Ch6 Synthetic Collateralized Debt Obligations

1. First-Generation SCDO(Synthetic Collateralized Debt Obligation) Structure
1-1 Video lecture: http://www.youtube.com/watch?v=0Q7ji-vPlP4

1-2. Fully Funded SCDOs
- securities have been issued & funds collected from investors in an amount adequate to cover any potential default-related loss on the underlying asset portfolio
- assets do not change ownership
- whole capital structure CDOs

1-2-1. Fully Funded Balance Sheet SCDOs
- a reference portfolio is defined by the originator and notes are issued by a SPE in the same amount as the size of the reference portfolio
- the proceeds from the note issue are invested with a trustee in high-quality marketable securities (government bonds or term repurchase agreement)
- the securities are pledged as collateral by the SPE to the originator through a CDS
- the originator remits CDS premium

** priority in the cash flow waterfall
- default payments
- senior notes
- subordinate notes
- residual

1-2-2. Fully Funded Arbitrage SCDOs
- the reference portfolio (by a collateral manager) is synthetically securitized when the SPE sells credit protection using CDS.
- the composition of the reference portfolio may change over time depending on whether the structure is passive/static, lightly managed, or actively managed.
- the equity (residual) tranche is available for sale or retained by the collateral manager.

1-2-3. Fully Funded CLNs
- CLNs are the sole class of fixed obligation issued by the SPE that has aquired its asset exposure synthetically.
- a single layer of subordination => all losses are borne equally pro rata by holders of the CLN

1-3. Partially Funded SCDO
Partial funded CDOs owing to the following reason:
- Synthetically securitizing the whole portfolio is time-consuming, expensive, structuring-intensive, & required numerous different investors with varying appetites for risk.
- Spreads & yield gap have steadily narrowed

1-3-1. Regulatory Capital Consideration in Balance Sheet SCDOs
1-3-1-1. Fully Funded Structures
- the regulatory capital charge: 100% of the retained residual tranche plus a risk-adjusted charge for the actual swap based on the collateral.

** capital charge
- CDS backed by Treasuries: 0%
- OECD bank: 20%
- Basel, the risk weighing relative to the base-case of 8% capital

e.g.) $500M loan portfolio, 1% equity tranche, CDS collateralized with AAA-rated securities
==> 100% x 1% x $500M + 100% x 8% x $500M = $45M

e.g.) CDS with OECD bank
==> 100% x 1% x $500M + 20% x 8% x $500M = $13M
*** OECD bank: fronting credit protection provider

1-3-1-2. Partially Funded Structures
- the same general concepts apply to regulatory capital computation
- the capital treatment for the unfunded super-senior tranche: hedged via a CDS or the standard risk weights if unhedged

1-4. Appeal of Synthetic Structures
1-4-1. Operational Benefits: The same economic result as a securitization can be obtained using SCDOs without the associated legal issues.

1-4-2. Flexibility in Design: Constructing a customized synthetic reference portfolio is generally far easier than divesting a true portfolio of assets. CDS's provide tremendous flexibility to banks for combining different loans and risk exposures in a single credit protection structure.

1-4-3. Ease of Documentation: help facilitate the rapid growth in the market

1-4-4. Selective Risk Transfer & Asymmetric Information: isolate the pure credit component of credit-sensitive assets from the other risks (interest rate, political, & currency risks)

1-4-5. Cost of Capital: Senior tranche is rated AAA, which will probably price around 35 to 75 basis points. The WACC of the originator will usually be lower using a partially funded SCDO because the super-senior tranche enables the bank to access better than AAA financing on at least part of its assets.


2. Seconde-Generation SCDO Structures
2-1 Single-Tranche SCDOs (Bespoke CDO)
- an investor-driven or reverse enquiry transaction
- the exposure requested is generally some mezzanie tranche of a reference asset portfolio
- the originator issue only a single class against the synthetic pool
- the time from first inquiry by investors to deal closing and execution can be very short

2-2. Resecuritizations & CDO squared
2-2-1. Synthetic Resecuritization: A CDO that repackages pieces of other CDOs into new securities. Resecuritization can be done using traditional ABSs, CMBSs (commercial mortgage-backed securities), RMBSs(residential mortgage-backed securities), REITs(real estate investment trusts), & CNLs

2-2-2. CDO squared: A special case of resecuritization where the reconstituted tranches are CDOs. The mechanics of a CDO squared deal are no different from those of the funded and partially funded multiclass SCDOs. The difference is entirely in the collateral heldd against the securities issued.A CDO squared deal provides a good opportunity for the cash flows on those otherwise-undersirable tranches to be repackaged and sold through a resecuritization.

2-2-2-1. ST-CDO squared
- CDO squared: almost entirely with STSCDOs
- ST-CDO sqaured: a single-tranche structure which provide a huge amount of flexibility to tailor attachment points in multiple reference portfolios to end investor needs,but very complex and hard to analyze.

2-2-2-2. Master CDO (repackaging)
- CDO backed with a pool of ABSs and a basket of STSCDO issues.
- the combination of higher-yielding customized STSCDO tranches with a portfolio of ABSs can easily be structured to produce a more attractive funding gap and a more customized security offering