The CDO market continues to expand in leaps and bounds, and along with the expected surge in loan-only credit default swaps, one of the latest manifestations of its growth comes in the form of synthetic CLOs that uses total return swaps (TRS). This structure, the TRS CLO, is becoming more popular both with CLO managers as well as with investors, and if the loan market remains as it is today, market players expect the popularity of the TRS CLO to increase further.

For managers, a TRS CLO is a good way to get around the problem of allocation. In the loan market, competition for assets is still fierce, a CLO manager said, and there are still more buyers of leveraged loans than there is supply. Through the usage of a synthetic product, managers can ramp up with greater ease and are less reliant upon funded warehouse lines, as a TRS provider does not need to hold the loans, and can therefore avoid both the difficulty and cost of getting allocations, the manager said.

According to a recent report put out by Fitch Ratings, a synthetic TRS CLO also reduces the administrative burden of investing in loans that managers typically face. In addition to being less costly to put together, these vehicles also assure ease and transparency of performance measurement, Fitch said.

From an investor's point of view, a synthetic TRS CLO also offers certain benefits. Investors can benefit from the ability to tailor a desired investment with respect to portfolio composition requirements and tenor, thereby allowing for a quick response to changes in economic cycles and credit markets. Most importantly, investors can customize leverage to a given risk tolerance, Fitch said.

To be sure, a typical TRS is levered five times to eight times, whereas a CDO is levered 12 times, a manager said. "This is often the biggest reason for doing a TRS."

In a typical TRS CLO structure, the primary form of credit enhancement is the excess spread between the costs of financing the reference portfolio and the interest and fees generated by the loans. The issued notes are typically first- or second-loss tranches that are dependent on the availability of excess spread as credit enhancement, Fitch said. The successful performance in the structure depends upon the excess spread in the transaction and the more predictable and superior performance of senior secured bank loans relative to other types of corporate debt, namely high yield bonds.

TRS CLOs incorporate mechanisms to divert and trap cash flows similar to those found in cash-funded CLOs, but they use different triggers, Fitch said. Instead of the standard overcollateralization and interest coverage tests, TRS CLOs use a market value test, wherein a sponsoring bank will typically mark the reference portfolio to market at regular intervals using various pricing services and/or dealer polls.

"This test then compares to the current value of the reference assets belonging to the [special purpose vehicle] (including any excess spread that has been trapped within the structure as well as collateral), net-of-credit losses and market value erosion of such assets, to the aggregate amount of outstanding notes or a predetermined threshold amount," the Fitch report stated. "If this percentage drops below a certain point due to either excessive credit losses or market value decline, a test is breached."

Although the fundamentals of TRS CLOs are established, variations occur from deal to deal. Thus far, all synthetic TRS CLOs rated by Fitch have primarily referenced senior secured bank loans, and have had very small buckets for unsecured, subordinate or structured finance debt, the rating agency said. The synthetic TRS CLO market, though, is just growing, and it's likely there will be greater innovation as the structure becomes more widespread and more people get comfortable with it, sources said. Indeed, very few people in the market-at-large even know what a synthetic TRS CLO really is, a source said, so it will take some time for the knowledge to spread.

(c) 2006 Asset Securitization Report and SourceMedia, Inc. All Rights Reserved.

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