Since late 1999, CBOs referencing structured product have been an established part of the investment landscape, representing over a third of total CBO issuance. The major drivers behind this growth are the stable spreads, minimal event risk, nearly non-existent defaults, relatively stable credit migration and enhanced diversity of the underlying collateral. Multi-sector CBOs reference some combination of structured product (e.g., ABS, CMBS, MBS and CDOs themselves), with a small bucket often allocated to investment grade and high yield bonds and leveraged loans. In this report, we evaluate structured product collateral as a candidate for synthetic multi-sector CBOs.

What are synthetic multi-sector CBOs?

There are myriad collateral combinations in multi-sector CBOs. However, the two principal structure types are cash and synthetic. The traditional cash structure is the most visible in the market, because cash deals are almost always publicly rated and widely advertised. Since January 2000, $25 billion of cash multi-sector CBOs have been issued in 60 transactions. The synthetic variety falls into the category of tranched portfolio default swaps or CLNs, which allow investors to leverage a well-diversified portfolio of credits without exposure to interest rate, price and collateral sourcing risks normally associated with cash CBOs. Many portfolio default transactions are unfunded, with tranched participations swapped out to counterparties off balance sheet. Further, since many tranches are unrated, most of the issuance has fallen under the radar screen, making this type of structure substantially less visible than the cash format.

The ability to invest the majority of the collateral in triple-A and double-A structured product greatly reduces sourcing risk in synthetic multi-sector CBOs. With over $5 trillion of senior structured product notes outstanding and financial institutions seeking regulatory and economic capital relief for this asset class, we foresee robust issuance of synthetic multi-sector CBOs in the years to come. To the extent the recent terrorist attacks dampen CDO issuance, we believe any decline will be minimal for a few reasons. First, among all collateral going into CBOs, structured product is the most stable and free of event risk. Second, synthetic multi-sector CBOs focus their buying on the highest rated tranches of structured product. Lastly, we believe the need for insurance companies to obtain alternative sources of funding off balance sheet in the wake of large P&C losses will result in additional securitization of structured product via multi-sector CBOs.

The primary motivation for issuing traditional cash multi-sector CBOs is arbitrage. Hedge funds and other asset managers specializing in structured product have relied greatly on CBOs to increase assets under management and create a stable source of fee income. On the synthetic side, the primary motivation has historically been regulatory capital arbitrage, internal economic capital relief, and off-balance sheet funding. However, arbitrage is increasingly driving synthetic issuance as well.

Issuance

Although the limitations of deal disclosure force us to estimate, we believe synthetic multi-sector CBO issuance to have already easily exceeded cash issuance of $25 billion on a notional basis. Because many of the synthetic deals are privately rated and unfunded, or only partially funded, little information is available. Further, to a large extent the Street prefers to maintain confidentiality for these deals because the structures tend to be proprietary. Nevertheless, we have identified 14 publicly rated synthetic multi-sector deals totaling $4 billion in notes that have closed since May 2000. The fact that they were publicly rated meant that they were intended for wide distribution, necessitating dissemination of the deals' structure and pricing.

Although the rating agencies got comfortable with rating cash multi-sector deals last year, they are still climbing the learning curve for rating synthetic structures. Consequently, among the publicly rated deals, it has been typical that only one agency rated a particular deal. For the eight deals disclosing the full capital structure, on average, 84% (with a range between 75% and 92%) is rated triple-A and/or super senior.

Structure and arbitrage

Synthetic multi-sector CBOs can be either funded, unfunded or a combination of the two. In a funded deal, the issuer or sponsor buys protection on each credit via a portfolio default swap and pays a premium to the trust, which issues rated or unrated CLNs with various degrees of exposure to losses incurred by credit events in the portfolio. The first loss, or a portion thereof, is typically retained by the issuer or sponsor. Then, the second and third loss exposures may be taken by respective triple-B and triple-A rated CLNs, for example. The highest part of the capital structure is referred to as the super senior tranche and typically represents greater than triple-A protection. In a partially funded deal, some of these exposures - usually the super senior tranche - may be swapped out to a third-party entity through a credit default swap. Finally, in an unfunded transaction, all the exposures are swapped out, requiring no CLNs.

Whether the transaction is a fully rated balance sheet deal or a privately rated, unfunded tranched portfolio default swap, or something in between these two extremes, synthetic structures require less equity and note placement than traditional cash structures. Consequently, deal execution is more efficient. Often much, if not all, of the first-loss equity piece is retained by the sponsor, avoiding the time-consuming and expensive equity placement process.

In a synthetic transaction, the dealer or sponsor may simply retain the senior loss position, as it represents a de minimis risk. If the super senior loss position is swapped out on an unfunded basis, the payment is usually in a range of 6 to 20 basis points, depending on the structure and collateral. Therefore, the arbitrage can be significantly more attractive than that seen in cash CBOs, whose triple-A tranches require at least L+45 basis points due to the complexity and liquidity premium demanded by traditional cash investors.

While cash multi-sector CBOs usually require a maximum WARF of triple-B-plus to achieve an attractive arbitrage, synthetic structures allow for a WARF as high as triple-A/double-A-plus, although some deals may have collateral WARFs as low as those seen in the traditional cash structure. A driver behind the higher WARFs in synthetic deals is regulatory capital arbitrage, which is greatest in triple-A structured product held on balance sheet. That said, the synthetic format creates an arbitrage in triple-A collateral.

Whereas we estimate the typical cash multi-sector CBO with a WARF of triple-B has had an arbitrage spread in the 100 to150 basis points range over the last two years, a synthetic structure having a WARF of triple-A/double-A-plus may require an arbitrage spread of only 50 to 60 basis points. It is principally the relatively high leverage in the synthetic structure and the ability to bypass traditional cash investors for the higher rated funding that allows for such a low arbitrage spread.

The major advantage of the higher WARFs in synthetic deals is that collateral sourcing risk is negligible because outstanding triple-A structured product paper is plentiful. We estimate that triple-A paper accounts for 85 to 90% of all structured product. On the other hand, there is a limited supply of subordinated paper, which traditional cash deals require to achieve a suitable arbitrage (for this reason, the cash CBO bid has driven subordinated paper to artificially tight levels in the past few years).

For investors, the advantages of the synthetic structure are equally compelling. Investors have exposure only to credit events as defined by specific language written into the credit default swap or CLN agreement. Unlike cash CBOs, which have strict collateral performance tests affecting the waterfall (e.g., priority of payments to rated tranches), synthetic investors are not affected by collateral trading losses and spread widening unrelated to a credit event. Further, investors do not bear other risks associated with cash deals, such as ramp-up risk, interest rate risk, reinvestment risk, currency risk, hedging risk or prepayment risk on the assets in the reference pool.

Spread performance

Spreads on structured product have maintained relatively high stability through all cycles. The reasons spreads have been stable are several: credit enhancement features (particularly subordination levels for all but the most junior tranche), low event risk, very few defaults on all outstanding deals to date, relatively few downgrades and, as of yet, an untested environment for a downturn in credit for the collateral supporting the deals. However, regarding the last point, in the wake of the terrorist attacks on September 11, it is possible to imagine a spread contagion period similar to that experienced in the Fall of 1998 when spreads widened despite steady collateral performance. Rather than being a deterrent to future issuance, though, we think such spread widening would provide a window of opportunity for CBO managers to lock in wide spreads before they return to more normal levels once the crisis dissipates.

Default & recovery

performance

The merits of structured product from a historical default perspective are compelling. According to Fitch data, average annual defaults since 1989 for all structured product are less than 0.01% and have a cumulative default rate of 0.05% by original principal balance. When viewed in contrast to same-rated corporate securities, whose default rate averages 0.23%, the advantages for structured product are clear.

Fitch's January 8, 2001 report, Structured Finance Default Study, covers default performance through June 30, 2000. An S&P study through June 2001, which we highlight below, reports that the total number of defaulted structured product bonds is 116 in the period 19782001, whereas Fitch counts 89 defaults in the period 19892000.

Fitch's cumulative default rate of 0.05% (by original principal balance) for all structured product means that 99.95% of all rated structured finance securities have not defaulted. According to Fitch, "This high rate of success supports the concept that isolating a pool of assets from an originator or seller significantly reduces default risk." Despite the less-than-favorable economic environment we are entering, there are several factors that protect structured product from defaults:

Securitization of a diversified pool of assets avoids event risk associated with corporate bonds. By isolating assets in a bankruptcy-remote SPV, default risk is strictly a function of the underlying assets.

Structured product withstands multiple levels of due diligence and outside review by underwriters, auditors, rating agencies, counsel and investors before issuance.

In many instances, the originator has stepped in to support a transaction to maintain access to the securitization market. Correction techniques have included trapping residual interest to build up reserves, purchasing underperforming collateral from the trust, subordinating servicing fees and simply adding more credit enhancement.

According to its report, "Since these factors are naturally inherent in structured finance securities, Fitch believes that default rates for structured finance securities will remain below those of similarly rated corporate bonds."

The low occurrence of structured product defaults is particularly impressive when we compare them to same-rated corporate bonds. An average annual default rate of 0.01% for structured product is substantially lower than both IG corporate bonds (0.08%) and HY corporate bonds (3.07%). Even if we weight the ratio of HG to HY corporate bonds to correspond with the ratio for structured product, the comparison remains remarkable. Taking into consideration the actual 77/23% split between HG and HY corporate bonds outstanding, the average annual default rate for all corporate issuance is 0.77%. However, when we weight the corporate bond default statistics to correspond with Fitch's estimate of a 95/5% split between HG and HY rated bonds in structured product, the adjusted average annual corporate bond default rate becomes 0.23%.

S&P's September 4, 2001 report, Life After Death: Recoveries of Defaulted US Structured Finance Securities, indicates in the last 23 years up to June 30, 2001 there have only been 116 defaults out of 13,538 rated classes. Accordingly, S&P's cumulative and average annual default rates for structured product are 0.86% and .04%, respectively, on a per bond basis. Of the 116 defaulted bonds, RMBS accounted for 83 of those defaults; CMBS, 14; and ABS, 19. According to the S&P report, "Not only do [structured securities] rarely experience default, but they also recover a major portion of their original principal even after default." Defaulted structured product has generally managed to recover more than 50% of principal. Of the 116 defaults, recoveries for RMBS (in contrast to Fitch's definition, this includes HEQ ABS and other subprime mortgages), CMBS and ABS averaged 61%, 66% and 29%, respectively.

Downgrade performance

From a rating migration standpoint, structured product is superior to same-rated corporates. According to Moody's data, ABS and CDOs have a 7.8% average one-year downgrade rate for all ratings between B3 and Aaa since 1986, whereas the comparable downgrade statistic for corporate bonds is 13.6% - a difference of 5.8 percentage points. Over the same period, according to S&P data, the average rate of annual downgrades for CMBS and RMBS rated between B and triple-A is 1.8% and 3.2%, respectively, versus 7.5% for corporates.

Average life variability

Unlike traditional cash deals, in the typical synthetic multi-sector CBO, the investor is not exposed to certain market risks, including prepayment risk. Instead, the manager or sponsor bears this risk. All structured product has some average life uncertainty - the question is the degree of uncertainty. Generally, prime RMBS has the most average life uncertainty while CMBS has the least. After RMBS is subprime mortgage ABS. Next comes non-mortgage ABS, which varies by sector.

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