For some time, foreign investors have been purchasing, unhedged, local paper in Mexico, Brazil and other non-developed countries. Now such products as Evolution II CDO are on offer. The deal, arranged by Citigroup Global Markets, gives foreign investors a way to take on FX risk in less developed countries without having to enter a domestic market themselves.

A Citigroup official couldn't be reached for comment about the transaction, which totals $600 million and consists of eight tranches, from A to H. The ratings from Moody's Investors Service range from B2' to AAA'. An unrated tranche of $150 million also figures in the mix.

The deal is a synthetic CDO that references credit-linked notes issued by Citigroup Funding. Each note, in turn, references local currency government bonds from an emerging market. Upon issuing the eight tranches of the CDO, the issuing vehicle, Emerald Capital, will enter into a total return swap with Citigroup Global Markets. Sydbank Asset Management manages the portfolio of referenced assets.

"The flows from the underlying assets are synthetically allocated to the notes, with a sequential priority, through a swap with Citi as a counterparty," said Fabian Astic, associate analyst with Moody's. "These flows may be affected by a risk event."

A risk event can be a number of things, including a failure to pay by one of the referenced government bonds or a situation in which the currency of one of the referenced bonds is no longer convertible to dollars.

If an event takes place, the deal is first hit through its most subordinated tranche and then the corrosion makes its way up the credit ladder. Depending on the severity of the damage, "you just reduce the size of the most subordinated tranche," Astic said. This bottom-up approach differs from the top-down approach of cash flow CDOs, where problems eat into subordinated tranches when payments have shrunk to where they don't make it all the way down the waterfall.

The deal enables investors to take on the risk associated with oscillating currencies in emerging markets, a hazard that naturally rises as one moves down the waterfall. As a result, tranche size can shrink or grow with moves in exchange rates. There is also residual interest rate risk, which is mitigated by the total return swap.

The basket of reference notes must meet certain criteria, mostly designed to ensure a degree of diversification.

(c) 2007 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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