S&P Announces: CDO Spotlight: Synthetic Growth Drives Innovation in Europe's CDO Market.

Business Editors

NEW YORK--(BUSINESS WIRE)--May 19, 2004

Synthetic transactions continue to drive growth in the European CDO market. While the U.S. remains primarily a cash CDO market, though more synthetic transactions are being done, most of the CDO transactions rated in Europe are synthetic.

In 2003, 93% of rated European CDO transactions were synthetic, compared with only 31% in the U.S. This trend has continued in 2004: 92% of European CDOs rated in 2004 to date have been synthetic. The European CDO market almost tripled last year, spurred by growth in synthetic transactions, most of which were arbitrage (95.5% of the market) rather than balance sheet transactions (4.5%).

As a result, the European offices of banks - including those of U.S. banks - are developing a range of new synthetic products and structures. This article examines the key trends shaping Europe's CDO market.

Attraction of Synthetics

Synthetic CDOs can be defined broadly as CDOs where the risk transfer of the assets is achieved by using credit default swaps, rather then by physically selling the assets through a true sale. Given the lack of liquidity in the European market and the many different jurisdictions, which can make achieving true sale cumbersome, synthetic risk transfer has proven very attractive.

Synthetic technology is also more flexible, enabling the structuring bank to tailor the transaction to the specific needs of the investor. Bespoke transactions are popular with Europe's fragmented investor base, and this partly accounts for the phenomenal growth in single-tranche synthetic CDOs.

Single-Tranche Synthetic CDOs

In a single-tranche synthetic CDO transaction, the size of the liability (i.e., the note issued by the SPE) is lower than that of the assets (i.e., the notional of the reference portfolio). For example, an SPE issues a $10 million 'A' rated note that is credit-linked to the risk of a reference portfolio of $1 billion notional. The investor in the $10 million note is exposed to the credit risk of $1 billion of assets.

The growth of single-tranche synthetic CDOs has been made possible through the development of delta hedging or correlation techniques, which allow the arranging banks to hedge the remaining risk (in our example, $90 million).

In 2003, 92% of the synthetic transactions rated in Europe were single-tranche transactions; in 2004 this figure is close to 100%.

Investors can have considerable input in structuring single-tranche synthetic transactions, determining the rating, tranche thickness, assets in the reference portfolio, counterparties involved, and so on. Some investors even manage the reference portfolio of the transaction in which they have invested, giving them the possibility of trading out of a name deemed to be close to default.

The trend toward managed portfolios is growing. Investor-managed transactions are typically defensive and lightly managed. However, different trading strategies exist. A credit derivative trading desk involved in trading decisions will be influenced more by spread and the potential impact on the delta hedging.

Synthetic Rated Overcollateralization (SROC)

The recent high corporate default rate has thrown a spotlight on the performance of synthetic CDOs. In 2003, 16.2% of synthetic transactions experienced a downgrade, an improvement on 2002, when the corresponding figure was 24.3%.

As not all transactions are structured with the same credit enhancement and cushion, there is a need for a tool that makes it easy to compare different synthetic CDOs and to assess how close a tranche within a synthetic CDO is to a potential upgrade or downgrade.

To meet this need, Standard & Poor's has introduced a new benchmark for synthetic CDOs called synthetic rated overcollateralization (SROC).

Calculated for a tranche in a synthetic CDO transaction, SROC is a comparable measure, expressed as a percentage, of the sensitivity of that tranche to future rating action. It acts as a red flag for nonperformance of transactions and indicates when upgrades might be appropriate. It takes into account a range of factors, including: current and future-scenario portfolio credit risk, default and recovery, and levels of available credit enhancement, including dynamic enhancement from exotic structures.

From SROC, two key performance measures can be generated, the rating cushion and the entity cushion. The rating cushion gives a dollarized amount indicating the losses a portfolio can withstand before probable rating action, while the entity cushion is a measure of how many entities in a portfolio can default before a downgrade is likely.

Recoveries in Synthetic CDOs

As synthetic CDOs are a fairly new asset class, there is limited historical data available on recoveries. If the recoveries achieved upon a default of an asset are lower than the recoveries assumed at closing, the transaction will suffer additional losses that have not been sized for. Therefore, some arrangers are opting for fixed recoveries.

Standard & Poor's continuously re-assesses its recovery assumptions and uses amalgamated data from the universe of synthetic CDO transactions it rates. From this data, it can be concluded that, on average, recoveries achieved after default are higher than those assumed at closing.

Since 2000, credit events have been called on 71 global credits, affecting approximately $6.1 billion in 436 transactions rated by Standard & Poor's.

Bankruptcy is the most common credit event called. Bankruptcy has historically led to the lowest recovery rates, while restructuring has led to the highest. Recoveries remain varied across industries, though in general Standard & Poor's considers industry classification to be less important than domicile or seniority in driving recovery rates.

Actual recovery values for North American credits in synthetic CDOs remain close to the recovery assumption made at transaction closing. The average assumed recovery is 33.3% for both U.S. and Canadian credits for most transactions structured under typical documentation and using market-standard bidding processes.

This means that, on average, a pool of typical, liquid credits domiciled in these two countries can be expected to recover 33.3% of its notional amount after a credit event. Given that 49 Canadian and U.S. credits have delivered average recoveries of 31.1% with a high standard deviation (on a nominal basis), this hypothesis is not inconsistent with the historical data.

Recovery rates for European credits are high on an exposure-weighted basis due to the low number of credit events called and the consequent disproportionate impact of Railtrack PLC's restructuring - 16 credit events were called on European entities through the end of 2003, affecting 207 CDO transactions rated by Standard & Poor's.

Standard & Poor's assumes a range of recoveries (averaging approximately 28%) for European credits, depending on domicile. Clearly, historical average recoveries have been considerably higher than this assumption on an exposure-weighted basis, but have been closer to the average on a nominal basis. The Parmalat credit event should provide further clarification on these assumptions when recovery rates are delivered.

Relatively few globally liquid credits exist in areas outside Europe and North America, though the number is growing. Only six credit events have been called outside Europe and North America, affecting 13 transactions. Most of these were Argentinean entities caught up in the Argentinean default and sovereign credit event in November 2001.

Nevertheless, given that five out of the six credit events recorded were on reference entities domiciled in Argentina, the nominal average recovery of 9.9% appears to be consistent with the 9.0% to 13.5% range typically assumed for emerging markets.

Standardization and Index Trades

With the growth of the synthetic market has come increased standardization. Most synthetic CDOs follow market-standard ISDA contracts and arrangers try as far as possible to use identical structures and documentation as this is the only way to deal with the high volume, short execution time, and low execution costs. Standardization is also being driven by the increased use of index trades.

Index trades are credit default swaps on publicly disclosed indices of corporate credits like iBoxx and TRAC-X. The main selling point of all the indices is that they seek to represent a particular market. The names in the indices are generally highly liquid, well known, and diverse within the limits of the index.

The fact that indices are constructed to represent closely the market as a whole makes them powerful tools for managing marked-to-market risk. An investor in a credit-linked note or a seller of protection under a credit default swap seeking to offset spread volatility could purchase protection on an index. In addition, a simple arbitrage opportunity exists between an index itself and the components of that index.

An investor could profit by buying protection on the index and selling protection at wider spreads on the individual names. Another use of these indices is for managers of cash CDOs, who can buy credit-linked notes referenced to an index to minimize negative drag during ramp-up.

The index instruments can be analyzed both on a leveraged and an unleveraged basis. The approach to rating the leveraged instruments is largely the same as that for standard synthetic CDOs. However, there is a crucial difference in the rating methodology for unleveraged index trades and how such instruments are incorporated as assets in CDOs.

The main analytical challenge when looking at index trades concerns unleveraged transactions. An unleveraged index credit default swap is similar to a "first-to-default" transaction, in that as soon as one credit event in the pool occurs, the seller must make a payment to the buyer. For these transactions, Standard & Poor's will assign a portfolio weighted-average rating, which is designed to indicate the average credit quality that an investor in an index is exposed to.

The combination of the weighted-average view with a clear explanation that an investor is highly likely to experience at least $1 of loss should provide for a more nuanced view of the risks of index trades.

The Search for Yield

One of the biggest challenges facing arrangers is how to compensate for tightening investment-grade corporate spreads. Arrangers are therefore looking for alternative assets to put into the portfolio. Two recent examples are the inclusion of equity default swaps and CDO-squared transactions.

CDO-Squared Transactions

CDO-squared transactions are typically leveraged single-tranche CDOs in which the underlying assets are CDO tranches or a mixture of CDO tranches and ABS.

Should a credit event occur on an underlying corporate name, typically a bidding process is used to establish a recovery value. The resulting loss is incurred by each CDO tranche referencing that corporate name.

If total losses exceed the attachment point for the CDO tranche, a loss is incurred at the CDO-squared level. The overall effect of a single corporate credit event will clearly depend on the number of CDO tranches referencing that corporate name -- or the overlap among the underlying CDO tranches.

A typical CDO-squared transaction rated by Standard & Poor's might reference as many as 1,000 corporate names. However, given that the most liquid corporates in the credit default swap market number about 400, it is highly likely that each name will appear in more than one CDO tranche. Therefore, the default of one name could affect several CDO tranches.

Fundamental to Standard & Poor's new approach is the ability to "drill down" to the corporates underlying each CDO tranche included within the CDO-squared transaction. In this way, it is possible to accurately assess the effect of the overlap between CDO tranches.

The technique involves the simulation of the correlated default and recovery of all assets in the CDO-squared reference portfolio. Simulated net losses are passed through to each CDO tranche referencing a given underlying asset. When these net losses exceed the attachment point for that tranche, the excess net loss is passed on to the CDO-squared transaction.

Net losses are capped by the "detachment point", also called the "exhaustion point". Investors in a CDO-squared transaction will not be required to make payments for losses on an underlying CDO tranche that exceed the detachment point. Therefore, the maximum loss that can be passed on is equal to the difference between the attachment and detachment points, or the tranche thickness.

The principal benefit of the drill-down approach is that each corporate name is explicitly linked to one or more CDO tranches. Therefore, when a corporate name experiences a credit event, and generates a net loss, this net loss is passed through to each CDO tranche referencing that name.

Equity Default Swaps

There has been considerable interest recently in CDOs referencing portfolios of equity default swaps. These contracts trigger a payment when the underlying equity price falls below a predetermined level. The price decline is often referred to as an "equity event", analogous to a credit event within a credit default swap contract.

As the trigger price is set closer to zero, these contracts can be expected to become more "credit-like", and equity/credit default swap spreads should start to converge. In a CDO that references a pool of equities under an equity default swap contract, the same basic roles exist. The seller is paid a premium in exchange for a principal commitment when losses exceed the threshold amount. In this case, however, losses are defined as the notional amount of equities whose prices fall to the trigger level, minus a predetermined recovery rate.

In this way, one of the main criticisms of credit default swap contracts -- namely, uncertain recoveries -- is removed, while retaining a view on credit deterioration.

Standard & Poor's quantitative analysis addresses the probability that an investor will experience a non-zero loss resulting from credit and/or equity events within the reference portfolio. For a single equity default swap, the probability of triggering the contract is driven mainly by the volatility of underlying equity price movements, which contains both systematic (market driven) and idiosyncratic (company specific) components.

For a portfolio of equity default swaps, the correlation of equity price movements is key in determining the joint price movements over a given horizon.

European Leveraged Loan market

The leveraged loan CLO market continues to be active and Standard & Poor's has rated five CLOs so far this year, compared with three from the same period last year. Four of these transactions are repeats for their respective managers. Mizuho Corporate Bank Ltd. is the only new CLO manager.

The performance of the underlying portfolio of loans continues to be stable with only one default so far this year, and no rating actions have been taken on any of the CLO transactions.

Managers are experiencing high levels of prepayments in their loan portfolios, and as a consequence are holding higher than expected levels of cash while they seek suitable replacement loans. High loan prepayment rates are one of the reasons behind recent transactions being structured to allow managers to invest in a limited bucket of bonds.

CLO spreads have recently tightened, with 'AAA' tranches pricing at around 50 basis points (bps), which compares with an average of 61 bps in 2003. Investor demand has also caused many transactions to increase in size at pricing, though managers are reluctant for their transactions to increase too much as this puts added pressure on sourcing loans during the ramp-up period.

The CLO pipeline remains strong and the high primary loan issuance levels in February and March will have assisted those CLOs that are in the warehouse stage. Standard & Poor's expects at least another nine transactions to close by the end of the year.

European Balance-Sheet CDOs

The activity for balance-sheet transactions remains sustained with the number of transactions and issuance volumes at levels comparable to previous years. In particular, originators across Europe are seeking favorable capital relief from securitizing assets held on their books. Depending on the jurisdiction, the need for alternative sources of financing for the originating banks is also driving transaction flow.

As a result, synthetic structures as well as cash transactions are being seen, depending on the jurisdictions and what the originating banks aim to achieve through the transaction. Considering the busy pipeline, Standard & Poor's expects that the market for balance-sheet securitizations will continue to grow rapidly over the rest of 2004.

Various factors are influencing the number and type of transactions that are in the pipeline or at the enquiry stage. Standard & Poor's considers that most of the growth will continue to come from the small to midsize enterprise (SME) segment of the market. SME loans are an attractive asset class and investor demand for them remains very high.

For investors in this sector, Europe offers diversity. In Spain, for instance, the well-established government-sponsored programs are expected to continue to fuel the transaction pipeline. In Germany, a number of transactions have been put on hold pending the latest developments of the "true sale initiative". It is expected that German SME transactions in 2004 will be structured using cash technology in place of synthetics, which have been more prevalent in recent years.

Standard & Poor's expects to see heightened activity in Italy where the SME asset class so far has not been among those of choice for securitizations. This is changing and there is clearly considerable potential in the Italian SME market, as indicated by the numbers of enquiries to Standard & Poor's. Finally, more marginal contribution is expected from France, The Netherlands, and the U.K.

Conscious that the growth of the European SME CLO market represents a challenge for rating agencies, Standard & Poor's is continually updating its rating approach for the asset class. The general approach undertaken by Standard & Poor's for rating pools of SME loans has been extensively described in a series of articles, including a piece titled "Standard & Poor's Rating Methodology for CLOs Backed by European Small- and Midsize-Enterprise Loans", published in January 2003 on RatingsDirect, Standard & Poor's Web-based credit analysis system.

Since the publication of these articles, Standard & Poor's Structured Finance Ratings group has undertaken an intensive review of its approach to assessing the probability of default of SMEs. This includes using specific tools for CLOs that have been developed by the Risks Solutions unit. The launch of Standard & Poor's Credit Risk Tracker product as a tool for rating CLOs backed by SME loans in a variety of European jurisdictions is expected shortly.

Credit Risk Tracker is a Web-based information service that provides probabilities of default for more than 825,000 companies in France, Italy, Germany, and the U.K. Users can look up the quantitatively derived rating estimate for middle market firms, as well as SMEs. Subject to certain adjustments, these rating estimates can be used as an input to traditional models used by Standard & Poor's in rating CLOs, such as the CDO Evaluator.

The Credit Risk Tracker can be used with and as support for the conventional rating methodology (as described in the above-referenced articles) for new transactions originated in the countries where Credit Risk Tracker is already available. Standard & Poor's expects that this new product will help sustain the growth of the rated SME CLO market.

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