Blame it on the euro. With currency plays and other European trading strategies no longer possible with the advent of a single currency, European banks and market participants were keen to latch onto something new.

As a result, Europeans have been the vanguard of the credit derivatives world. And now they have come up with a synthetic CDO that is doing for European bank balance sheets what securitizations, or cash-funded CDOs, have done in the U.S.

Synthetic CDOs use credit derivatives (usually credit default swaps or credit-linked notes) to transfer risk without actually transferring collateral or issuing notes for the liabilities. Similarly, the liabilities also take the form of default swaps with reinsurers and other counterparties.

European players are busy developing new structures to take advantage of burgeoning demand for this type of product. They have taken to securitizing credit in all its forms, using loans, bonds, as well as the so-called synthetic measures using credit default swaps and credit derivatives.

Although the U.S. is known as a leader in financial engineering techniques, investors had long considered credits on an individual basis, whereas a whole section of European money managers did nothing but invest in currencies. "They weren't constrained by their history as much as some of the U.S. money managers were," said Alex Reyfman, a vp in the credit derivatives strategies group at Goldman Sachs. "That played a big role in the early development of the market."

Another factor that sets the two markets apart is that, in recent years, European banks have been far more active in managing their regulatory capital with credit derivatives. Many U.S. banks, meanwhile, have favored cashflow CDO transactions that are much more akin to the credit card securitizations that they are familiar with.

The growing trend among European banks toward synthetically securitizing their balance sheets enables them to remove unwanted credit risk from their balance sheet using credit derivatives. These transactions are done for regulatory capital reasons rather than to raise cash.

"These are banks progressively managing their balance sheet, realizing that they've only got a finite amount of capital, and they've got to recycle it," said Nick Morgan, head of syndication at Dresdner Kleinwort Wasserstein in London. "The way they do this and get more clients, and do more business with the same amount of capital is to go on servicing the loan portfolio while freeing up as much of the capital they have to hold against it as they can. And they do that by securitizing."

So far, the majority of these have come out of Germany, which is awash with the small and medium-size enterprises that have become the bread and butter of the European asset securitization market. Lending to this sector of the market has been a big piece of the German banks' overall franchise.

German federal agency Kreditanstalt fur Wiederaufbau (KfW) set up Promise, a CLO that is designed to encourage lending to Germany's mittelstand.

KfW set up the Promise program to help European banks free up capital for lending to German small and mid-size companies. The agency acts as an intermediary with which the issuing bank conducts the credit default swap. KfW offsets the risk it has taken on by placing further credit default swaps and selling credit-linked notes via the Promise special purpose vehicle.

Dresdner will be the third bank to avail itself of the program when it prices E1 billion of risk in the next two weeks. The Promise-K 2001-1 PLC deal will be split into single-A, double-B and triple-B rated segments of a five-year maturity and all denominated in euros. The CLO will be securitized by certificates of indebtedness ("Schuldscheine") issued by KfW.

While Promise-K's classic eurobond structure will prevent it from being sold to U.S. investors, interest from this sector is strong. "We are seeing a lot of European risk going into U.S. accounts in addition to accounts that generally buy U.S credit exposure, be they banks, insurers or reinsurers, as these investors look to diversify their credit exposures," says Jeremy Vice, head of collateralized debt obligations at Dresdner in London. Investors in both the U.S. and Europe are happy to buy into German banks, as it offers diversification and gives them exposure to a market that they wouldn't otherwise be able to access.

Promise-K may have been beyond their reach, but U.S investors have taken part in many such transactions that have been conducted privately. Analysts expect a good number of loans in the German mittelstand sector to be securitized outside the KfW Promise program as the criteria that KfW has set for banks to refinance their program through them are very exacting.

"It's one of these markets where European investors are a little bit ahead of their U.S. counterparts in terms of acceptance and in terms of comfort with these securities and these strategies," said Goldman's Reyfman.

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