UBS Financial Services within the next month expects to close the first visibly rated synthetic municipal collateralized debt obligation. The deal, a $105.07 million portfolio of credit default swaps known as Alpine III, is a pooling of hedged exposure in order to reallocate resources to municipalities and allow the bank additional capacity to enter into future transactions with municipalities, according to Elwyn Wong, analyst at Standard & Poor's and author of the agency's presale report on the deal.

Unlike municipal debt, the coupon on the tranches on the CDO are not tax-exempt. The primary reason for the transaction is not to facilitate the pass-through of tax-exempt interest, but for UBS to free up its capacity. In exchange for a premium, investors are charged with taking on the risk of the reference portfolio, which totals $750 million in size.

The assets consist of derivatives' contracts referencing municipalities from UBS derivative books, Wong said. The derivatives' contracts encompass various geographic areas and municipal sectors. Alpine III is seen as a way for UBS to exchange credit risk in case of the default of one of the reference assets. Alpine III will be actively managed.

Muni CDS

The technology has been virtually absent in the municipal market, however, because municipal credits are considered high-quality, said Tom Benison, vice president of credit derivatives marketing at J.P. Morgan Securities, and therefore do not offer the yield arbitrage that drives collateralized securitizations.

The municipal market has seen credit default swaps, but those have been done on a single-deal basis.

Benison noted that New York and California CDS have traded in single deals because some investors have seen a need to buy protection on these credits. "Until we see that type of demand across the board, we will not have a fully developed credit default swap market in the municipal market," Benison said. And unless another bank sees fit to reduce its credit exposure, there may not be a flurry of Alpine-like deals hitting the market, he added.

Moody's Investors Service has also been asked to rate the Alpine III deal. The ratings agency, however, declined to comment and noted that it is not expected to publish a pre-sale report. Fitch Ratings is not rating the transaction.

"The challenge to bring such a municipal CDO to market, however, has been the challenges faced in maintaining the tax benefits for CDO investors," Moody's stated. This challenge does not apply in the Alpine deal, however, because the motivations are different and the deal is taxable.

According to the Standard & Poor's pre-sale report, no top four geographical-area concentrations of the municipalities can be greater than 10% apiece. No remaining single geographical-area concentration can be greater than 5%. In the different sectors, no more than 20% can be in healthcare, 15% in housing, 10% in public power, and 10% in private education.

The two largest financial guarantors cannot be greater than 15% each and no single financial guarantor can top 10%.

One market player said, the municipal credit default swap market is extremely thin, and "there are no real trades going on." He noted that there is more demand for those who want to buy exposure and receive a premium than those who want to sell exposure and pay a premium. The imbalance is caused because the market doesn't really believe there is a high probability that municipal issuers will default, he said.

Copyright 2004 Thomson Media Inc. All Rights Reserved.

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