The synthetic solution

The development of the credit default swap market has allowed originators to issue CDOs where the exposure to underlying credits is referenced via a CDS rather than directly to the funded asset

Balance-sheet and arbitrage CDOs can be structured as cashflow or synthetic instruments, although an increasingly popular formula among originators is to combine the two into so-called hybrid CDOs. The cashflow CDO, which formed the bread and butter of the market in its formative years, is a structure in which CDO notes are collateralised by a portfolio of cash assets purchased by the originator. In other words, in this classical structure the CDO owns the physical bond, loan or other security referenced by the instrument.

The volume of traditional cashflow CDOs has been eclipsed in recent years by synthetic products, sometimes referred to as collateralised synthetic obligations. In a synthetic CDO, no legal or economic transfer of bonds or loans take place, with the underlying reference pool of assets remaining on the balance sheet of the originator. Instead, the CDO gains exposure to credit risk by selling protection to others through a CDS, which functions very much like an insurance contract. In other words, the CDO is still being paid for bearing credit risk, just as it would do if it physically owned a bond or loan.

From the perspective of originators, there are a number of clear benefits associated with synthetic CDOs. One of these is that risk transfer via synthetic structures allows bank originators in the CDO market to ensure that client relationships are not jeopardised. That is an especially relevant consideration in the market for CLOs, given that deal documentation in the syndicated lending market often prevents the transfer of loan ownership. Even where loan transfer is permitted, CDOs would often need, in theory, to secure the written permission of each borrower in order to construct a cashflow, which would amount to an impractical burden.

Synthetic structures are also attractive for originators securitising multi-jurisdictional portfolios or loans made in countries where the local legal framework either does not allow for the so-called ‘true sale’ of assets or, more probably, where the local tax system makes the transfer of legal title of assets uneconomic. Until recently, it was the tax-related disadvantages with true sales that made synthetics the main source of securitisations in Germany.

The market for synthetic CDOs owes its dramatic growth in recent years to the explosive expansion in the market for CDS. A CDS is a privately negotiated bilateral agreement in which one party, variously known as the protection buyer or risk shedder, pays a premium to another, generally referred to as the protection seller or risk taker, in order to secure protection against any losses that may be incurred through exposure to an investment as a result of an unforeseen development (or ‘credit event’).

A Deutsche Bank report on synthetic CDOs traces the strong growth in investment-grade CDOs back to 2000, by which time – notes the Deutsche report – “the credit default swap market was expanding at a seemingly exponential rate. We estimate the outstanding notional amount was growing at about 75% per annum and that the market totalled about E800 billion. Between the US and Europe, about 150–200 names were actively traded.”

Since then, liquidity in the CDS market has continued to grow at breakneck speed, with some estimates suggesting that by the end of 2004, the CDS market will be worth some $4,800 billion.

For investors there are a number of important attractions associated with exposure to the CDS market rather than to cash bonds. CDOs made up of CDS allow investors to buy ‘pure’ credit because the structure separates the credit risk component of from the other asset’s risks, such as interest rate and currency risk.

The explosion of liquidity in the CDS market has had a beneficial knock-on effect on the market for synthetic CDOs at a number of levels. For one thing, it has allowed for portfolios of default swaps to be assembled (or ramped up) much more quickly than those of cash instruments. As a report published by Citigroup analysis explains: “This is especially important in such markets as European investment-grade cash, where the liquidity in the corporate bond market does not permit the ramp-up of a diversified portfolio within such a short time.”

Synthetic CDOs began to appear for the first time in the European market in 1997, with JP Morgan’s Bistro (Broad Index Secured Trust Offering), launched in December of that year, one of the first instruments of its kind to transfer the risks embedded in a portfolio of loans to the capital market, and hence reduce regulatory capital requirements.

Synthetic CDOs were much slower to catch on in the Asian market, which was attributed by some market commentators to a reluctance among Asian investors to buy bonds that are not backed by physical, tangible assets, which in turn explained why the broader CDS market was slower to develop in Asia than in Europe. Since 2001, however, issuance of synthetic products has been rapidly gaining in popularity in Asia.

Recently the market has seen the development of standardised synthetic CDOs in the form of tradable CDS indices – most notably iBoxx and Trac-x (see page 25). These products allow investors to buy and sell a proxy for credit market risk and individual subsectors, quickly.

The structure of a synthetic CDO

In the so-called unfunded portion of a synthetic CDO, the risk embedded in a portfolio of assets (as opposed to the assets themselves) is transferred directly to a ‘super-senior counterparty’ via a super-senior CDS. In this instance, the CDO acts as the protection buyer, by agreeing to pay a premium to the counterparty (the protection seller) in return for a commitment from the counterparty to pay compensation to the CDO in the event of any defaults in the reference portfolio.

The super-senior swap is a vital driver behind the economics of a synthetic CLO and the key reason underlying the compelling cost benefits of these structures for originators. Within a synthetic structure, the super-senior swap will typically account for at least 80% of the CLO’s capital structure, and will generally be provided by a highly rated bank or insurance company.

Those super-senior buyers or sellers of credit protection are attracted by the security of the instrument, which is often referred to as a ‘quasi quadruple-A’ or triple-A-plus tranche, and is therefore, presumably a more solid credit than the US government or the World Bank, which of course is not possible.

Nevertheless, it is broadly accepted that the risk embedded in the super-senior tranche of a synthetic CLO referencing a pool of investment-grade assets is remote in the extreme. This is because even if a super-senior swap accounts for as much as 90% of a CDO’s capital structure (which is not uncommon), more than 10% of the assets within the reference pool would have to default for losses to be sustained by the most senior tranche – an improbably high default rate for investment-grade bonds when the historical norm has been for a default rate of about 0.3%. Because the perceived risk associated with the super-senior swap is so low, the investor in this tranche is typically paid a premium that is no more than 8 basis points to 10bp of the CDO’s notional size, which is considerably below what an investor in the most senior tranche of a cash CDO would demand.

The very compelling cost benefits associated with synthetic CDOs compared with their traditional cash counterparts are neatly outlined in a primer on the market published in 2002 by Bear Stearns, which analyses the liability structure of a hypothetical CDO with a notional value of $1 billion compared with that of a cash product. The collateral pool for both CDOs is investment-grade credits. But in the synthetic transaction, no cash is paid upfront for physical bonds, whereas in the cash CDO the entire liability structure is used to fund the physical purchase of the collateral.

In the synthetic CDO, 89% of the capital structure is accounted for by the super-senior swap, for which the CDO is paying just 8bp. The result is that the weighted average cost of liabilities for the whole capital structure is 20bp. That compares with a weighted average cost of 66bp for a comparable cash CDO in which 85% of the capital structure is accounted for by triple-A Class A notes, 10% by A3 Class B notes and the remaining 5% by junior-most equity.