Feature FIGURE 2 : Partially funded synthetic CDO structure - PDF document

THE SYNTHETIC TOOLBOX: UNLOCKING LIQUIDITY KEY POINTS Feature � Synthetic products allow investors to invest in assets that may otherwise be inaccessible and to separate credit risk from other risks that aff ect cash assets. � Whilst taking synthetic exposure to commercial real estate (‘CRE’) assets helps create further liquidity in the market there are risks associated with investing in synthetic structures. � Financial derivatives provide a valuable mechanism for managing credit risk. Authors Andrew V Petersen, Anthony RG Nolan and James A Spencer The synthetic toolbox: unlocking liquidity INTRODUCTION This article examines the rapid rise in the use of synthetic structures in the commercial real estate securitisation market, exploring the use of derivative Ti e CRE structured fi nance market instruments such as credit default swaps (‘CDS’), credit linked notes (‘CLN’) and total is currently witnessing a rapid rise return swaps (‘TRS’). in the use of synthetic structures, both debt and equity based. Whilst high levels of market liquidity have, paradoxically, made advent of managed CRE CDO structures, event occurs, the proceeds of issuance of the it increasingly more diffi cult to execute cash buyers are now able to obtain low-cost matched- CLNs are invested by the issuer in risk-free collateralised debt obligation (‘CDO’) and term funding in a structure that creates and investments such as government securities. commercial mortgage-backed securitisation monetises excess spread. CRE CDOs provide Ti e principal amount of each class of CLNs is (‘CMBS’) transactions, the relatively excellent arbitrage opportunities because they written down in line with a principal reduction inexpensive nature of synthetic products provide a vehicle with which to exploit the in the market value of the reference portfolio has resulted in the growing use of derivative higher yields earned on the underlying portfolio resulting from a credit event. See Figure 2. products in synthetic CDO and CMBS against the lower weighted average spread due to Hybrid structures have also developed transactions to gain exposure to CRE assets. the holders of rated notes. Ti is is of particular recently, where the portfolio manager is able to Ti e ability to quickly create or eliminate benefi t to the equity holders in such deals, invest not only in cash assets but also synthetic credit exposure on an underlying asset, whether such as the portfolio manager who typically collateral. Whilst the earlier deals provided for for arbitrage or balance sheet reasons, has meant subscribes for the economic equity or receives a relatively small ‘buckets’ of synthetic collateral, that synthetic structures and credit derivatives fee based on the equity return. the size of the synthetic bucket is increasing; have become an effi cient investment mechanism In typical cash CDO or CMBS addressing the lack of cash collateral in the as well as an important risk management tool. transactions, the issuer acquires the portfolio of market. Given current market conditions, For these purposes, synthetic products are used assets in a true sale from the proceeds of issuing CDO managers are also using CDS to go by a whole raft of fi nancial institutions from tranched mortgage-backed securities to capital short on portfolio assets which they view investment banks, pension or hedge funds to market investors. See Figure 1. negatively. However, given that short positions managed investment vehicles (such as issuers of However, in a synthetic securitisation, the are generally costly and may reduce the amount CDO or CMBS debt securities). issuer achieves the same economic result without of subordination in the CDO (and the need, Ti is article examines this trend and legally owning the assets by entering into therefore, to create additional liquidity on the explores the use of various derivative derivative contracts in respect of the portfolio. long portfolio) the rating agencies are fairly instruments in real estate structured products. Ti e issuer (as protection seller) agrees to pay restrictive in permitting managers to trade in the legal owner of those assets (the protection this way. THE RISE OF SYNTHETIC CMBS AND buyer) an amount equal to the losses it suff ers Ti e market has also seen multi-layered CRE CDOS as a result of certain credit events occurring on derivative structures that re-securitise existing European CRE securitisation began with the underlying portfolio (such as a borrower synthetic CMBS transactions, whereby a CMBS transactions backed by static pools of payment default). Ti ese payments are funded synthetic CDO is put in place which references traditional commercial mortgage loans. Heavily from the proceeds of issuing CLNs to capital a static CMBS tranche (rather than a pool infl uenced by the US practice, the European market investors. Until such time as a credit of CMBS). In the CMBS transaction itself, market has also seen CDO technology being FIGURE 1 : Cash CDO structure applied as a means to securitise CRE assets without the constraints of traditional CMBS Principal and structures. Ti is culminated in the fi rst CRE Investments interest payments AAA CDO reaching Europe in late 2006 with the Portfolio of assets Issuer closing of the groundbreaking Anthracite Euro A CRE CDO 2006-1 plc. Principal Investment and CRE CDOs provide a long-term, non- interest BBB mark-to-market fi nancing for holders of CMBS payments B-pieces, B notes and mezzanine loans. Buyers of such assets would, in the past, have fi nanced Unrated them with short-term repo facilities. With the 461 Butterworths Journal of International Banking and Financial Law September 2007