Synthetic multi-sector CBOS.

• Author: Gibson, Lang
• Position: Collateralized bond obligations

Since late 1999, CBOs referencing structured product have been an established part of the investment landscape, representing over a third of total CBO issuance. The major drivers behind this growth are the stable spreads, minimal event risk, nearly non-existent defaults, relatively stable credit migration and enhanced diversity of the underlying collateral. We will use the term "multi-sector CBOs" to label CBOs referencing predominantly structured product, although the name "ABS CBO" is also commonly used. Multi-sector CBOs reference some combination of structured product (e.g., ABS, CMBS, MBS and CDOs themselves), with a small bucket often allocated to investment grade and high yield bonds and leveraged loans.

In this article, we evaluate structured product collateral as a candidate for synthetic multi-sector CBOs.

1. OVERVIEW

   There are myriad collateral combinations in multi-sector CBOs. However, the two principal structure types are cash and synthetic. The traditional cash structure is the most visible in the market, because cash deals are almost always publicly rated and widely advertised. The synthetic variety falls into the category of tranched portfolio default swaps or CLNs, which allow investors to leverage a well-diversified portfolio of credits without exposure to interest rate, price and collateral sourcing risks normally associated with cash CBOs. Many portfolio default transactions are unfunded, with tranched participations swapped out to counterparties off balance sheet. Further, since many tranches are unrated, most of the issuance has fallen under the radar screen, making this type of structure substantially less visible than the cash format.

   The two principal motivations for issuing multi-sector CBOs are arbitrage and capital relief. Whereas the former is structured in either the cash or synthetic format, the latter principally relies upon synthetic structuring. It is the high funding cost in the cash alternative that requires managers to target a weighted average rating factor (WARF) in the BBB area. Therefore, CBO managers specialized in buying subordinated structured product tranches are ideally suited for running a traditional multi-sector CBO fund. However, with a substantially lower funding cost in the synthetic format, it is possible to achieve an adequate arbitrage with an AAA/AA+ WARF. Of course, higher WARF multi-sector CBOs can have substantial leverage (e.g., less equity, or first loss protection), which further reduces the funding cost. Lastly, many synthetic transactions are more passively managed and therefore involve significantly lower, if any, management fees, which again enhances the equity IRR.

   The ability to invest the majority of the collateral in AAA and AA structured product greatly reduces sourcing risk in synthetic multi-sector CBOs. With over $5 trillion of senior structured product notes outstanding (see appendix for supply figures) and financial institutions seeking regulatory and economic capital relief for this asset class, we foresee robust issuance of synthetic multi-sector CBOs in the years to come. To the extent the recent terrorist attacks dampen CDO issuance, we believe any decline will be minimal for a few reasons. First, among all collateral going into CBOs, structured product is the most stable and free of event risk. Second, synthetic multi-sector CBOs focus their buying on the highest rated tranches of structured product. Lastly, we believe the need for insurance companies to obtain alternative sources of funding off balance sheet in the wake of large P&C losses will result in additional securitization of structured product via multi-sector CBOs.

2. MULTISECTOR CBO ISSUANCE TRENDS

   Between January 2000 and August 2001, $25 billion of cash multi-sector CBOs had been issued in 60 transactions. The first publicly rated multi-sector cash flow deal--the $300 million DASH--was issued in late 1999 when the cash arbitrage spread for subordinated structured product was near today's level of approximately 140 bps. Despite a tightening arbitrage spread in February 2000 as Y2K fears started subsiding, issuance took off and has held relatively steady ever since. Exhibit 1 shows monthly issuance volume in dollars (bars) and by number of deals (lines).

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   Over this period, an average of three deals have been issued per month, totaling about $1.25 billion per month. In fact, the only month to have no issuance was July 2000. Year to date through August 2001, $11.5 billion of cash multi-sector CBOs have been issued, an annual run rate of $17.2 billion--29% above last year's $13.4 billion of issuance. We expect multi-sector CBO issuance to continue to account for at least 30-40% of total CDO issuance, primarily due to the high defaults being experienced in both high grade and high yield corporate collateral, the competing asset class. The major threat to future cash multi-sector CBO issuance is sourcing risk due to the dependence on subordinated structured product to earn a high arbitrage spread. However, managers have recently somewhat circumvented this supply constraint by diversifying into corporate collateral. Although increasing default risk, adding more corporate debt to the mix also increases the diversity scores in these deals.

   Although the limitations of deal disclosure force us to estimate, we believe synthetic multi-sector CBO issuance to have already exceeded cash issuance of $25 billion on a notional basis. On a rated note basis, we estimate there is over $7 billion in synthetics outstanding. Because many of the synthetic deals are privately rated and unfunded, or only partially funded, little information is available. Further, to a large extent the Street prefers to maintain confidentiality for these deals because the structures tend to be proprietary. Nevertheless, Exhibit 2 details 14 publicly rated synthetic multi-sector deals totaling almost $4 billion in notes that have closed since May 2000. The fact that they were publicly rated meant that they were intended for wide distribution, necessitating dissemination of the deals' structure and pricing.

   Although the rating agencies got comfortable with rating cash multi-sector deals last year, they are still climbing the learning curve for rating synthetic structures. Consequently, among the publicly rated deals, it has been typical that only one agency rated a particular deal. Of the 14 deals in Exhibit 2, 11 were rated by Fitch only and two by Moody's only, while the remaining deal was rated by all three rating agencies. For the eight deals disclosing the full capital structure, on average, 84% (with a range between 75% and 92%) is rated AAA and/or super senior. Although most of these publicly rated deals are denominated in USD, many others are in Euros. With little data on the overall synthetic multi-sector CBO market publicly available, it hardly makes sense to draw conclusions on structures for past deals. That said, in our Structure and Arbitrage section (see page 7), we present a template for a generic structure going forward.

3. ISSUANCE MOTIVATIONS

   The primary motivation for issuing traditional cash multi-sector CBOs is arbitrage. Hedge funds and other asset managers specializing in structured product have relied greatly on CBOs to increase assets under management and create a stable source of fee income. On the synthetic side, the primary motivation has historically been regulatory capital arbitrage, internal economic capital relief, and off-balance sheet funding. However, arbitrage is increasingly driving synthetic issuance as well.

   As regulatory capital rules still require 8% equity (100% risk weight x 8% minimum capital requirement) applied against all structured product except for some residential mortgage classes, financial institutions are strongly motivated to free up regulatory capital by securitizing these assets via balance sheet CBOs. Exhibit 3 shows risk weights for all structured product sectors. Only home equity ABS and RMBS pass-throughs have risk weights under 100%. Further, since the sponsor typically retains only the first loss exposure, securitization allows for a reduction in the amount of economic capital allotted to the securitized portfolio. Lastly, banks and insurers use multi-sector CBOs as a means of off-balance sheet financing. Particularly in times of distress, financial institutions can obtain funding synthetically without alarming the markets publicly and raising their cost of funds.

   Financial institutions hold structured product on balance sheet in one of four ways:

   * As an unsold portion of an underwriting.

   * As an unsold portion of a sponsored transaction.

   * As a securities portfolio investment.

   * As a loan portfolio investment (whole loan).

   Financial institutions have typically used synthetic securitization to securitize the highly rated collateral on their balance sheets. At least until 2008, regulatory capital charges for structured product will remain onerous. Further, most market participants believe that even the new capital rules will be out of sync with true economic capital requirements and remain...