Structured Finance

Loan Products
Special Report
Synthetic CDOs: A Growing
Market for Credit Derivatives

Analysts ■ Summary
New York The market for collateralized debt obligations (CDOs) continues to
Roger Merritt show healthy growth despite a notable rise in corporate defaults and
1 212 908-0636 negative rating actions related to poorly performing 1997 and 1998
roger.merritt@fitchratings.com vintages. Exceptionally wide arbitrage opportunities, as well as
increased market acceptance of CDO technology and credit derivatives
Michael Gerity to manage portfolio risk and diversify funding, continue to drive
1 212 908-0628
issuance activity. One of the more interesting developments in the
michael.gerity@fitchratings.com
market is the growing popularity of synthetic CDO structures. By some
Alyssa Irving estimates, synthetic CDOs now comprise in excess of 50% of total
1 212 908 0733 CDO issuance and are the preferred structure for the expanding
alyssa.irving@fitchratings.com European CDO market.
London
Synthetic structures differ from more traditional cash-funded CDOs in a
Mitchell Lench
44 20 7417 6324
number of important ways. Cash-funded CDOs are typically structured
mitchell.lench@fitchratings.com as securitizations, whereby ownership of the assets is legally transferred
to a bankruptcy-remote trust or special purpose vehicle (SPV). The
assets are fully cash funded with the proceeds of debt and equity issued
by the SPV, with repayment of the obligations directly tied to the cash
Synthetic CDOs: Key flow of the assets. Conversely, synthetic CDOs simulate the risk
transference benefits of cash-funded CDOs, without a legal change in the
Attributes ownership of the assets, by utilizing credit derivatives to transfer credit
• Cost of funding advantage risk related to a portfolio of reference assets.
• Regulatory/economic capital relief
• No borrower notification In a synthetic CDO, the sponsoring institution transfers the total return
• Administratively efficient profile or default risk of a reference portfolio via a credit derivative
• Customized exposures agreement (total return swap [TRS] or credit default swap [CDS]) or a
• Efficiency vis-a-vis market risks credit-linked note. Correspondingly, the SPV issues one or more
tranches of securities with repayment contingent upon the actual loss
experience relative to expectations. Proceeds may be held by the SPV
and invested in highly rated, liquid collateral, or the funds may be
passed through to the sponsor as an investment in a credit-linked note.

Broadly speaking, there are two types of synthetic CDOs — arbitrage

and balance sheet. Arbitrage CDOs are used by asset management
complexes, insurance companies, and other investment boutiques with
the intent of exploiting a yield mismatch between the yield on the
underlying assets and the lower cost of servicing the CDO securities.
Alternatively, balance sheet CDOs are utilized primarily by banks for
managing regulatory and risk-based capital.

■ Motivating Factors for Synthetic Structures

There are a number of reasons for the growing popularity of synthetic
CDOs, although the motivations will differ somewhat between
arbitrage and balance sheet transactions. As previously mentioned, the
primary motivation for entering into an arbitrage CDO is to exploit the
yield mismatch between a pool of assets and the CDO liabilities. The
February 6, 2001
www.fitchratings.com

motivations for using a balance sheet CDO are
typically driven by regulatory or risk-based capital
considerations.
Because the reference assets, for the most part, are not
actually removed from the sponsoring financial
institution’s balance sheet, synthetic CDOs are
typically easier to execute than cash-funded structures.
This is particularly the case with bank loans, which
may require borrower notification and consent or have
other restrictions on loan sales that can interfere with
borrower relations. Synthetic structures are less
administratively burdensome when compared with
cash-funded transactions and are superior to cash-
funded CDOs in their ability to transfer partial claims
on a particular credit. Finally, issues related to interest
rate and currency hedging are efficiently addressed in
synthetic balance sheet CDOs. For example, currency
risk can be neutralized by setting the exchange rate at
the outset for purposes of establishing the loss amount
on a defaulted asset.
Synthetic CDOs generally accomplish risk transfer at
a lower cost, since the amount of issuance is typically
small relative to the reference portfolio, reflecting
Cash vs. Synthetic Balance Sheet CDOs: Comparative Benefits
——————— Degree of Importance ———————
Benefit Provided Cash-Funded
Transfer Credit Risk High
Regulatory/Economic Capital Relief High
Funding Diversification High
Customization/Flexibility Medium
Ease of Execution Low/Medium
CDOs – Collateralized debt obligations.
Synthetic CDOs: A Growing Market for Credit Derivatives
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Structured Finance
some multiple of losses. In these “partially funded”
structures, funding is largely provided by the
sponsoring financial institution at a cost that is lower
than fully funded CDO structures. Synthetic
structures also can facilitate exposure to assets that
may be relatively scarce and, therefore, difficult to
acquire via the cash market. Finally, synthetic
structures allow banks to create more customized
transfers of balance sheet risk. For example, losses
may be subject to a threshold, and mechanisms can
be employed to reimburse carrying costs for non-
performing assets during a predefined workout
period. Contingent exposures, including undrawn
revolving facilities, and counterparty credit exposures
also can be accommodated with relative ease.
The primary motivation for European banks, in
particular, to issue synthetic CDOs is to take advantage
of the fact that the risk weightings used to determine a
bank’s minimum capital adequacy requirements do not
differentiate between various levels of risk. Currently,
the amount of capital that international banks are
required to hold against any corporate exposure is
100% of the capital adequacy ratio. The requirements
for a synthetic CDO, however, are much less than this
Synthetic
High
High
Low
High
High
 Structured Finance
since the funded portion of the structure is backed by These structures invest the proceeds from the note
government securities, which have a 0% risk and equity issuance in high-quality, liquid “eligible”
weighting (if the collateral is pfandebriefe, it is 10%). collateral, which generally earns a rate approximating
The equity tranche, which is typically retained by the LIBOR and serves to defray the coupon on the notes.
bank, will receive a one-for-one capital charge. When This collateral is pledged on a primary basis to cover
the proposed Basle requirements are implemented, losses, if necessary. Provided losses do not exceed
however, the new risk weightings will be scaled to
more closely match the risk of the asset.
Foundation Built on Credit Derivatives
■ Synthetic Arbitrage CDOs
Credit Default Swap
Synthetic arbitrage CDOs replicate a leveraged
A credit default swap is a bilateral contract in which
exposure (generally five to seven times [x] levered
the credit protection buyer pays a periodic premium
depending on the portfolio characteristics) to a
on a predetermined amount (notional amount) in
reference portfolio of assets, most frequently
exchange for a contingent payment from the credit
syndicated loans or bonds. Investors and the collateral
protection seller to cover losses following a
manager have the potential for attractive returns on a
specified “credit event” on a specific asset
leveraged basis, while the sponsoring financial
(reference asset). Credit events generally follow the
institution (typically a bank) generates fee income and
definitions promulgated by the International Swaps
an additional distribution outlet for origination/lending
and Derivatives Association. Market convention, to
activities. Examples of these programs include but by
date, has defined a credit event as failure to pay,
no means are restricted to Chase’s CSLT, J.P.
bankruptcy, restructuring, repudiation or
Morgan’s SEQUILS/MINCs, Bank of America’s
moratorium, and acceleration. The premium,
SERVES and Citibank’s ECLIPSE programs.
notional amount, reference asset, credit instrument,
and credit events, as well as other terms of the
In a typical structure, an SPV enters into a series of TRS
contract, are negotiated between the protection
on a portfolio of credits that is diversified by obligor and
buyer and seller (counterparties) at inception.
industry. The portfolio may be fully or partially ramped-
up at the outset, at the discretion of the investment
manager, and is actively managed over the transaction’s
life, subject to established investment guidelines. In
accordance with the terms of the TRS, the SPV receives
the total realized return on the reference portfolio and
pays the sponsoring bank the London Interbank Offered
Rate (LIBOR) plus a spread, which generally
corresponds to the bank’s funding/administrative costs
with respect to the reference portfolio. The SPV, in turn, Total Return Swap
issues a combination of notes and equity, which serve to A total return swap is also a bilateral contract, but, in
fund the first loss exposure to the reference portfolio. this case, the protection buyer exchanges the entire
The reference portfolio is funded on-balance sheet by economic performance (interest, fees, and realized
the sponsoring institution. The TRS generally is marked gains/losses) of a reference asset in exchange for a
to market on a periodic basis, and these structures may payments tied to the London Interbank Offered Rate
be subject to one or more market value triggers. If so, a (LIBOR) (or some other index) plus a spread. Total
degree of market risk exists that is not present in cash return swaps closely resemble asset-based swaps in
flow CDOs. substance, effectively allowing the total return
receiver to create a synthetic leveraged position in
J.P. Morgan’s SEQUILS/MINCS vehicles provide the reference asset.
synthetic exposure to a reference portfolio of leveraged
bank loans through a CDS, rather than a TRS. There is
no mark-to-market component, and the transaction
triggers are based purely on realized losses under the
CDS. The reference portfolio is funded off-balance
sheet by the SEQUILS portion of the transaction,
which is senior in priority to the MINCS notes.

Synthetic CDOs: A Growing Market for Credit Derivatives

3

expectations, commensurate with the assigned rating,
the collateral is available at maturity to repay the
obligations.
Fitch’s analytical framework for evaluating synthetic
arbitrage CDOs corresponds closely to the published
criteria for rating any cash flow CDO (see Fitch
Research on “Rating Criteria for Cash Flow
Collateralized Debt Obligations,” dated Nov. 30,
2000, available on Fitch’s web site at
www.fitchratings.com). Key inputs include level and
timing of stressed defaults, recovery expectations,
and asset-liability management. Additionally, these
transactions have distinctive features that may
warrant additional analytical emphasis, including the
use of leverage, buildup and release of excess spread,
and mark-to-market triggers that may necessitate a
hybrid cash flow/market value analysis. The eligible
collateral also must conform to certain criteria in
order to mitigate market and liquidity risk, which
would arise in the event there is a liquidation prior to
the transaction’s maturity date, in order to satisfy
payments by the trust under the TRS.
■ Synthetic Balance Sheet CDOs
Increasingly, banks have embraced synthetic structures
to execute balance sheet CDOs for purposes of
managing credit exposures and improving returns on
risk/regulatory capital. Synthetic structures, which can
be structured using either a CDS or a credit-linked
note, allow banks to achieve risk/regulatory capital
relief at lower all-in funding and administrative costs
when compared with fully cash-funded CDOs.
Synthetic CDOs: A Growing Market for Credit Derivatives
4
Structured Finance
Europe, in particular, has been quick to embrace the
use of synthetic balance sheet CDOs. Synthetic
structures are especially well suited for European
CDOs because of the ability to reference exposures
across multiple legal and regulatory regimes. ABN
AMRO’s Amstel 2000-1 and 2000-2, a
EUR8.5 billion synthetic CDO issued in December
2000, is an example of a typical, albeit large,
synthetic structure that transfers the credit risk of a
portfolio of large European corporates originated by
ABN AMRO. Proceeds from the notes were
deposited into an account in the name of the SPV at
ABN AMRO (rated ‘F1+’ by Fitch) and will be used
to cover any losses (over and above the amount in the
reserve account) and to redeem the notes at maturity.
One of the current growth areas in the European
CDO market is the securitization of small and
medium-sized enterprise (SME) portfolios via
synthetic structures. One of the primary roles of state
development banks, such as Kreditanstalt fuer
Wiederaufbau (KfW) of Germany and Instituto de
Credito Oficial (ICO) of Spain, is to assist in the
growth of SMEs. By securitizing their SME loans
these banks are transferring a significant portion of
the risk associated with these loans to the capital
markets and, therefore, are able to originate
additional loans to help expand this market.
Another emerging asset class for European CDOs is
the repackaging of asset-backed, residential
mortgage-backed, and commercial mortgage-backed
securities. Banks are now transferring the risk of
referenced portfolios of structured securities, largely
via unfunded structures. This is useful for banks both

in terms of managing their own credit exposure and,
for German banks in particular, by enabling them to
use the repackaged asset-backed portfolio as
collateral for their own pfandebriefe issuance.
In synthetic structures involving a CDS, the issuing
bank establishes an SPV and enters into a CDS that
references a portfolio of loans, bonds, commitments,
or other credit instruments. Alternatively, the bank
may execute the transaction through a third-party
intermediary, such as in J.P. Morgan’s BISTRO
program. The bank normally will retain a relatively
small first loss piece that serves to align its interests
with the noteholders. The SPV issues one or more
tranches of notes whose ultimate performance is
linked to the actual default and recovery experience
of the reference portfolio. Any losses arising from
defaults are allocated to the noteholders, according to
their priority in the capital structure. Losses are
determined by specific credit events and settlement
mechanisms, which are set forth in the CDS
confirmation.
Note proceeds are invested in high-quality, liquid
collateral. This eligible collateral is pledged, on first
priority basis, to the sponsor in order to satisfy loss
claims under the CDS during the transaction’s life and,
secondarily, to the investors for repayment of the notes
at maturity. In European synthetic transactions, the
collateral used to delink the rating of the bank from the
notes initially took the form of the sponsoring bank’s
‘AAA’ rated pfandebriefe; however, the market has
5
Structured Finance
now evolved to include other highly rated securities,
with overcollateralization sized to cover market risk.
To mitigate market and credit risk, some structures
also may allow for delivery of the eligible collateral
at par to satisfy loss claims under the CDS. The
transaction remains linked to the senior debt rating of
the sponsoring bank in the form of ongoing premium
payments on the CDS, which serve to cover shortfalls
on coupon payments, losses, and other miscellaneous
expenses. In these structures, it is possible to de-link
the transaction and achieve a higher rating than that
of the bank on the basis of the collateral’s rating, as
well as structural mechanisms that include
defeasance triggers, substitution rights, early
termination, and other provisions.
In credit-linked note structures, note proceeds are
invested in a credit-linked note issued by the bank.
As a result, proceeds from the CDO issuance are
available to the bank for general corporate purposes,
and the most senior tranche of the CDO typically will
be subject to a rating cap equal to the sponsoring
bank’s senior debt rating. The rating cap underscores
the position of CDO investors as senior unsecured
creditors of the bank with respect to timely debt
service and ultimate repayment.
For either structure, the amount of issued notes
typically is a fraction of the notional amount of the
reference portfolio. The partially funded nature of the
more recent synthetic balance sheet CDOs is a
Synthetic CDOs: A Growing Market for Credit Derivatives

Loss Recognition for Synthetic CDOs
Loss Recognition
• Cash or physical settlement
• Immediate or deferred settlement
• With or without cost of carry
• Loss thresholds may apply
Credit Events*
• Failure to pay (modified for structured securities)
• Bankruptcy
• Acceleration
• Repudiation or moratorium
• Restructuring
*See 1999 International Swaps and Derivatives Association Credit
Derivatives Definitions.
distinctive feature and underscores that the main
motivation is regulatory and economic capital
management rather than funding driven.
The bank is able to achieve maximum regulatory
capital relief through the combination of the synthetic
CDO, as well as through a super senior CDS
transacted with an OECD bank. The super senior
CDS is sized to provide credit protection for the
balance of the reference portfolio in excess of the
most senior tranche of the synthetic CDO.
Alternatively, it may be possible, at least for U.S.
banks, to gain full regulatory capital without the
super senior CDS, as per guidelines issued by the
Federal Reserve.
■ Loss Recognition
The mechanisms for determining and settling losses
are interesting and unique features of synthetic
balance sheet CDOs that merit some discussion. Loss
indemnification can occur immediately following a
credit event or can be deferred in order to allow for
higher recoveries through active workout. In the
latter case, there may be a mechanism to compensate
the bank for its negative carry cost on the non-
performing asset.
Protection payments on defaulted assets may be
under a “cash settlement” method, in which the
protection payment is based on the difference
between the par value of the asset and its post-default
market value. Alternatively, the CDO may provide
for physical settlement, in which case the SPV is
required to make a payment based on the full par
value of the asset, and ends up owning the defaulted
asset. Immediate cash settlement may prove to be
more costly for CDO investors since technical trading
Synthetic CDOs: A Growing Market for Credit Derivatives
6
Structured Finance
factors immediately following a credit event can
depress asset prices below their intrinsic recovery
value. This is particularly true for senior secured
bank loans, due to their superior creditor status,
which positively influences ultimate recovery in
bankruptcy proceedings.
Definitions of “credit events” also play a role in
synthetic structures that are not present in traditional
CDOs. Credit event definitions conform to 1999
International Swap Dealers Association (ISDA)
Credit Derivatives Definitions. Market convention
generally defines a credit event as failure to pay,
bankruptcy, restructuring, repudiation or moratorium,
and obligation acceleration. Restructuring, in
particular, has become a hot button issue, and this
definition may be subject to substantial revision or
excluded altogether as a standard credit event by
market participants (see Fitch Research on
“Restructuring: A Defining Event for Synthetic
CDOs,” dated Jan. 8, 2001, available on Fitch’s web
site at www.fitchresearch.com).
For synthetic CDOs referencing asset-backed and
other structured securities portfolios, the standard
credit event definitions require modification. Because
many structured securities are contractually permitted
to defer interest payments without being in default,
the definition of failure to pay is modified to ensure
consistency with the underlying reference assets.
Again, the analytical framework for synthetic balance
sheet CDOs mirrors Fitch’s published CDO criteria.
These transactions, however, do have a number of
features that are unique, including mechanisms to
ensure de-linkage from the issuing bank’s rating,
timing and procedures for making protection
payments on defaulted assets, and investment
restrictions in collateralized structures designed to
minimize or offset market and liquidity risk.
Additionally, these transactions may have early
redemption features that permit the issuer to call the
transaction in the event of changes in the regulatory
capital framework. On the other hand, these
structures can offer greater simplicity with respect to
asset/liability management and cash flow modeling.
■ Credit Default Swaps
Increasingly, Fitch is asked to evaluate more customized
synthetic exposures in the form of portfolio CDSs.
These transactions closely resemble synthetic balance
sheet CDOs in so much as a CDS is used to transfer
credit risk on a well defined reference portfolio of

credits. That said, there are important differences that
make these transactions more akin to synthetic CDOs-
lite (all the benefits, but half the credits).
In a typical portfolio CDS, the arranger seeks to
transfer first loss or second loss exposure on a
predetermined percentage of the reference portfolio
in return for an annual premium. The seller of credit
protection effectively is taking a levered position in
the reference portfolio, with the leverage inversely
related to the loss percentage. For example, a 5% first
loss exposure is equivalent to a 20x levered position
in the underlying reference portfolio. This has
important analytical implications since a single
default, however low the statistical probability, can
result in a high loss severity depending on the size of
the first loss position and the corresponding leverage.
As compared to synthetic CDOs, portfolio CDS tend
to be more customized with respect to the structure and
the reference portfolio characteristics. Protection
buyers may use portfolio CDS to rebalance their
portfolios and synthetically transfer excessive
concentrations. Similarly, protection sellers are able to
take on name-specific risk on the basis of their
investment parameters and risk-reward appetite.
Portfolio CDS can be transacted as a pure credit
derivative or, alternatively, in funded form as a credit-
linked note. A funded format may be more attractive to
some buyers of credit risk who operate under specific
investment guidelines, want a cash instrument that
pays a stated coupon, and desire to limit counterparty
credit risk through the use of collateral.
Fitch’s rating methodology for portfolio CDS has
some fundamental differences when compared with
traditional CDOs or synthetic CDOs. First, the
reference portfolio may be significantly less diverse in
7
Structured Finance
terms of the number of obligors. It is possible for a
portfolio CDS to reference as few as 10–15 obligors,
although 20–25 obligors is more normal. This would
not be the case in a well diversified CDO. Moreover,
there will be no upfront credit enhancement in the case
of first loss exposures, although there may be
mechanisms to capture and accumulate excess cash
derived from the CDS premium payments. Fitch’s
analytical approach will be based on the reference
portfolio’s credit profile, with particular emphasis on
the expected default probability of the weaker credits,
the degree of diversification and its impact on expected
defaults, and an assessment of recovery values.
■ Conclusion
Growth in synthetic CDOs directly corresponds to the
rapid growth and innovations in traditional credit
derivative markets. The fact that credit derivatives
and CDOs are still relatively new indicates that more
innovations and further acceptance is likely.
Underscoring this trend is the application of synthetic
structures to an ever wider range of asset types,
including investment-grade and leveraged loans,
corporate bonds, asset-backed securities, commercial
and residential mortgage-backed securities, and,
even, counterparty risk from derivatives and other
activities.
Synthetic CDOs have a number of features that are
unique and distinctive. Fitch’s analysis of synthetic
CDOs is fundamentally based on the methodology
used to rate cash-funded CDOs. A number of
additional analytical factors, however, come into play
when rating synthetic CDOs. To summarize, these
include a review of the underlying credit derivative
instrument, including definitions of credit events, loss
recognition, market value triggers, and counterparty
and collateralization requirements.
■ Related Fitch Research
For more information on Fitch’s rating criteria for
CDOs, see the following Fitch Research, available on
Fitch’s web site at www.fitchresearch.com:
• “Restructuring: A Defining Event for Synthetic
CDOs,” dated Jan. 8, 2001.
• “Rating Criteria for Cash Flow Collateralized
Debt Obligations,” dated Nov. 30, 2000.
• “Rating Criteria for Cash Flow ABS/MBS
CDOs,” dated Nov. 9, 2000.
• “Rating Criteria for European Arbitrage
Collateralised Debt Obligations,” dated June 5, 2000.
• “Market Value CBO/CLO Rating Criteria,”
dated June 1, 1999.
Synthetic CDOs: A Growing Market for Credit Derivatives
 Structured Finance

Copyright © 2001 by Fitch, One State Street Plaza, NY, NY 10004

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Synthetic CDOs: A Growing Market for Credit Derivatives

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