Synthetic structured finance CDO volume could reach $38 billion in total issuance in the second half of this year - a 483% increase over the $7 billion of issuance seen in this year's first half, according to Merrill Lynch. The investment bank is anticipating synthetic SF CDO issuance could outpace cash SF CDO issuance in the second half of the year - with a forecast of 32 cash deals in the 5Q05 and 4Q05, versus 38 synthetic.
"We expect the $11 billion of synthetic SF CBO issuance-to-date to be merely a rounding error for what is to come," Merrill analysts wrote in research released last week.
The appetite for the synthetic structures is two-pronged. First, the relatively unrestricted ability for managers to choose from a wide menu of assets, and second, a higher yield pick-up and much faster ramp-up time. And as demand fuels increased uniformity and transparency in the sector, issuance is only expected to increase, according to Merrill. However, unlike synthetic CDOs referencing corporate entities, the complexity of the new ABS counterparts is expected to bring mostly managed deals.
To date, some $11 billion notional of both funded and unfunded synthetic structured-finance CDO notes have been issued in the U.S. market, Merrill analysts wrote. The 17 deals occurred over the last year, and consisted of 11 mezzanine, three senior, and three hybrid mezzanine/senior deals. Only one of those deals was independently managed, the rest being dealer-arranged bespoke transactions, Merrill found.
The ability to reference synthetic ABS is exciting for CDO managers because of the wide range of options available to them. For example, a manager seeking triple-B rated home equity ABS could simply reference an older vintage that is free of IO and ARM loans instead of being limited to ABS available for sale, Merrill analysts wrote.
Since synthetic ABS CDO tranches are more liquid than cash deals, and because of the complexity involved in the structures, the yield pickup is higher, according to Merrill. For example, the $100 million triple-A rated A1 tranche of the recently priced synthetic mezzanine Abacus 2005-3 deal underwritten by Goldman Sachs, referencing home-equity ABS, CMBS and CDOs, priced at 55 basis points over one-month Libor. Synthetics are so far relatively cheap to fund. For example, while the cost of cash funding on a super senior runs about 27 basis points, reinsurers and monolines charge about 12 basis points, Merrill points out, resulting in a 10 basis point spread pick-up for synthetic mezzanine deals and 13 basis points in senior deals.
But investors are being paid for taking on the complexity and risk of uncertainty with the transaction. While the ISDA's June 6 release of pay-as-you-go documentation template is expected to go a long way to provide uniformity in the sector, more innovation is expected - and needed - market participants have said. Tradable indexes for ABS and CMBS are expected by the end of this quarter, according to Merrill and other market participants.
Fitch Ratings last month identified three primary areas of concern for synthetic CDO investors - if losses on the reference portfolio exceed the tranche attachment point or credit enhancement levels built into the deal; when credit losses on the security are funded with issue proceeds; and for losses that happen when the credit default swap counterparty defaults.
For the most part, defining a credit event - a situation that would trigger a change in the payment structure of the synthetic CDO, has proved difficult when ABS is the reference obligation. The ISDA template was designed primarily for use when RMBS and CMBS securities are the reference obligation for synthetics. Merrill is anticipating the form will grow to encompass more securities than mortgage ABS, resulting in more liquidity and less complexity in the sector. For example, super-senior swap investors, so-called reinsurers, are working on a version of the template for use in full capital structure deals, added Merrill analysts. Mezzanine deals are poised to benefit most from the new documentation standards because of their increased likelihood of default.
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