Leveraged loans are expected to become the next collateral type in line for growth within the synthetic arena. Despite the increasingly wide use of synthetics within ABS CDO structures, pure synthetic deals are not expected to overtake cash and hybrid deals as the most commonly issued structure, according to a Fitch Ratings report released last week.
Capital flows within the ABS CDS market increased dramatically following the International Swaps and Derivatives Association's release of a standard template to use when executing synthetic transactions last year. The start-up of indices referencing baskets of home equity ABS, and subsequently commercial mortgages, is expected to prompt even more development within the sector - so much so that some market participants have estimated that synthetic CDO issuance will overtake the cash market. Quick ramp-up times and a wider selection of collateral are among a number of reasons why CDO managers have turned to the synthetic market to either create hybrid cash and synthetic CDO structures or ramp fully synthetic deals. However, synthetics are not likely to become the majority of issuance within the entire ABS CDO market, Fitch analysts wrote last week.
The level of risk inherent in mezzanine CDO transactions will probably keep the sector grounded with all-cash and hybrid structures, according to Fitch, while a preponderance of synthetic CDOs are more likely within high-grade transactions. Because more credit support is required on the mezzanine deals - usually about 30% in the form of triple-B and equity tranches - synthetic CDOs wishing to reference mezzanine debt are tasked with seeking out a counterparty willing and able to take on the higher risk in synthetic form and pay in the case of losses, Fitch wrote. Because a high-grade deal has a smaller portion of subordinate and equity tranches, a counterparty that is creditworthy enough is easier to find.
Like the RMBS and CMBS CDS markets, standardizing documentation used to trade credit default swaps on leveraged loans would first need to occur, according to Fitch, before liquidity would begin to pour into the sector. Dresdner Kleinwort Wasserstein, Morgan Stanley and GFI Group brought the first leveraged loan CDS transaction to the market late last year. "It's a natural fit, as corporates are doing so already, and it allows the manager to more custom tailor maturity profiles," said one CDO trader.
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