The fast growth of the credit derivatives market as of the late 1990s was conducive to the expansion of the synthetic CDO market. Issuance of synthetic CDOs rapidly gained ground as the use of credit derivatives gradually extended to several hundred underlying names. This growth was particularly marked in Europe, due to persistent legal and market obstacles in some countries to securitisation transactions involving a true sale of underlying assets. By using a synthetic arbitrage structure it is possible to generate a substantial yield spread between the underlying asset portfolio and the liability tranches issued, and the proportion of synthetic arbitrage CDOs in total issuance increased substantially. The trend was fuelled by banks’ declining interest in balance sheet CDOs as they started to show a preference for managing the risk of loan portfolios through individual credit default swaps rather than through synthetic CDOs. The broadening of the range of underlying assets was also largely associated with the rapid and pronounced narrowing of credit spreads as of late 2002. As spreads narrowed, fewer assets offered sufficiently high yield to be worth securitising in arbitrage transactions, forcing CDO sponsors to use more specific underlying instruments that provided additional yield due to their complexity or lack of liquidity. This gave rise to the securitisation of existing structured finance products (CDOs of ABS, etc.). Similarly, issuance of CDOs of CDOs (CDO^2) emerged. As investors became increasingly familiar with the CDO market, they started to target either tailored or standard products. The demand for tailored products resulted in the creation of synthetic single-tranche CDOs. Conversely some market participants showed increasing interest in standard CDO tranches in order to maintain sufficiently liquid buy or sell positions for their active
Cash flow CDOs Synthetic balance
sheet CDOs
Synthetic arbitrage CDOs
Synthetic CDOs of ABS Synthetic CDOs of CDOs (CDO^2)
Single-tranche synthetic CDOs CDOs of standard tranches of credit
portfolio management strategies. To meet this requirement synthetic CDOs based on standard tranches of indices representing credit default swap portfolios such as the Dow Jones iTraxx index were created (Cousseran and Rahmouni, 2005:52).
Within the realm of synthetic CDOs there are many variations among structures (Bakalar and Prince, 2003:6 - 9; Standard & Poor’s, 2003:4 - 10, and 56 - 62; and Yoshizawa, 2003a:2 - 5). They differ by asset management (static vs managed), liability distribution (unfunded vs funded), liability structure (whole capital structure vs single-tranche), reference asset type (loans/bonds vs structured finance assets), and underlying motivation (balance sheet vs arbitrage). The common thread among all of these structures is the synthetic nature of the credit risk exposure.
3.1 Static Synthetic CDO
In a static transaction, the initial reference portfolio is selected at the outset and does not change over the life of the transaction. All parties are cognisant of the specific reference obligations included in the portfolio. Often the protection seller (investor) has significant input into which names are included. There is no risk that during the life of the transaction certain obligations can be switched for lower quality obligations (Adams et al., 2004:2).
3.2 Managed Synthetic CDO
In a managed transaction, changes can be made to the reference portfolio by a third-party manager, the investor, or the dealer who is arranging the transaction. The transaction can thus benefit from the ability to switch obligations for the sake of maintaining or improving the performance or risk profile of the underlying portfolio (Adams et al., 2004:2). The investment manager actively manages the portfolio within specified guidelines.
In a managed transaction, the SPV enters into credit default swaps through a single basket credit default swap to one counterparty, selling protection on a portfolio of reference assets, or through multiple single name credit default swaps with a number of swap counterparties. The latter arrangement is more common and is referred to as a multiple dealer CDO (Choudhry, 2003b:39). A percentage of the reference portfolio will be identified at the inception of the transaction, with the remainder being selected during the ramp-up period ahead of closing. Thereafter the investment manager can trade out of its exposure in the following ways:
− by buying credit protection from another credit default swap counterparty on the same reference entity; this will offset the existing exposure but there may be residual risk exposure unless the maturity dates of the swaps are matched exactly, or if there is a default in both the reference entity and the swap counterparty;
− by unwinding or terminating the credit default swap with the counterparty; and
− by buying credit protection on an asset outside the reference portfolio.
Fitch Ratings (2003:2) identified a number of factors that has led to a shift towards managed synthetic transactions. Critics argue that static CDOs are not well diversified and are therefore vulnerable to both underlying entity-specific risk and market risk. Another criticism is the inability of static transactions to take losses early where credit deterioration and eventual default are considered inevitable. Some investors believe they have not been adequately compensated for the underlying risk associated with static portfolios where underlying credits are clearly deteriorating. Investors who own static CDOs are locked into portfolios often containing deteriorating credits, with little or no flexibility to transfer reference assets out of the portfolio to limit or prevent losses. Investors who own managed synthetic CDOs have a portfolio manager who has the flexibility to manage credit risk, and a good manager could improve portfolio performance.
3.3 Unfunded Synthetic Portfolio CDO
In its most basic form a synthetic CDO is structured as an unfunded credit default swap between two parties whereby the protection seller makes payments as losses occur in the reference pool. Since the transaction is entirely unfunded, no cash is exchanged at the outset and if no credit event occurs, the only cash that would be transferred throughout the course of the transaction would be the premium paid by the protection buyer. The transaction can be layered to allow protection sellers to participate at different risk levels.