JPMorgan recently published a report on collateralized swap obligations (CSO) that claims the new hybrid blends the benefits of a managed cash CDO with those of a static synthetic CDO, bringing out the best in both structures.

CSOs essentially combine the arbitrage opportunity and asset management benefits of cashflow CDO technology with the efficiency of the credit derivative market, according to authors Chris Flanagan and Tim Milton. Some of the key differences between a CSO structure and more traditional CDO structures are largely the result of the underlying collateral. A CSO sources collateral credit risk and return from the high-grade credit derivatives market versus traditional funded cash CDOs that are backed by corporate credit obligations or structured finance assets.

While many aspects of the CSO are almost identical to the now-common static synthetic CDO, CSOs have several unique characteristics. Regarding credit enhancement, CSOs typically have the ability to trap excess spread, where other CDOs usually offer subordination as their main source of enhancement. CSOs also might have overcollateralization and interest coverage triggers, which are typically found only in 100% funded CDOs.

Managers have flexibility in CSOs versus the traditional static synthetic CDO. Managers in CSOs have the ability to short credit and have a one- to two-year workout period following a credit event; CSOs are expected to use current standard ISDA documentation, where a credit event is considered (i) Failure to pay, (ii) Bankruptcy, or a (iii) Restructuring.

Managed cash CDOs, meanwhile, are generally restricted to going long credit and typically have a one-year workout period following a default.

CSOs are almost identical to the static synthetic CDO in that they both offer an immediate ramp-up and a cost of funds of between 20 to 30 basis points versus a three- to six-month ramp-up and a 65 to 85 basis point cost of funds in managed cashflow CDOs. JPM expects to see the CSO market grow rapidly over the next two years, but expects some impediments to that growth due to a limited universe of traded names and an expected decrease in arbitrage opportunities as the product becomes more common. To date, no CSOs have visibly priced, but it is rumored JPMorgan has at least one mandate.

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