercial mortgage-backedsecurities. Banks are now transferring the risk ofreferenced portfolios of structured securities, largelyvia unfunded structures. This is useful for banks both
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Synthetic CDOs: A Growing Market for Credit Derivatives
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in terms of managing their own credit exposure and,for German banks in particular, by enabling them touse the repackaged asset-backed portfolio ascollateral for their own pfandebriefe issuance.
In synthetic structures involving a CDS, the issuingbank establishes an SPV and enters into a CDS thatreferences a portfolio of loans, bonds, commitments,or other credit instruments. Alternatively, the bankmay execute the transaction through a third-partyintermediary, such as in J.P. Morgan�s BISTROprogram. The bank normally will retain a relativelysmall first loss piece that serves to align its interestswith the noteholders. The SPV issues one or moretranches of notes whose ultimate performance islinked to the actual default and recovery experienceof the reference portfolio. Any losses arising fromdefaults are allocated to the noteholders, according totheir priority in the capital structure. Losses aredetermined by specific credit events and settlementmechanisms, which are set forth in the CDSconfirmation.
Note proceeds are invested in high-quality, liquidcollateral. This eligible collateral is pledged, on firstpriority basis, to the sponsor in order to satisfy lossclaims under the CDS during the transaction�s life and,secondarily, to the investors for repayment of the notesat maturity. In European synthetic transactions, thecollateral used to delink the rating of the bank from thenotes 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 structuresalso may allow for delivery of the eligible collateralat par to satisfy loss claims under the CDS. Thetransaction remains linked to the senior debt rating ofthe sponsoring bank in the form of ongoing premiumpayments on the CDS, which serve to cover shortfallson coupon payments, losses, and other miscellaneousexpenses. In these structures, it is possible to de-linkthe transaction and achieve a higher rating than thatof the bank on the basis of the collateral�s rating, aswell as structural mechanisms that includedefeasance triggers, substitution rights, earlytermination, and other provisions.
In credit-linked note structures, note proceeds areinvested in a credit-linked note issued by the bank.As a result, proceeds from the CDO issuance areavailable to the bank for general corporate purposes,and the most senior tranche of the CDO typically willbe subject to a rating cap equal to the sponsoringbank�s senior debt rating. The rating cap underscoresthe position of CDO investors as senior unsecuredcreditors of the bank with respect to timely debtservice and ultimate repayment.
For either structure, the amount of issued notestypically is a fraction of the notional amount of thereference portfolio. The partially funded nature of themore recent synthetic balance sheet CDOs is a
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factors immediately following a credit event candepress asset prices below their intrinsic recoveryvalue. This is particularly true for senior securedbank loans, due to their superior creditor status,which positively influences ultimate recovery inbankruptcy proceedings.
Definitions of �credit events� also play a role insynthetic structures that are not present in traditionalCDOs. Credit event definitions conform to 1999International Swap Dealers Association (ISDA)Credit Derivatives Definitions. Market conventiongenerally defines a credit event as failure to pay,bankruptcy, restructuring, repudiation or moratorium,and obligation acceleration. Restructuring, inparticular, has become a hot button issue, and thisdefinition may be subject to substantial revision or
Loss Recognition for Synthetic CDOsLoss 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 CreditDerivatives Definitions.
ynthetic CDOs: A Growing Market for Credit Derivatives
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istinctive feature and underscores that the mainotivation is regulatory and economic capitalanagement rather than funding driven.
he bank is able to achieve maximum regulatoryapital relief through the combination of the syntheticDO, as well as through a super senior CDS
ransacted with an OECD bank. The super seniorDS is sized to provide credit protection for thealance of the reference portfolio in excess of theost senior tranche of the synthetic CDO.lternatively, it may be possible, at least for U.S.anks, to gain full regulatory capital without theuper senior CDS, as per guidelines issued by theederal Reserve.
Loss Recognitionhe mechanisms for determining and settling lossesre interesting and unique features of syntheticalance sheet CDOs that merit some discussion. Lossndemnification can occur immediately following aredit event or can be deferred in order to allow forigher recoveries through active workout. In theatter case, there may be a mechanism to compensatehe bank for its negative carry cost on the non-erforming asset.
rotection payments on defaulted assets may bender a �cash settlement� method, in which therotection payment is based on the differenceetween the par value of the asset and its post-defaultarket value. Alternatively, the CDO may provide
or physical settlement, in which case the SPV isequired to make a payment based on the full paralue of the asset, and ends up owning the defaultedsset. Immediate cash settlement may prove to beore costly for CDO investors since technical trading
excluded altogether as a standard credit event bymarket participants (see Fitch Research on�Restructuring: A Defining Event for SyntheticCDOs,� dated Jan. 8, 2001, available on Fitch�s website at www.fitchresearch.com).
For synthetic CDOs referencing asset-backed andother structured securities portfolios, the standardcredit event definitions require modification. Becausemany structured securities are contractually permittedto defer interest payments without being in default,the definition of failure to pay is modified to ensureconsistency with the underlying reference assets.
Again, the analytical framework for synthetic balancesheet CDOs mirrors Fitch�s published CDO criteria.These transactions, however, do have a number offeatures that are unique, including mechanisms toensure de-linkage from the issuing bank�s rating,timing and procedures for making protectionpayments on defaulted assets, and investmentrestrictions in collateralized structures designed tominimize or offset market and liquidity risk.Additionally, these transactions may have earlyredemption features that permit the issuer to call thetransaction in the event of changes in the regulatorycapital framework. On the other hand, thesestructures can offer greater simplicity with respect toasset/liability management and cash flow modeling.
� Credit Default SwapsIncreasingly, Fitch is asked to evaluate more customizedsynthetic exposures in the form of portfolio CDSs.These transactions closely resemble synthetic balancesheet CDOs in so much as a CDS is used to transfercredit risk on a well defined reference portfolio of
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Synthetic CDOs: A Growing Market for Credit Derivatives
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credits. That said, there are important differences thatmake these transactions more akin to synthetic CDOs-lite (all the benefits, but half the credits).
In a typical portfolio CDS, the arranger seeks totransfer first loss or second loss exposure on apredetermined percentage of the reference portfolioin return for an annual premium. The seller of creditprotection effectively is taking a levered position inthe reference portfolio, with the leverage inverselyrelated to the loss percentage. For example, a 5% firstloss exposure is equivalent to a 20x levered positionin the underlying reference portfolio. This hasimportant analytical implications since a singledefault, however low the statistical probability, canresult in a high loss severity depending on the size ofthe first loss position and the corresponding leverage.
As compared to synthetic CDOs, portfolio CDS tendto be more customized with respect to the structure andthe reference portfolio characteristics. Protectionbuyers may use portfolio CDS to rebalance theirportfolios and synthetically transfer excessiveconcentrations. Similarly, protection sellers are able totake on name-specific risk on the basis of theirinvestment parameters and risk-reward appetite.Portfolio CDS can be transacted as a pure creditderivative or, alternatively, in funded form as a credit-linked note. A funded format may be more attractive tosome buyers of credit risk who operate under specificinvestment guidelines, want a cash instrument thatpays a stated coupon, and desire to limit counterpartycredit risk through the use of collateral.
Fitch�s rating methodology for portfolio CDS hassome fundamental differences when compared withtraditional CDOs or synthetic CDOs. First, thereference portfolio may be significantly less diverse in
terms of the number of obligors. It is possible for aportfolio CDS to reference as few as 10�15 obligors,although 20�25 obligors is more normal. This wouldnot be the case in a well diversified CDO. Moreover,there will be no upfront credit enhancement in the caseof first loss exposures, although there may bemechanisms to capture and accumulate excess cashderived from the CDS premium payments. Fitch�sanalytical approach will be based on the referenceportfolio�s credit profile, with particular emphasis onthe expected default probability of the weaker credits,the degree of diversification and its impact on expecteddefaults, and an assessment of recovery values.
� ConclusionGrowth in synthetic CDOs directly corresponds to therapid growth and innovations in traditional creditderivative markets. The fact that credit derivativesand CDOs are still relatively new indicates that moreinnovations and further acceptance is likely.Underscoring this trend is the application of syntheticstructures to an ever wider range of asset types,including investment-grade and leveraged loans,corporate bonds, asset-backed securities, commercialand residential mortgage-backed securities, and,even, counterparty risk from derivatives and otheractivities.
Synthetic CDOs have a number of features that areunique and distinctive. Fitch�s analysis of syntheticCDOs is fundamentally based on the methodologyused to rate cash-funded CDOs. A number ofadditional analytical factors, however, come into playwhen rating synthetic CDOs. To summarize, theseinclude a review of the underlying credit derivativeinstrument, including definitions of credit events, lossrecognition, market value triggers, and counterpartyand collateralization requirements.
� Related Fitch ResearchFor more information on Fitch�s rating criteria forCDOs, see the following Fitch Research, available onFitch�s web site at www.fitchresearch.com:• �Restructuring: A Defining Event for Synthetic
CDOs,� dated Jan. 8, 2001.• �Rating Criteria for Cash Flow Collateralized
Debt Obligations,� dated Nov. 30, 2000.• �Rating Criteria for Cash Flow ABS/MBS
CDOs,� dated Nov. 9, 2000.• �Rating Criteria for European Arbitrage
Collateralised Debt Obligations,� dated June 5, 2000.• �Market Value CBO/CLO Rating Criteria,�
dated June 1, 1999.
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Copyright © 2001 by Fitch, One State Street Plaza, NY, NY 10004Telephone: New York, 1-800-753-4824, (212) 908-0500, Fax (212) 480-4435; Chicago, IL, (312) 368-3100, Fax (312) 263-1032;London, 011 44 20 7417 4222, Fax 011 44 20 7417 4242; San Francisco, CA, 1-800-953-4824, (415) 732-5770, Fax (415) 732-5610Printed by American Direct Mail Co., Inc. NY, NY 10014. Reproduction in whole or in part prohibited except by permission.Fitch ratings are based on information obtained from issuers, other obligors, underwriters, their experts, and other sources Fitch believes to be reliable. Fitch does not audit or verify the truth oraccuracy of such information. Ratings may be changed, suspended, or withdrawn as a result of changes in, or the unavailability of, information or for other reasons. Ratings are not arecommendation to buy, sell, or hold any security. Ratings do not comment on the adequacy of market price, the suitability of any security for a particular investor, or the tax-exempt nature ortaxability of payments made in respect to any security. Fitch receives fees from issuers, insurers, guarantors, other obligors, and underwriters for rating securities. Such fees generally vary from$1,000 to $750,000 per issue. In certain cases, Fitch will rate all or a number of issues issued by a particular issuer, or insured or guaranteed by a particular insurer or guarantor, for a singleannual fee. Such fees are expected to vary from $10,000 to $1,500,000. The assignment, publication, or dissemination of a rating by Fitch shall not constitute a consent by Fitch to use its name asan expert in connection with any registration statement filed under the federal securities laws. Due to the relative efficiency of electronic publishing and distribution, Fitch Research may beavailable to electronic subscribers up to three days earlier than print subscribers.
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