[By Carl Neff, Terry McCarthy, and Christopher Howley, analysts, structured finance ratings group, Standard & Poor's]
Change is the constant. As in past years, the Standard & Poor's Structured Finance Ratings synthetic securities group continued to see an evolution in the types of U.S. synthetic securities it was asked to rate during 1999. The year's highlights included changing trends in the types of securities being repackaged, as well as in the types of structures used to repackage these securities.
In a break from years past, however, many of these structures were targeted toward the retail investor base. In addition, 1999 was marked by a growing demand for credit-linked notes, and the publication of new criteria that allows short-term A-1' rated swap counterparties to enter into long-term AAA' rated transactions by posting collateral.
General Trends in Structures and
Underlying Assets in 1999
A synthetic security is a security whose cash flow is derived from an underlying asset. The underlying asset may be a pass through of principal and interest, or it may be repackaged, either by means of a swap or by allocating different portions of the cash flow from the underlying asset to different investors. Thus, synthetic securityholders will receive either the pass-through rate or cash flows that differ from those generated by the underlying assets.
The primary attraction of synthetic securities is the ability to tailor the securities to suit specific investor preferences by creating securities that may not be readily available in the marketplace. The value of transactions rated in 1999 by Standard & Poor's Structured Finance Ratings synthetic securities group decreased to $35.1 billion from $46.7 billion in 1998 while the number of transactions the group rated decreased to 65 from 114. There are a few synthetic transactions that are not included in this total because they were rated in other groups.
The total number of transactions decreased, primarily because of the lack of arbitrage opportunities in the interest-only/principal-only (IO/PO) market. In IO/PO transactions, an underlying bond with a long maturity is sold to a trust whose synthetic security maturity is shorter than the maturity on the underlying bond. Interest received by the trust is passed through to the IO class and the underlying bonds are distributed to the PO class at the expiration of the trust. The IO class is typically a security with a shorter maturity than the underlying asset and is discounted at a lower yield. Therefore, the combined sale proceeds of the IO and PO classes may be higher than the purchase price of the underlying asset. As arbitrage opportunities decreased, the market for this product fell dramatically. In addition to a decrease in IO/PO transactions, Y2K concerns played a role in reducing the overall number of transactions. The number of rated IO/PO transactions fell from 22, totaling $1.3 billion, in 1998 to two, totaling $70 million, in 1999.
While the market for IO/PO structures contracted, total return swap transactions remained the most common type of transaction in 1999, with 23 rated transactions totaling $28.5 billion. These transactions are typically funded through the issuance of commercial paper or short-term notes. The notes are typically marketed to money market investors, because the notes meet rule 2(a)7 requirements under the Investment Company Act of 1940. In total return swap transactions, swap counterparties agree to pay to a special-purpose entity (SPE) all amounts needed to make all principal and interest payments to the SPE's rated securityholders. In return, the SPE agrees to pay to the swap counterparty all principal, interest, and liquidation proceeds from the SPE's underlying securities. Ratings for these transactions reflect the rating of the swap counterparty, because the swap counterparty is the ultimate source of credit support.
In 1999, the synthetic securities group rated increasingly complicated pass-through structures, which often involved multiple SPEs and multiple types of collateral. The more complex structures enabled issuers and/or investors to obtain favorable financing, accounting, and tax arrangements.
The types of assets that were securitized in synthetic vehicles also continued to change during 1999. Although corporate debt remained the most common underlying asset, newly developed types of assets and securities continued to find their way into the synthetics market. For example, as the CBO and CLO market has grown, so has the number of synthetic transactions involving these securities. Five transactions involved CBO/CLO securities in 1999, up from a solitary transaction in 1998. Other types of securities that have been credit dependencies in synthetic transactions are credit card ABS, trust preferred securities, municipal bonds, preferred stock, U.S. government securities, insurance company funding agreements, and residential mortgage-backed securities (RMBS). The variety has been even more diverse for transactions in which the underlying securities are not rating dependencies, such as total return transactions. Underlying assets in these transactions have included unrated securities and common stock.
New Products to Satisfy Retail Demand
This year also witnessed the rise of several new programs that were targeted toward retail investors, including equity-linked and pass-through structures. Under programs known as Corts (a Salomon Smith Barney Inc. acronym for Corporate-Backed Trust Securities) and Cabco (a PaineWebber Inc. acronym for Corporate Asset Backed Corp.), eight transactions, totaling $510 million, were structured in 1999. These transactions synthetically redenominate bonds and make them available in increments of $25 instead of $1,000, thus making them accessible to retail investors as well as institutional investors.
The Corts and Cabco trust certificates carry the same rating as the underlying bonds deposited into the trusts. For example, Salomon Smith Barney purchased a $100 million block of corporate bonds, deposited them into its Corts Trust, and issued four million Corts certificates at $25 apiece. Essentially a pass-through certificate, the interest and principal payments on the underlying corporate bond pass directly through the trust to the synthetic retail investor. Underwriters typically use bonds from issuers whose names are familiar to retail investors, including J.C. Penney Co., BellSouth Corp., and Xerox Corp.
The credit derivatives market likewise continued to grow in 1999. During 1999, six default swap transactions totaling approximately $1.1 billion were rated, up from four transactions totaling only $305 million during 1998. A default swap allows a swap counterparty to exchange the credit risk of a particular asset, or reference security, for a premium paid to the issuer of the synthetic securities. The reference security may or may not actually be owned by the swap counterparty. Under a standard default swap, a swap counterparty will pay the premium to investors, through the issuer, in the form of principal and interest due to the investors. In exchange, the investors accept exposure to the credit risk of the reference obligation.
If a default occurs under the reference obligation, the default swap counterparty will deliver either the post-default market value of the obligation or the reference security itself as a fulfillment of its obligation under the swap. The default swap allows a third party to sell the credit risk of an asset without actually removing it from its balance sheet. In 1999, sovereign entities made their debut as reference entities, although corporations remain the most common reference entities. Looking ahead to 2000, as a widening spectrum of investors continue to be attracted to the benefits that credit risk transfer provides, the volume of transactions rated should increase.
New Swap Criteria Are Published In January, 1999
Swap criteria were expanded in 1999 with the publication of new criteria that effectively broadens the universe of acceptable swap counterparties in structured transactions. According to the new criteria, entities with a short-term A-1+' rating may provide swaps in certain long-term AAA' rated transactions, provided that they agree to collateralize to required levels or replace themselves upon a downgrade to A-1.' Furthermore, A-/A-1' rated entities may provide swaps in AAA' transactions provided that the required collateral levels are met at the outset, and subject to additional specified conditions .
The new criteria apply only to interest rate, basis risk, and currency swaps, and not to total return swaps. Because a large portion of the rated synthetic market comprises interest rate and currency swap transactions, it is expected that the increase in the number of available swap counterparties will facilitate continued growth in this market. (For the new criteria, go to www.standardandpoors.com/ratings/structuredfinance.)
The Future Of Synthetic Securities
In 2000, the number of synthetic transactions rated is likely to return to or even exceed 1998 levels. Growth should be driven by an increase in term ABS securitizations, which is expected to materialize in the first quarter. As the volume of term securitizations increases, so should the volume of synthetic securities, as bankers and traders tailor newly issued securities to suit their investors' needs. Growth is also likely to be driven by increasingly innovative and complex structures that reflect solutions to investor and issuers' accounting issues and tax profiles.