While few such deals closed last year, the collateralized debt obligation market will see increased arbitrage-motivated synthetic CDOs going forward.

These deals utilize cashflow-type modeling in order to capture excess spread, said Nik Khakee, an analyst at Standard & Poor's.

According to S&P, two of these transactions are scheduled to close by the end of the week, which is as many synthetic arbitrage CDOs as S&P rated in all of 2000.

Though S&P wouldn't name the deals, American Express Management is in the market with Centurion V, a $480 million synthetic CDO via J.P. Morgan Chase (see CDO Round-up, page 9).

"I think we have been seeing more arbitrage synthetic CDOs either with a funded credit-linked portion or without it - in which case it's totally done on a swap basis," said Adam Glass, a partner at Sidley & Austin.

Glass and Khakee were both panelists on a synthetic discussion session at the recent CDO conference held by Information Management Network.

In a synthetic CDO, the issuer takes on risk by assuming liabilities through credit default swaps associated with a reference pool. The income stream is derived from the swap premiums it collects. The issuer then distributes notes backed by this income stream.

When a credit event occurs in the reference pool, the transaction taps into its pile of cash, often stored in highly-rated securities such as Government Sponsored Enterprise (GSE) debt. Cash is then transferred to the counterparty, so that it can fulfill its obligation under the swap.

The two deals S&P rated last year were Marylebone I and Epoch 2000-1.

Epoch, a hybrid balance-sheet/arbitrage synthetic CDO, was structured by Morgan Stanley Dean Witter.

According to a presale report from Fitch, which rated six classes of the transaction, including a principal-only single-B-rated class, the deal has exposure to 24 "Fitch" industries.

Since the structure's inception in 1997 with Bistro, synthetic CDOs have been traditionally used for balance sheet management, as a way to achieve favorable capital risk weighting.

By selling the risk but not the assets, issuers found it a cheaper alternative than structuring cash funded CLOs, which are also used for capital relief.

"The arbitrage transactions are less about the regulatory relief and more about the arbitrage that you realize between the cost of your liabilities and the income derived from your portfolio of assets," S&P's Khakee said. "In these transactions, your portfolio of assets are the premium income coming off of each of the default swaps."

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