$7.3 billion in risk transferred in first index-linked synthetic CDO

Horizon’s structure is similar to a traditional synthetic CDO, except the reference asset is an index, not an actual portfolio (see Risk, March 2002, page 10). In a standard synthetic, exposure to credit risk is transferred to a special purpose vehicle via a portfolio default swap or series of single-name default swaps. But for Horizon, just one single index default swap linked to more than 2,000 names was used - making the deal cheaper than traditional large synthetics.

The structure is akin to a credit catastrophe bond, referenced to an index designed to replicate the credit portfolio that is being hedged. “We constructed a credit index by combining the weighted performance of Moody’s single-A and Baa default cohorts starting in 2000,” Oldrich Masek, London-based head of structured credit at JP Morgan Chase, told RiskNews.

The credit protection buyer SCOR, a French reinsurer, was looking for a more flexible and cost-effective way to risk-manage its credit reinsurance activity. Horizon hedged SCOR against any losses in the index in excess of a maximum of $100 million per annum. “The transaction allowed the risk transfer of a second loss position on a portfolio equivalent to $7.3 billion," said Tim Van den Brande, London-based vice-president, structured credit at JP Morgan Chase. "On the other side of the deal, we placed €130 million of mezzanine tranche index-linked notes [rated Aaa, Aa3, A3 and Baa2] in both dollars and euros," he added.

“This vehicle allows SCOR to issue new tranches as and when it wishes, so it can continue to develop its hedging programme going forward,” said Van den Brande. The US bank signed up nine investors to the deal – a relatively large number for an offering of €130 million on this type of structure.

Reinsurers showed a lot of interest in unfunded participation initially. But SCOR did not want to add counterparty correlation risk to the protection being purchased, so JP Morgan Chase mainly distributed to cash buyers elsewhere.