There are four generic forms of rated synthetic collateralized debt obligations: (1) Balance Sheet Static Synthetic CDOs, (2) Managed Static Synthetic CDOs, (3) Balance Sheet Variable Synthetic CDOs and (4) Managed Variable Synthetic CDOs. This article describes the structure of each synthetic CDO, highlights some of the features that an investor may prefer with respect to each and describes some of the documentation issues that may arise when structuring each type of CDO.
In each structure a special purpose vehicle (the "SPV") issues securities, the proceeds of which are invested in permitted eligible investments, commonly in the form of a guaranteed investment contract, repurchase agreement, deposit swap or other liquid investment which provides for principal or "par" protection on the investment.
Depending on the structure, the SPV either sells credit protection through a single basket credit-default swap on a diversified portfolio of credit obligations or sells credit protection through a series of credit-default swaps, each credit-default swap referencing a single credit obligation. Most of the synthetic CDO transactions also contain an unfunded "super senior" tranche which is subject to the credit risk of the credit-default swaps only after all of the funded securities have suffered losses. The sponsor may retain this super senior tranche or the synthetic CDO may sell the super senior tranche to a monoline insurer or a super senior credit default swap provider.
(1) The Balance Sheet Static Synthetic CDO
Structure: In a typical balance sheet static synthetic CDO the SPV sells credit default protection through a single basket credit-default swap to the sponsoring institution on a portfolio of diversified credit obligations. The portfolio is selected by the sponsor at the beginning of the transaction and typically consists of credit obligations that are on the balance sheet of the sponsor, which may be seeking to reduce its regulatory capital requirements. There are no additions, removals or substitutions allowed in the portfolio of credit obligations during the term of the CDO. The credit default swap is cash settled upon the occurrence of a credit event with respect to a credit obligation.
Investor Preferences: An investor may prefer this structure over the other structures because the underlying portfolio is fixed when the investor purchases his security; in other words, it may prefer the lack of discretion of a third party over trading decisions and the comfort of knowing the exact portfolio of credit obligations to which it is exposed for the life of the CDO. In addition, there are no management fees and an investor may have input in the selection of reference entities.
Basic Structuring Issues: Since there is only one credit-default swap and one credit-default swap counterparty, the documentation issues are easier than with multiple swap counterparty synthetic CDOs because there are fewer parties involved. In addition, unlike in managed variable synthetic CDOs with multiple swap counterparties, the super senior provider may directly contract with the credit-default swap counterparty rather than with the SPV which also decreases documentation complexities. The prohibition on trading the portfolio also eliminates the need for negotiations with the rating agencies on investment trading guidelines.
(2) The Managed Static Synthetic CDO
Structure: In a managed static synthetic CDO the SPV sells credit-default protection through a single basket credit-default swap to a single credit-default swap counterparty on a portfolio of diversified credit obligations. The portfolio is selected at the beginning of the transaction by the investment manager. Like the balance sheet static synthetic CDO, there are no additions, removals or substitutions allowed in the portfolio of credit obligations during the term of the CDO. In these transactions, the credit-default swap usually is cash settled but may be physically settled upon the occurrence of a credit event with respect to a credit obligation.
Investor Preferences: The pros and cons of a managed static synthetic CDO are similar to a balance sheet synthetic CDO with the major disadvantage being that the investor now bears the additional expense of a management fee. Some investors prefer this structure. Instead of having the credit-default swap counterparty select the portfolio, an investment manager represents the investors' interests in selecting a portfolio of credit obligations which will produce a low level of credit events, timely service the debt of the SPV and provide a good rate of return for the equity. The investment manager may also have a role in the cash settlement process (and certainly will have a role in a physical settlement process) that is intended to protect the investors.
Basic Structuring Issues: Like the balance sheet static synthetic CDO, since there is only one credit-default swap and one credit-default swap counterparty, the documentation issues are easier than with multiple swap counterparty synthetic CDOs because there are fewer parties involved. In addition, like the balance sheet static synthetic CDO, the super senior provider may directly contract with the credit-default swap counterparty rather than with the SPV, which also may decrease documentation complexities. Unlike the balance sheet synthetic CDO, the parties have to negotiate an investment management agreement.
(3) The Balance Sheet Variable Synthetic CDO
Structure: In a typical balance sheet variable synthetic CDO the SPV sells credit-default protection through a single basket credit-default swap to a single credit default swap counterparty on a portfolio of diversified credit obligations. Cash settlement typically follows a credit event. Unlike in a static synthetic CDO, the portfolio of credit obligations may be "ramped-up" within a specified period of time after closing. In addition, unlike in a static synthetic CDO, the credit-default swap counterparty may actively trade (add, remove, or substitute for the original reference entities and reference obligations) the portfolio of credit obligations subject to specific investment guidelines.
Investor Preferences: An investor may prefer a balance sheet variable synthetic CDO over a managed structure because there is no management fee and, in some cases, the ability to trade within specific investment guidelines may operate as a protection for investors. On the other hand, an investor may not prefer this structure if it perceives that the credit default swap counterparty's incentives when trading may not align with that of the investors; in that circumstance, tight trading guidelines and, in some instances, investor approval over trading may be requested by investors.
Basic Structuring Issues: Once again, since there is only one credit-default swap and one credit-default swap counterparty, the documentation issues can be fairly straightforward. For example, the credit-default swap counterparty may be willing to enter into an off-market standard credit default swap in order to satisfy rating agency guidelines. Consequently, the documentation issues may be less difficult than with a multiple swap counterparty synthetic CDO. However, because there is an element of control by the credit-default swap counterparty over the management of the portfolio, the debate over the appropriate investment guidelines with the rating agencies and other parties may increase the complexity of the negotiations.
(4) The Managed Variable Synthetic CDO
Structure: In a managed variable synthetic CDO the SPV sells credit-default protection either through a single basket credit-default swap to a single credit-default swap counterparty on a portfolio of credit obligations or, more commonly, through multiple single name credit-default swaps with multiple credit-default swap counterparties. A portion of the underlying portfolio is selected at the beginning of the transaction with the "ramp-up" of the portfolio to be completed within a specified time after closing. The SPV, advised by an investment manager, actively manages the portfolio within specific investment guidelines. The investment guidelines, for example, frequently provide the SPV with a discretionary trading "basket" within which the SPV may actively terminate, hedge and substitute reference entities under the credit-default swaps. In addition, the SPV may trade credit-default swaps in order to maximize gains or mitigate losses on credit obligations that have improved or declined in credit quality. This structure typically provides for physical settlement rather than cash settlement upon the occurrence of a credit event with respect to a credit obligation.
Investor Preferences: The main benefit to this structure is that it is actively managed by an investment manager and the investment manager may have the opportunity to obtain competitive pricing through the use of multiple credit-default swap counterparties or other mechanisms. In addition, if there is physical settlement, the SPV, through the investment manager, has the ability to obtain the highest recovery.
Basic Structuring Issues: Since these CDOs may have multiple credit-default swap counterparties, it can be difficult to obtain a standard swap agreement for all the parties (which is necessary in order to control documentation and other legal risks). Further, because there is more control provided to the SPV's management of the portfolio, parties, such as the investment manager, the rating agencies and super senior provider may have different perspectives as to the scope of such discretion. If there are multiple credit-default swap counterparties, it is usually necessary to obtain an insurance policy or super senior swap to provide a source of payment to the counterparties for the super senior tranche.
This week's Learning Curve was written by Kristin Boggiano, senior associate, Paul Watterson, senior partner, and Craig Stein, partner, at Schulte Roth & Zabel in New York.
