Fitch: Is 'One Size Fits All' The Best Solution For Synthetic SF CDOs?

NEW YORK & LONDON -- Introducing lower rated and different types of reference assets in a rapidly progressing synthetic structured finance (SF) CDO sector has implications for credit events and valuation processes that investors need to understand. In particular, investors should consider the consequences of a 'one size fits all' approach, according to Fitch Ratings.

Innovative transactions have become increasingly popular in the synthetic SF CDOs market for investors with an appetite for higher yields, leading to a wider range of reference assets along with more concentrated portfolios in a given type of SF security. But while protection mechanisms and other structural features are in place for the valuation process of these transactions, they may not entirely eliminate the uncertainty associated with valuation processes.

'A predefined, standalone list of credit events attempting to capture all types of risk within all structured securities may actually lead to a greater risk of triggering soft credit events and should be considered carefully,' said Tania Cunningham, Director, Fitch Ratings. 'Investors need to clearly understand all credit events included and the definitions of such events in each and every transaction.'

For example, some mezzanine tranches among the more recent synthetic SF CDOs allow for pay-in-kind (PIK) securities to be referenced. Other features seen more often of late include securities with available fund caps as reference assets, which Fitch has rated several of in the form of synthetic SF CDOs that reference 100% home equity loans. Available funds cap risk is higher in home equity loans because the deals are backed by a pool of hybrid ARMs that can limit the promised coupon to what can be supported by the available interest cash flows from the loans.

'Synthetic Structured Finance Assets and Associated Valuation Processes: Help or Hindrance?' is available on the Fitch Ratings web site at www.fitchratings.com.