By David Bleakley, ratings specialist, Standard & Poor's Ratings Services
The year 2000 was a year of change for synthetic securities. The sector responded to a strong upswing in demand for both credit-linked notes and credit-default swaps, and these trends affected both the types of securities being repackaged, as well as the structures used to repackage them.
The value of synthetics transactions and programs rated by Standard & Poor's North American ABS group increased to $42.4 billion in 2000, from $34.6 billion in 1999, and the number of deals increased to 111 from 65 (see chart, next page), with a majority of the rated transactions being private placements.
Total return swaps remained the most common form of the transaction, followed closely by credit-linked notes and credit default swaps, with the total amount of issuance for the three comprising approximately 54.5% of all synthetic issuance for 2000. In addition, Standard & Poor's rated complicated pass-through structures, which often involved multiple special-purpose entities and multiple types of collateral. The use of segregated trusts also saw an increase in activity, with two new programs being established in the year 2000.
Expanding Asset Classes and Structures
The asset classes that were securitized into synthetic vehicles continued to expand last year. These included corporate debt, credit card ABS, trust preferred securities, municipal bonds, preferred stock, insurance company funding agreements and CBO's, in addition to other types.
Moreover, the utilization of new structures added a dimension that led to growth, with the two segregated trusts previously mentioned providing $15 billion of new issuance capacity. The segregated trust structure allows a single trust to issue multiple series of notes and/or certificates that are backed by separate series of assets. This in turn, permits the trust to issue differently rated series of notes. Among its advantages, a segregated vehicle can provide issuers with administrative cost savings and deliver greater flexibility in bringing transactions to market.
Growing Innovation
The increased acceptance of credit derivatives as a financing tool served as a laboratory for structural innovations. In the past, many credit derivatives typically took the form of total-return swaps, in which a swap counterparty pays the interest and principal due on rated securities in exchange for the total return of a pool of assets owned by the issuer of the synthetic securities. These structures still continue to represent the greatest percentage of rated synthetic securities, both in total dollar amount and volume of deals. However, new structures are emerging that are now focusing on the use of default swaps. By implementing default swaps a third party is effectively able to sell the credit risk of an asset to investors, without actually removing the asset from the balance sheet.
Under a standard default swap, a swap counterparty will pay a premium to investors via the issuer, which represents the principal and interest due to the investors. In exchange the investors accept exposure to the credit risk of a certain reference obligation. If a default occurs under the reference obligation, the default swap counterparty will deliver either the post-default market value (known as cash settlement) of the obligation, or the reference security itself (known as physical delivery) as complete fulfillment of its obligation under the swap.
During 1998 and 1999, Standard & Poor's North American ABS group rated a total of 12 credit derivative transactions, totaling approximately $1.9 billion. In 2000 Standard & Poor's rated a total of 41 such transactions totaling $1.5 billion, almost matching the amount rated in the previous two years combined.
Rising Investor Interest Boosts Demand
The demand for credit-default swaps and credit-linked notes has risen substantially since 1998, when the first equity-linked note was rated. During 2000, ratings were assigned to a total of eight equity-linked note transactions totaling $450 million. The interest expressed in equity-linked structures comes mainly from investors who do not invest directly in the equity markets. Most often these securities are principal-protected and provide investors with a way to obtain the opportunity for higher returns without taking on the same level of downside risk.
Typically these transactions maintain principal protection in the form of U.S. Government securities or other highly rated obligations. The equity upside may be tied to the S&P 500 Index, specific stocks, the equity tranche of a CBO, or the general performance of a mutual fund. Supplemental payments representing additional yield on the synthetic security are then paid to investors on a contingent basis.
If the reference asset or benchmark performs well, investors will obtain returns commensurate with the returns on that asset or benchmark. If the reference asset does not perform well, investors will still receive the principal but may realize a very low return on the investment.
Standard & Poor's rating only addresses the likelihood of return of principal and not the likelihood of receiving the coupon on these securities. In some cases, however, the principal is not protected from noncredit-related erosion. The prospectus advises the investor of this risk when present.
Synthetics' Flexibility Raises Their Appeal
As issuers and investors gain a better understanding of the risks and rewards offered by synthetic structures, it is expected that expansion in the sector will continue. One of the primary advantages of synthetic securities is flexibility; synthetics can tailor, rated ABS or other debt obligations to meet the needs of both issuers and investors in a quickly changing marketplace. Synthetics may also be engineered to provide investors with specific currency, credit, equity exposure, interest-rate, or maturity profiles that would not otherwise be available.
Another common feature of synthetic structures that will continue to attract issuers is their ability to offer arbitrage opportunities under various market conditions. If a generic ABS can be transformed into a product that provides investors greater value and little additional risk, the issuer may be able to capture that increased return.
Despite the tremendous flexibility synthetic securities provide to both issuers and investors, they carry some disadvantages as well. As with most structured financings, investors must accept more legal and structural risks than if they were buying corporate debt, for example. In a synthetic transaction there is also the possibility of an early termination of a swap agreement leading to a prepayment counterparty credit risk. There is the issue of the performance of third parties such as trustees or custodians. There may also be concerns about maintenance of a first priority perfected security interest in the underlying asset depending on the structure. In addition, most synthetic securities are sold as Rule 144A private placements and therefore, may be less liquid.
Disadvantages aside, the synthetic securities market has reason to expect continued growth in 2001. With additional structures being conceived and new assets being repackaged all the time, the market is expected to continue its steady expansion.
