The use of synthetic exposures in cashflow collateralized debt obligations has recently spiked from next-to-nil one year ago, to as much as 15% of a deal's collateral pool currently, said rating agency sources.

According to analysts at Moody's Investors Service, while the buckets for synthetics are hardly new to the CDO structure, managers, who may not have expertise in synthetic securities, have been more readily using them in the last few months, often at the woo of their bankers.

Of course, ratings agencies and investors are concerned with collateral managers who are buying into risks they are not educated in.

"What we're basically seeing is two trends," said Jeffrey Tolk, a vice president and senior credit officer at Moody's. "The buckets are starting to be filled up more than they were in the past... and the buckets themselves are getting larger."

Opinions vary on whether this is a positive or negative development. Credit default swaps are generally higher yielding than their cash market counterparts, which is one selling point for managers looking to capture spread.

Moreover, synthetics represent a good way for managers to diversify into credits they may not otherwise be able to, and, in the same way, they can be useful for matching duration requirements, said Lori Evangel, a managing director in the CDO group at MBIA.

Last fall, experts started talking up synthetic exposures in cashflow deals as a way to beat the ramp-up challenge - then rotating real assets into the deal when they became available.

"I think what happens is that often the underwriters in the bank CDO groups are also in the derivatives groups," one banker said. "So if a collateral manager is looking for collateral that they may not be able to find, the underwriter may say, Hey look, we can go synthetically.'"

Having CDOs as an investor base for synthetics can be positive, as it expands the market, which is another way for banks with bulge-bracket derivatives desks to hedge their own exposures.

Under virtually every indenture in today's CDOs, if the collateral manager wants to buy a synthetic, the purchase is subject to rating agency confirmation, meaning that the agency needs to confirm that the act of buying that security won't lead to a downgrade of the notes.

A similar approach is taken by the sureties. MBIA, for example, will ask to have certain approval rights built into deals they participate in, Evangel said, usually when the synthetic buckets reach a predetermined limit. "We're very careful about our buckets," she added.

"The worst scenario is when a collateral manager will come to us with an investment and say, Here it is,' and we'll say, What is it and how does it work?' And they'll say, I don't know, ask the banker,'" Moody's Tolk explained.

However, others argue that to isolate increasing use of synthetics as a problem is unfair. It is always a problem, those sources say, if a manager is bulking up on an asset he or she is not familiar with.

"This synthetic argument seems like one of those arguments that makes no sense in the real context of things," said one bank researcher.

Hidden dangers

For the most part, synthetics are showing up in high-yield bond CDOs, where the manager is looking for extra yield. However, these exposures can open the investor to different risks than a typical bond, such as counterparty risk.

Further, under swaps agreements adhering to International Swaps and Derivatives Association's guidelines (referred to as full ISDA), there is additional default propensity, associated with so called "soft credit events."

While in the cash market, the only time a bond defaults is if there is non-payment, in full ISDA the contracts are exposed to factors such as restructuring risk. In this sense, synthetics tend to be more structurally and legally complicated than cash market assets. Also, recovery rates can vary significantly.

Another consideration is the particular market the synthetic security has exposure to, because different markets differ in susceptibility to ISDA soft credit events.

For example, synthetics of emerging markets corporates and sovereign exposures are more likely to get hit with a restructuring credit event.

"The other problem with the credit derivatives market, is that there's just less of a track record and less of a history," said an industry source. "And with some of the recent events, such as Conseco's restructuring, people are starting to look at the documentation more closely, and realizing things may be covered under ISDA that the market really didn't intend to be covered.

"It's like any market that's in its infancy and then starting to mature - as things happen people realize that maybe they didn't fully appreciate all of the risks involved," she added.

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