Synthetic credit portfolio transactions are similar to traditional cash CDOs except that the trust involved obtains credit exposure through the use of credit derivatives on an unfunded basis. The notes are issued in either funded or unfunded form to the investors. Much attention in research has been given to synthetic balance sheet CLOs at the exclusion of other synthetic credit portfolio transactions. However, with the difference between balance sheet CLOs and cash arbitrage CDOs dissipating from a pricing and performance standpoint, we find it valuable to consider other categories of synthetic credit portfolio transactions that offer advantages for both the issuer and the investor. In synthetics, the largest growth in the last year has occurred in tranched basket default swaps and managed synthetic arbitrage CDOs.

Synthetic CDOs and cash CDOs are increasingly being used interchangeably by the same portfolio manager. Consequently, full-service dealers have adapted by integrating their cash CDO business with their credit derivatives business. The result is a more efficient distribution of credit risk between protection buyers and sellers. Furthermore, investors benefit because they have access to the full range of cash and synthetic vehicles representing a variety of risk/return combinations through the same desk.

Market scope

We estimate total issuance of synthetic credit portfolio transactions globally to have exceeded $120 billion in 2000. Our estimate is based on the full notional amount of the portfolio and includes both funded and unfunded structures, whether rated or unrated. Total oustandings of synthetic credit portfolio transactions represent 27% of the global credit derivatives market based on the 1999/2000 British Bankers Association (BBA) survey, and, in our estimation, stands at approximately $327 billion today.

The first synthetic transactions were issued in 1997 and consisted of both sponsor-linked and synthetic balance sheet CLOs. With notionals on many synthetic balance sheet CLOs ranging from $510 billion, total synthetic issuance was already approximately equivalent to cash CDO issuance in the second year of the synthetic market's existence. The year 2000 marked the first time global synthetic issuance doubled non-synthetic CDO issuance of approximately $60 billion globally.

The synthetic market has evolved into the following three distinct categories: the original regulatory-driven transactions, tranched basket default swaps and arbitrage CDOs. While balance sheet deals still represent the majority of synthetic outstandings with a 68% market share, the largest growth is occurring in tranched basket default swaps (24% market share) and managed synthetic arbitrage CDOs (8% market share).

Synthetic balance

sheet CLOs

Since the first balance sheet CLO was issued in 1996, there have been approximately $130 billion of notes issued in the global markets, although the majority of these notes have been sponsor-linked and true sale CLOs, not synthetics. The synthetic balance sheet CLO market stands at approximately $220 billion in outstanding notional and $30 billion in outstanding notes. Last year saw robust issuance of 40 balance sheet CLOs in the US and Europe, 30 of which were synthetics equally split between the US and Europe. However, for 2001 YTD, we have identified 16 publicly rated balance sheet CLOs, none of which had a US bank sponsor. Only five of these deals reference IG corporate collateral, with the remaining 11 referencing an unparalleled diverse asset base. Although we are only slightly more than halfway through the year, we attribute this trend to the proliferation of fallen angels and ratings downgrades in the U.S. IG corporate market as well as Basel 2, which has spurred European banks to seek nontraditional capital relief solutions.

Whereas earlier synthetic balance sheet deals consisted of mostly IG corporate collateral, last year's deals were dominated by leveraged loans, particularly in Europe. The balance of the deals consisted of IG bank loans and ABS. In stark contrast to 2000, the collateral mix underlying synthetic balance sheet CLOs so far in 2001 reflects the success of credit derivative technology applications referencing diverse asset classes on European bank balance sheets. European banks have been the most innovative users of credit derivatives for synthetic securitization, primarily because the European debt market still remains largely intermediated by commercial banks. The relatively small European debt capital markets both in high grade and high yield means that most of the debt remains on bank balance sheets. With ROEs well below US banks, European banks have adapted by freeing up capital in lower yielding assets and investing the proceeds in higher returning assets.

In 2001, 16 publicly rated balance sheet deals have closed, 10 of which were synthetic. Fourteen of these 16 deals had European sponsors, putting year-to-date European issuance well ahead of last year's pace. In the 10 synthetic transactions issued year to date, collateral referenced SME loans, ABS, RMBS, aircraft loans, CMBS, EM debt, cash bonds and CDOs. European banks proved that virtually any loan on a bank's balance sheet can be securitized. Total note issuance for these 10 synthetics was $3.2 billion, with the notional approximating $15 billion.

At the start of 2001, balance sheet CLO downgrades began plaguing the market. So far this year, nine synthetic balance sheet CLO deals have been downgraded. In these nine deals, 32 tranches have been downgraded, with two deals having been downgraded twice. These nine deals represent 23% of the total 39 CDOs downgraded year to date (the others are mostly high yield non-synthetic arbitrage CDOs).

All of the nine balance sheet CLOs consisted of IG collateral which has suffered from the proliferation of fallen angel defaults and downgrades this year. In fact, as of June 2001, 43% of Fitch's YTD default rate consisted of fallen angels. Consequently, most synthetic balance sheet deals are trading wider than their new issue levels in the secondary market. Balance sheet deals that have been downgraded are trading significantly wider. Furthermore, although transparency has become extremely thin, pricing on new balance sheet CLO issuance this year has widened to levels comparable to arbitrage CDOs.

Tranched basket

default swaps

Basket default swaps are structurally similar to synthetic balance sheet CLOs. What differentiates them is the issuer's motivation. Instead of buying protection on an entire bank loan portfolio to more properly balance regulatory capital with economic capital, the motivation for structuring basket default swaps is arbitrage. Generally the issuer and investor agree on a static basket of credits. The predominant collateral in the baskets is typically large, liquid U.S. and European IG names due to the depth of the CDS market for these credits. However, in the coming years we expect these deals to increasingly reference portfolios consisting of structured product and lower rated corporates.

Tranched basket default swaps allow investors to leverage a well diversified portfolio of IG credits without exposure to the market, price and collateral sourcing risks normally associated with cash CDOs. Most basket default swaps are unfunded, with tranched participations swapped out to counterparties off balance sheet. Further, many tranches are unrated. Therefore, most of the issuance has fallen under the radar screen, making this type of structure the least visible in the synthetic credit portfolio sector.

Basket default swap activity grew substantially in 2000. We estimate approximately 40% of our $80 billion estimate of total outstandings, or $32 billion, was issued as basket default swaps last year, and an additional 35%, or $28 billion, has already been issued as of mid-year 2001. The impact of such robust market growth has driven CDS offer levels to technically tight levels this year.

Managed synthetic

arbitrage CDOs

CDO managers are increasingly taking advantage of the merits of choosing various synthetic funding structures over traditional cash flow models. For instance, there are limits on the amount of CLO note issuance the market can absorb. For market capacity and other reasons (e.g., funding and structural advantages), managed synthetic arbitrage CDOs have increasingly represented a larger share of the total CDO market. Just like the cash flow format, in a synthetic arbitrage CDO, an independent manager actively manages the bonds or loans.

We have identified 12 publicly rated managed synthetic arbitrage CDOs issued so far in 2001, representing $2.7 billion in aggregate note issuance. Five of these deals have leveraged loans as the underlying collateral. An additional four reference structured product. Finally, three publicly rated synthetic arbitrage deals YTD have IG corporate CDS as the underlying collateral. Babson manages both Phoenix Funding and Palmyra Funding, the first of which references bonds in addition to CDS. The Clinton Group manages the other synthetic arbitrage CDO referencing CDS. However, in the near future, we expect increasingly more managers to begin actively managing portfolios of CDS in a synthetic CDO structure. Furthermore, many privately rated synthetic arbitrage deals, whose specifics are not publicly disclosed, have been placed this year.

As more asset managers achieve a comfort level with synthetic structures and attempt to avoid the saturation in the cash CDO market, synthetic arbitrage CDO activity will proliferate. Since the equity in cash CDOs is increasingly difficult to place, the smaller equity deposits required by most synthetic CDO structures shorten the marketing period and achieve a lower cost of funding in the structure. Further, we believe investors will increasingly prefer an actively managed portfolio underlying structured transactions. Therefore, we expect to see more synthetic arbitrage deals similar to the Babson and Clinton Group deals, which involved an independent managed portfolio of CDS, as opposed to a static portfolio in a tranched basket default swap.

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