There wasn't any good news that emerged from the European CDO sector in 2007. But for banks and investors who braved the market and looked for some value in this beleaguered sector, European synthetic CDO tranches offered some respite.
Specifically, the single-tranche synthetic CDO of ABS allowed market participants using structured finance collateral to benefit from the advantages of synthetic technology. Among these advantages is better transparency because of the structure's customizable risk profile and relative simplicity. The ability to place single tranches also results in more cost-efficient trading as well as superior liquidity for cash CDOs.
Royal Bank of Scotland analysts said that the lack of warehousing/ramp-up risk made this structure an ideal candidate to address the shortcomings in the structured credit markets last year.
Interest in single-tranche synthetic CDOs appears to be on the rise. Observers said that as the market battles with credit problems, this structure will continue to offer value over cash products. Its characteristics are and will be "prized treasures in the current market conditions," Merrill Lynch analysts said.
For European banks with cash CDO desks, turning to these synthetic structures makes natural sense since the structure practically removes all the warehousing risks associated with cash CDO structures. "Sourcing the risk synthetically can be reduced to hours, days or weeks at worst, down from months of cash asset gathering," RBS analysts said. They added that hedging spread and correlation risk can be managed more efficiently because the standard tranche market is much more transparent.
A barrier the market is expected to face in 2008 is the limited liquidity in the underlying single names. But it's likely that investors who historically have been reluctant players might take a second look at synthetic CDOs "when highly rated high-grade and mezzanine ABS CDOs were yielding such healthy spreads on seemingly very safe collateral," RBS analysts said.
In the near term, Merrill Lynch analysts said the market could begin to see single-tranche synthetic CLOs make their entrance in 2008. "Basis plays should become more and more widespread, as the sharper movements in the synthetic instruments may allow investors to express a view at better levels, and to do so quicker than they would have with a cash portfolio," Merrill analysts said.
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