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Learn about Synthetic CDOs, their types, structures, and advantages, as well as a comparison with cash CDOs. Explore motivations and considerations for both sponsors and investors in this complex financial instrument.
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Should Your Next Deal be Cash or Synthetic? CDOs in the Heartland March 20, 2003 Marion Silverman
Types of Synthetic CDOs Static InvestmentGrade SyntheticsEg. SALS, EPOCH nth to DefaultBasketsEg. (private) High Yield Arbitrage CLOs Eg. SERVES, ELFS Synthetic Structures Synthetic Bond Fund Ratings Eg. HYDI Credit Linked Trust Single Name CreditLinked NotesEg. TIERS Trust Managed Synthetics Eg. Shoreline
Synthetic HY Arbitrage CDOs • CDO arbitrage programs are sponsored by higher rated financial institutions for the benefit of CDO managers. • Allow managers and capital market investors to replicate economics of cash arbitrage CDOs via credit derivatives.
Synthetic HY Arbitrage CDOs • To date, in the U.S., the only asset class has been domestic senior secured bank loans, reflecting the predictability of recoveries and a growing secondary market. • Going forward, expect asset classes to broaden, including European leveraged loans, middle market loans, and ABS.
Features of Synthetic HY Arbitrage CDOs • Credit Default Swap or Total Return Swap • Fully Funded • Cashflow or Hybrid (Market Value) Structures • Counterparty Exposure • Collateralized
$300 MM Loan Portfolio $47.5 MM ‘BBB’ Notes $2.5 MM Certificates Retained Excess Reserves Synthetic HY Arbitrage CDO (Total Return Swap) $50 MM High-Quality Collateral Account Coupon Portfolio Cash Flow Net Issuance Proceeds LIBOR + Spread Distrib. Bank of America (Total Return Swap Provider) SPV Portfolio Cash Flow, Net of Swap Rate (L+ Spread Paid to Bank of America) Excess Management Fees Investment Manager Source: Bank of America Securities LLC. Diagram of a SERVES transaction.
Motivations for HY Arbitrage Synthetic Vehicles Sponsor • Structuring/Fee Income • Distribution Outlet for Originations • Improved Flow for Secondary Trading • Smaller Unrated Equity Component • Favorable Capital Treatment
Manager “Captive” Assets Under Management Administrative Efficiency Attractive Cost of Funding/Arbitrage Structural Advantages Ability to Realize Leveraged Returns Motivations for HY Arbitrage Synthetic Vehicles
Investor Attractive Cost of Capital/Arbitrage Favorable Capital Treatment Stable Rated Coupon with Upside Opportunity Managers with Established Track Records Motivations for HY Arbitrage Synthetic Vehicles
Rating Considerations Ratings for synthetic arbitrage CDOs build off established CDO criteria, including default scenarios and recoveries. Other unique considerations include: • Collateral Requirements • liquidity • credit quality • coupon • Portfolio Yield • structural role of excess spread • assume yield compression • Triggers • mark-to-market thresholds • other • Counterparty Exposure • vis-à-vis CDO rating • collateralization
Comparison with Cash CDO • Coupon • Subordination • Ramp Up • Structural Tests • Flexibility
Synthetic HY Arbitrage CDO (BBB Rating) Reference Portfolio Yield L + 265* Less: Senior Financing / Total Return Swap <L + 70> Less Current Management Fee/Admin Fees <30> Equals = Available Excess Spread 165 Available Excess Spread provides levered cash flow to cover credit losses as well as rated note coupon and equity coupon *Fitch stress assumption.
Priority of Payments * Assumes LIBOR at 3%
Summary (Both Cash and Synthetic) • Upfront selection key to success • Low individual exposures • High credit quality better than high spread • Slow and steady • Managers can make a difference