Abridged from a report by Roger Merritt, managing director, and Mitchell Lench, senior director, Fitch

For more information on Fitch's rating methodologies for Synthetic CDOs and Credit Derivatives, see Synthetic CDOs: A Growing Market for Credit Derivatives at www.fitchresearch.com or contact Roger Merritt 212-908-0636 in New York or Mitch Lench 44-20-7417-6324 in London.

One of the more interesting developments in the CDO market is the growing popularity of synthetic CDO structures which, by some estimates, now comprise in excess of 50% of total CDO issuance. Synthetic CDOs simulate the risk transference found in cash-funded CDOs, without a legal change in the ownership of the assets, by utilizing credit derivatives to transfer credit risk.

In a synthetic CDO, the sponsoring institution transfers the total return profile or default risk of a reference portfolio via a credit derivative agreement or a credit-linked note. Correspondingly, the SPV issues securities whose repayment is contingent upon the actual loss experience relative to expectations. Proceeds may be held by the SPV and invested in highly rated, liquid collateral, or the funds may be passed through to the sponsor as an investment in a credit-linked note.

Broadly speaking, there are two types of synthetic CDOs - arbitrage and balance sheet. Arbitrage CDOs are used by asset management complexes, insurance companies, and other investment boutiques with the intent of exploiting a yield mismatch between the yield on the underlying assets and the lower cost of servicing the CDO securities. Alternatively, balance sheet CDOs are utilized primarily by banks for managing regulatory and risk-based capital. For European banks, in particular, the primary impetus for issuing synthetic CDOs is regulatory capital relief.

Motivating factors for

synthetic structures

Because the reference assets, for the most part, are not actually removed from the sponsoring financial institution's balance sheet, synthetic CDOs are typically easier to execute than cash-funded structures. This is particularly the case with bank loans, which may require borrower notification and consent or have other restrictions on loan sales that can interfere with borrower relations. Synthetic structures are less administratively burdensome than cash-funded CDOs, and are superior in their ability to transfer partial claims on a particular credit. Finally, issues related to interest rate and currency hedging are efficiently addressed.

Synthetic CDOs generally accomplish risk transfer at a lower cost, since the amount of issuance is typically small relative to the reference portfolio. In these "partially funded" structures, funding is largely provided by the sponsoring financial institution at a cost that is lower than fully funded CDO structures. Synthetic structures also can facilitate exposure to assets that may be difficult to acquire via the cash market. Finally, synthetic structures allow banks to create more customized transfers of balance sheet risk. For example, losses may be subject to a threshold, and mechanisms can be employed to reimburse carrying costs for non-performing assets during workout. Contingent exposures, including undrawn revolving facilities, and counterparty credit exposures also can be accommodated with relative ease.

Synthetic arbitrage CDOs

Synthetic arbitrage CDOs replicate a leveraged exposure to a reference portfolio of assets, most frequently syndicated loans. Investors and the collateral manager have the potential for attractive returns on a leveraged basis, while the sponsoring bank generates fee income and an additional distribution outlet for origination/lending activities.

These transactions have unique features that may warrant additional analytical emphasis, including the use of leverage, buildup and release of excess spread, and mark-to-market triggers that may necessitate a hybrid cash flow/market value analysis. The eligible collateral also must conform to certain criteria in order to mitigate market and liquidity risk, which would arise in the event there is a liquidation prior to the transaction's maturity date, in order to satisfy payments by the trust under the TRS.

Synthetic balance

sheet CDOs

Increasingly, banks have embraced synthetic structures to execute balance sheet CDOs for purposes of managing credit exposures and improving returns on risk/regulatory capital. In fact, the main motivation is regulatory and economic capital management rather than access to funding. Synthetic structures, which can be structured using either a CDS or a credit-linked note, allow banks to achieve risk/regulatory capital relief at lower all-in funding and administrative costs when compared with fully cash-funded CDOs. Synthetic structures are especially well suited for European CDOs because of the ability to reference exposures across multiple legal and regulatory regimes.

In synthetic structures involving a CDS, the issuing bank establishes an SPV and enters into a CDS that references a portfolio of loans, bonds, commitments, or other credit instruments. Alternatively, the bank may execute the transaction through a third-party intermediary, such as in J.P. Morgan's BISTRO program. The bank normally will retain a relatively small first loss piece that serves to align its interests with the note holders.

Note proceeds are invested in high-quality, liquid collateral. This eligible collateral is pledged, on first priority basis, to the sponsor in order to satisfy loss claims under the CDS during the transaction's life and, secondarily, to the investors for repayment of the notes at maturity. The transaction remains linked to the senior debt rating of the sponsoring bank in the form of ongoing premium payments on the CDS. It is possible to de-link the transaction and achieve a higher rating than that of the bank on the basis of the collateral's rating, as well as various structural mechanisms.

In credit-linked note structures, note proceeds are invested in a credit-linked note issued by the bank. As a result, proceeds from the CDO issuance are available to the bank for general corporate purposes, and the most senior tranche of the CDO typically will be subject to a rating cap equal to the sponsoring bank's senior debt rating.

The mechanisms for determining and settling losses are unique features of synthetic balance sheet CDOs. Protection payments on defaulted assets may be under a "cash settlement" method, in which the protection payment is based on the difference between the par value of the asset and its post-default market value. Alternatively, there may be physical settlement, in which case the SPV is required to make a payment based on the full par value of the asset.

Definitions of "credit events" also play an important role in synthetic structures. Credit event definitions conform to 1999 International Swap Dealers Association (ISDA) Credit Derivatives Definitions. Market convention generally defines a credit event as failure to pay, bankruptcy, restructuring, repudiation or moratorium, and obligation acceleration. Restructuring, in particular, has become a hot button issue ("Restructuring: A Defining Event for Synthetic CDOs," dated Jan. 8, 2001, available at www.fitchresearch.com).

Credit default swaps

Increasingly, Fitch is asked to evaluate more customized synthetic exposures in the form of portfolio CDSs, credit-linked notes and other forms of credit derivatives. Fitch's rating methodology for portfolio CDS and other forms of credit derivatives may fundamentally differ from CDOs. In the case of portfolio default swaps, for example, the reference portfolio often is significantly less diverse than a typical CDO. It is possible for a portfolio CDS to reference as few as 1015 obligors, and certain CLN structures may reference a single obligor. Moreover, there may be no upfront credit enhancement in the case of first loss exposures, although there may be mechanisms to capture and accumulate excess cash derived from the CDS premium payments.

The fact that credit derivatives and CDOs are still relatively new indicates that more innovations and further acceptance is likely. Underscoring this trend is the application of synthetic structures to an ever wider range of asset types, including investment-grade and leveraged loans, corporate bonds, asset-backed securities, commercial and residential mortgage-backed securities, and, even, counterparty risk from derivatives and other activities. There also is growing interest in applying synthetic balance sheet CDO structures to more homogeneous retail exposures such credit cards and other forms of consumer assets. Reflecting the demand for customized repackaging and transfer of credit risks, Fitch expects growing demand for ratings on more esoteric forms of credit derivatives.

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