Japanese investors are perusing what is believed to be the first-ever rated CDO that is entirely linked to equity default swaps.

Sources said similar transactions are already in the works from other issuers in Asia and Europe.

The yen-denominated deal from Daiwa Securities is backed by equity default swaps on 30 Japanese companies, all considered blue-chip stocks. A trigger event occurs if the stock price on a company drops 70% in the coming five years.

The structure is similar to a CDO with credit default swaps, except that the trigger is tied to corporate equity. Analysts said that makes the deal more volatile than other types of CDOs. But the risk is accompanied by wider spreads that are enticing yield-hungry investors.

Daiwa's 23.4 billion (US$211 million) deal has three tranches that are rated by Moody's Investors Service. Class A, worth 6.3 billion, has a subordination ratio of 56% and is rated A3'. Class B, worth 8.1 billion, comes with 38% subordination and a Baa2' rating. Class C, worth 9 billion, has 18% subordination and a Ba2' rating.

The launch spreads on those three tranches - all bullets with fixed-rate coupons - were believed to be 33.5 basis points over swaps for class A, 113.5 basis points over for class B and 243.5 basis points over for class C, according to one market source. Updated price talk was unavailable at press time.

The equity default-linked notes will be issued through a special purpose vehicle called Zest Investments V. The expected maturity for all the notes is December 2008 and the weighted average life is 4.8 years.

The notational value of the reference portfolio is 45 billion (US$400 million).

Not like the European hybrids

At least three rated CDO deals in Europe - all of them private - contained a small portion of equity default swaps, said Paul Mazataud, a managing director in the European CDO group at Moody's in Paris. The first of those three deals received ratings in late December.

Typically, the European deals consist of 90% credit default swaps and 10% equity default swaps, he said.

In contrast, the Japanese deal is the only one Moody's has rated so far that is fully exposed to equity default swaps.

This deal also has one other significant difference from the earlier European hybrids. If a trigger event occurs in the European deals, the recovery rate is equal to 50% of the notional amount of the equity default swaps, Mazataud said. For the Japanese notes, the recovery rate is the final stock price at the end of the transaction. So the potential loss is greater.

"The Japanese transaction has less protection for investors as far as the recoveries are concerned," Mazataud said.

The ratings reflect this difference, with the hybrid deals achieving triple-A or double-A ratings more easily.

"On a portfolio of pure equity default swaps, it would be difficult, if not impossible, to assign a triple-A rating," Mazataud said. "Even if you have a very large subordination, I'm not sure we would be able to assign a triple-A rating."

He noted that the senior tranche of Daiwa's deal is rated A3 despite a "huge subordination" of 56%.

The biggest risk factors for investors in the Japanese deal are the potential for a stock market crash - where traditional indices drop by more than 80% - and the correlation of the 30 companies in the reference pool.

Mazataud said although the companies are in different industries, they are all in Japan. "So if one of them suffers a 70% drop in stock price, it's quite likely there will be others that will be subject to the same sort of drop," he noted.

Given the subordination levels, the stock price for more than five of the 30 companies in the reference pool would have to drop below 70%, before investors in the most junior tranche might incur a loss.

Growing interest

Mazataud expects equity default swaps to make a noticeable dent in the overall CDO market this year. Even though the concept is new, interest is already high, he said.

He cited several advantages for issuers. One is the opportunity to attract new investors. The more traditional CDOs with credit default swaps attract large banks and institutional investors, while CDOs with equity default swaps appeal to retail investors and wealthy individuals, he said.

Another advantage is that the legal documentation is more simple and less subject to interpretations. "For traditional transactions, there is a definition of a credit event. But very often there are disputes about whether a credit

event happened," Mazataud said. "Here, either the stock price has dropped by 70% or it has not.

It leaves no room for legal disputes."


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