Super-senior risk buyer’s role seen as vital in managed synthetics

The future growth in managed synthetic collateralised debt obligation (CDO) deal-flow is dependent on the willingness of counterparties to sell super-senior risk protection to CDOs, said Jeff Huffman, a London-based executive director in Goldman Sachs’ credit derivatives group.

Speaking yesterday at Risk’s Credit Risk Summit 2002 Europe, Huffman said the superior economics of managed synthetic, versus cash CDOs are largely due to super-senior risk – typically equivalent to between 80% and 90% of the notional value of the entire deal – being laid-off to counterparties such as monoline insurers.

Super-senior risk is at the very top of the capital structure, so writing protection on it is equivalent to supplying the CDO with catastrophic risk protection.

Huffman told delegates attending the London conference that some monolines have recently been “taking a breather” from writing super-senior protection, leaving credit derivatives dealers trading default swaps with the CDO to bear the risk. “Dealers are not natural super-senior risk takers, though,” he added.

When super-senior risk is not being explicitly swapped-out to insurers, credit derivatives dealers may include an implicit super-senior risk premium in the cost of trading with CDOs. Also, additional mezzanine notes, for example, could be issued so that the typical size of the mezzanine tranche is increased from around 8% to 22% of a deal’s total notional, said Huffman.

Another factor challenging the continued growth in new, managed synthetic CDO deals is market confidence in the integrity and uniformity of credit default swaps contract language, Huffman said. There is still a lack of consensus among market participants regarding specific definitions of credit derivatives contracts, with restructuring a particularly contentious issue.