Synthetic CDOs

EXHIBIT 15.4 Comparing Cash and Synthetic CDOs in Terms of Risk Intermediation... 

As discussed, CDOs are generally categorised as either balance sheet CDOs or arbitrage CDOs depending on their intended purpose. In terms of operating mechanics, balance sheet CDOs are almost exclusively cash-flow-based while, arbitrage CDOs are structured either as cashflow-based or market-value-based. A later development, synthetic CDOs, now account for a growing number of transactions. 

The first European synthetic transactions were driven by bank originators with the nnderlying reference assets being commercial loans on the originator s balance sheet. Arbitrage synthetic CDOs have also been sponsored. Within the synthetic market, arbitrage-based transaction were the most freqnently issued during 2001. 

With this analysis, the synthetic CDO looks much like any operating company, as shown in Exhibit 22.7. The equity holders have purchased assets of 1 billion. Those assets are predicted to generate a return of 15 million (the asset spread ). To purchase those assets, the equity holders have put up 50 million, and borrowed 950 million. They must pay 4.75 million per year in a regate (the liability spread ) to service their debt, and if it all goes bad they will not lose any more than the 50 million that has been put up. Any losses in excess of this amount will begin to accrue to other tranches according to predetermined rules, which are discussed below. 

Constructing deals synthetically and in unfunded form can provide benefits on both the asset and liability side that explain the recent popularity of synthetic CDOs and their likely continued success. It is worthwhile to take a moment to examine these benefits in the context of pricing our hypothetical portfolio. 

The cumulative benefits to synthetic CDO structures versus cash structures, if they are all in play, amount to dramatically improved economics. For instance, if all of the asset side (flexibility, ramp-up, basis) benefits sum to only 10 bps, and the liability benefit is 40 bps on 70% of the capital structure, the savings would amount to 38 bps (= 40 x 0.7 + 10) on a 1 billion transaction. For a 5-year synthetic CDO, the PV of those 38 bps amounts to over 17 million. In a leveraged structure, of course, these benefits will primarily accrue to the equity and their impact will be magnified as shown in Exhibit 22.8. Clearly, the synthetic CDO may be an efficient vehicle for investors to use in accessing diversified tranches of risk. 

Having examined a snapshot of the no-loss potential return to investors as well as the potential execution benefits of synthetic CDO structures, the next question becomes the potential for loss. The allocation of gains and losses, and their order of priority (the waterfall ), is negotiated and governed by the language of the synthetic CDO. In a typical syn-... 

This value proposition may be conservative. CSFB assigns 15 bps of value to the basis alone, and 40 bps of value to 87% of the capital structure on the liahility side. Neil McPherson, Helen Remeza, and David Kung, Synthetic CDOs and Credit Default Swaps, CSFB (November 2002). 

For the balance of the discussion we will assume a traditional type of structure, but it is worth noting that, in lengthy bilateral contracts, issues far removed from attachment points and spread can have large impacts on pricing. The very flexibility available to investors in synthetic CDO structures means that additional attention is required to evaluate transactions. 

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