Should Your Next Deal be Cash or Synthetic?

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Should Your Next Deal be Cash or Synthetic?
CDOs in the Heartland March 20, 2003

• Marion Silverman

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Types of Synthetic CDOs

Static InvestmentGrade SyntheticsEg. SALS, EPOCH
nth to DefaultBasketsEg. (private)
High Yield Arbitrage CLOs Eg. SERVES, ELFS
Synthetic Structures
Synthetic Bond Fund Ratings Eg. HYDI Credit
Linked Trust
Single Name CreditLinked NotesEg. TIERS Trust
Managed Synthetics Eg. Shoreline
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Synthetic HY Arbitrage CDOs

• CDO arbitrage programs are sponsored by higher
  rated financial institutions for the benefit of
  CDO managers.
• Allow managers and capital market investors to
  replicate economics of cash arbitrage CDOs via
  credit derivatives.

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Synthetic HY Arbitrage CDOs

• To date, in the U.S., the only asset class has
  been domestic senior secured bank loans,
  reflecting the predictability of recoveries and a
  growing secondary market.
• Going forward, expect asset classes to broaden,
  including European leveraged loans, middle market
  loans, and ABS.

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Features of Synthetic HY Arbitrage CDOs

• Credit Default Swap or Total Return Swap
• Fully Funded
• Cashflow or Hybrid (Market Value) Structures
• Counterparty Exposure
• Collateralized

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Synthetic HY Arbitrage CDO (Total Return Swap)
50 MM High-Quality Collateral Account
Coupon
Portfolio Cash Flow
Net Issuance Proceeds
LIBOR Spread
Distrib.
Bank of America (Total Return Swap Provider)
SPV
Portfolio Cash Flow, Net of Swap Rate (L Spread
Paid to Bank of America)
Excess
Management Fees
Investment Manager
Source Bank of America Securities LLC. Diagram
of a SERVES transaction.
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Motivations for HY Arbitrage Synthetic Vehicles

• Sponsor
• Structuring/Fee Income
• Distribution Outlet for Originations
• Improved Flow for Secondary Trading
• Smaller Unrated Equity Component
• Favorable Capital Treatment

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Motivations for HY Arbitrage Synthetic Vehicles

• Manager
• Captive Assets Under Management
• Administrative Efficiency
• Attractive Cost of Funding/Arbitrage
• Structural Advantages
• Ability to Realize Leveraged Returns

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Motivations for HY Arbitrage Synthetic Vehicles

• Investor
• Attractive Cost of Capital/Arbitrage
• Favorable Capital Treatment
• Stable Rated Coupon with Upside Opportunity
• Managers with Established Track Records

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Rating Considerations
Ratings for synthetic arbitrage CDOs build off
established CDO criteria, including default
scenarios and recoveries. Other unique
considerations include

• Collateral Requirements
• liquidity
• credit quality
• coupon
• Portfolio Yield
• structural role of excess spread
• assume yield compression

• Triggers
• mark-to-market thresholds
• other
• Counterparty Exposure
• vis-à-vis CDO rating
• collateralization

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Comparison with Cash CDO

• Coupon
• Subordination
• Ramp Up
• Structural Tests
• Flexibility

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Synthetic HY Arbitrage CDO (BBB Rating)
Reference Portfolio Yield L 265 Less Senior
Financing / Total Return Swap ltL 70gt Less
Current Management Fee/Admin Fees lt30gt Equals
Available Excess Spread 165
Available Excess Spread provides levered cash
flow to cover credit losses as well as rated note
coupon and equity coupon
Fitch stress assumption.
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Priority of Payments
Income
Interest on loan portfolio (L 265 on 300mm) 16,950,000
Interest on swap collateral (L on 50mm) 1,500,000
Total Income 18,450,000
Assumes LIBOR at 3
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Priority of Payments
Expenses
Administrative expenses (5 bp on 300mm) 150,000
Senior asset manager fee (10 bp on 300mm) 300,000
Financing expense (L 70 on 300mm) 11,100,000
Coupon to noteholders (L 250 on 47.5mm) 2,612,500
Distribution to equity (L 600 on 2.5mm) 225,000
Subordinate manager fee (15 bp on 300mm) 450,000
Total Expenses 14,837,500
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Priority of Payments
Total Income 18,450,000
Total Expenses 14,837,500

Excess Spread 3,612,500

Over 10-year life 36,125,000

BB/B 10-year defaults (26.5 in BBB stress) 79,500,000
Net Loss (1-60 recovery) 31,800,000

Unused Excess Spread 4,325,000
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Summary

• (Both Cash and Synthetic)
• Upfront selection key to success
• Low individual exposures
• High credit quality better than high spread
• Slow and steady
• Managers can make a difference

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