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

Butterworths Journal of International Banking and Financial Law September 2007

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THE SYNTHETIC TOOLBOX: UNLOCKING LIQUIDITY

The synthetic toolbox: unlocking liquidity

INTRODUCTION

Ti e CRE structured fi nance market is currently witnessing a rapid rise in the use of synthetic structures, both debt and equity based. Whilst high levels of market liquidity have, paradoxically, made it increasingly more diffi cult to execute cash collateralised debt obligation (‘CDO’) and commercial mortgage-backed securitisation (‘CMBS’) transactions, the relatively inexpensive nature of synthetic products has resulted in the growing use of derivative products in synthetic CDO and CMBS transactions to gain exposure to CRE assets. Ti e ability to quickly create or eliminate credit exposure on an underlying asset, whether for arbitrage or balance sheet reasons, has meant that synthetic structures and credit derivatives have become an effi cient investment mechanism as well as an important risk management tool. For these purposes, synthetic products are used by a whole raft of fi nancial institutions from investment banks, pension or hedge funds to managed investment vehicles (such as issuers of CDO or CMBS debt securities). Ti is article examines this trend and explores the use of various derivative instruments in real estate structured products.

THE RISE OF SYNTHETIC CMBS AND CRE CDOS

European CRE securitisation began with CMBS transactions backed by static pools of traditional commercial mortgage loans. Heavily infl uenced by the US practice, the European market has also seen CDO technology being applied as a means to securitise CRE assets without the constraints of traditional CMBS

• structures. Ti

is culminated in the fi rst CRE CDO reaching Europe in late 2006 with the closing of the groundbreaking Anthracite Euro CRE CDO 2006-1 plc. CRE CDOs provide a long-term, non- mark-to-market fi nancing for holders of CMBS B-pieces, B notes and mezzanine loans. Buyers

• f such assets would, in the past, have fi

nanced them with short-term repo facilities. With the advent of managed CRE CDO structures, buyers are now able to obtain low-cost matched- term funding in a structure that creates and monetises excess spread. CRE CDOs provide excellent arbitrage opportunities because they provide a vehicle with which to exploit the higher yields earned on the underlying portfolio against the lower weighted average spread due to the holders of rated notes. Ti is is of particular benefi t to the equity holders in such deals, such as the portfolio manager who typically subscribes for the economic equity or receives a fee based on the equity return. In typical cash CDO or CMBS transactions, the issuer acquires the portfolio of assets in a true sale from the proceeds of issuing tranched mortgage-backed securities to capital market investors. See Figure 1. However, in a synthetic securitisation, the issuer achieves the same economic result without legally owning the assets by entering into derivative contracts in respect of the portfolio. Ti e issuer (as protection seller) agrees to pay the legal owner of those assets (the protection buyer) an amount equal to the losses it suff ers as a result of certain credit events occurring on the underlying portfolio (such as a borrower payment default). Ti ese payments are funded from the proceeds of issuing CLNs to capital market investors. Until such time as a credit event occurs, the proceeds of issuance of the CLNs are invested by the issuer in risk-free investments such as government securities. Ti e principal amount of each class of CLNs is written down in line with a principal reduction in the market value of the reference portfolio resulting from a credit event. See Figure 2. Hybrid structures have also developed recently, where the portfolio manager is able to invest not only in cash assets but also synthetic

• collateral. Whilst the earlier deals provided for

relatively small ‘buckets’ of synthetic collateral, the size of the synthetic bucket is increasing; addressing the lack of cash collateral in the

• market. Given current market conditions,

CDO managers are also using CDS to go short on portfolio assets which they view

• negatively. However, given that short positions

are generally costly and may reduce the amount

• f subordination in the CDO (and the need,

therefore, to create additional liquidity on the long portfolio) the rating agencies are fairly restrictive in permitting managers to trade in this way. Ti e market has also seen multi-layered derivative structures that re-securitise existing synthetic CMBS transactions, whereby a synthetic CDO is put in place which references a static CMBS tranche (rather than a pool

• f CMBS). In the CMBS transaction itself,

KEY POINTS

• 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.

This article examines the rapid rise in the use of synthetic structures in the commercial real estate securitisation market, exploring the use of derivative instruments such as credit default swaps (‘CDS’), credit linked notes (‘CLN’) and total return swaps (‘TRS’). Authors Andrew V Petersen, Anthony RG Nolan and James A Spencer FIGURE 1: Cash CDO structure

Issuer AAA A BBB Portfolio of assets Principal and interest payments Investments Investment Principal and interest payments Unrated

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THE SYNTHETIC TOOLBOX: UNLOCKING LIQUIDITY

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the underlying portfolio is also synthetic. Accordingly, neither the CMBS issuer nor the CDO issuer actually own the underlying asset(s), which themselves may be synthetic. Ti e ability to synthetically transfer risk has been greatly eased by the development of the robust International Swaps and Derivatives Association, Inc (‘ISDA’) templates for credit derivatives, in funded or unfunded form, each of which is explored below.

CREDIT DEFAULT SWAPS (‘CDS’)

A CDS is an unfunded derivative contract (usually based on the ISDA forms), analogous to a guarantee transaction, pursuant to which the protection buyer pays a fi xed amount fee to the protection seller on a periodic basis. Under the CDS terms, the protection buyer transfers to the protection seller the credit risk of an asset

• r portfolio of assets. Ti

e protection seller

• nly makes payments to the protection buyer

upon the occurrence of certain credit events, signifying a problem on the underlying asset. Unlike a guarantee, these credit events can extend beyond purely payment defaults and include, for example, potential events of default, insolvency restructuring and rating downgrades, in relation to a reference entity. Ti e obligations of the parties to each other are independent of any ownership of any

• bligation of the reference entity.

Following a credit event (but before the protection seller fulfi ls its payment obligations) the protection buyer is faced with the credit risk of the reference obligation as well as the credit risk of the protection seller. Ti e protection buyer can remove the credit risk

• f the protection seller by requiring it to ‘post’

collateral (usually cash, government securities and other low-risk collateral) with the protection

• buyer. If the protection seller doesn’t fulfi

l its payment obligations following a credit event, the protection buyer will apply the posted collateral to extinguish (at least in part) the amount due from the protection seller. Ti e sharp rise in the volume of synthetic asset-backed securities (‘ABS’) has been facilitated by the introduction of standardised ISDA documentation for CDS referencing mortgage-backed securities (MBS), ABS, CMBS and CDOs on both a single name and an index basis. Separate documentation became necessary because the credit events and settlement conventions in the 2003 ISDA credit derivative defi nitions (which were drafted with sovereign and corporate reference entities in mind) do not work for

• ABS. Ti

e principal form of ABS CDS (the so-called pay-as-you-go (‘PAUG’) form) was developed for the US market but has eclipsed the European-centric form known as the ‘cash or physical settlement’ form. Ti e PAUG form refl ects the unique credit characteristics

• f ABS such as rating dependency and

securitisation cash fl

• w issues, which include

principal writedowns due to excess spread erosion or losses on the underlying asset pool. Ti e PAUG form in essence replaces close-

• ut settlements with ongoing two-way cash

settlements that purport to put the protection seller in a situation similar to that which it would have been had it owned the reference

• bligation. Ti

e chart below illustrates

BBB

FIGURE 2: Partially funded synthetic CDO structure

AAA A Premiums Payments Contingent Payments Eligible Investments Unrated Super senior Credit Defaults Swap Credit Protection Buyer Pool of Reference Entities Issuer Credit Defaults Swap Investment Premium Investments Payment Unfunded super senior tranches Funded tranches

FIGURE 3: PAUG CDS settlement

Protection Seller Floating payment Pay Notional Value Fixed Amounts Receive Reference Obligation Buyer pays/Seller receives:

Fixed payments (ie premium) Additional fi

xed amounts in respect of reversals of writedowns, principal shortfalls, interest shortfalls Buyer Receives and Seller Pays:

Floating payments in respect of applicable

percentage of writedowns, principal shortfalls, interest shortfalls Buyer’s option to declare credit event except in case of:

Distressed ratings downgrade

(Credit event is only option)

Interest shortfall (Floating

amount event is only option) Multiple settlement possible Notice of physical settlement is void if reference obligation cannot be delivered Add'l Fixed Amounts Protection Buyer Protection Seller Protection Buyer

• Ref. Oblig
• Ref. Oblig

PAY AS YOU GO (PAUG) SETTLEMENT PHYSICAL SETTLEMENT AFTER CREDIT EVENT

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THE SYNTHETIC TOOLBOX: UNLOCKING LIQUIDITY

settlement of PAUG CDS following credit events and fl

• ating amount events.

Ti e PAUG form has been adopted in various templates to refl ect diff erent sorts of underlying securitisation instruments, such as CMBS and

• CDOs. More recently, although the PAUG form

has been drafted for use with single reference

• bligations, it has been adopted for ABS

indexes such as the ABX sub-prime, RMBS index and the new and growing CMBX index. Ti e CMBX index allows investors to gain long

• r short synthetic exposure to CMBS by either

selling or buying protection. Given the recent spread widening in CMBS prices (a knock-on eff ect to the recent sub-prime volatility) the demand for short portions is rising. From a regulatory capital perspective, a CDS is generally recognised as a risk transference device under Basel II, if the terms of the contract provides for an eff ective transfer of risk on the reference entity and if the protection buyer is protected from the credit risk of the protection seller through collateral

• r a qualifying guarantee.

CREDIT LINKED NOTES (‘CLNS’)

Synthetic securitisations typically involve a combination of CDS and CLNs. CLNs are structured debt securities embedded within a funded credit derivative and can be viewed in a similar light to a funded bank loan sub-participation. CLNs are issued by the protection buyer to noteholders (the protection seller) in exchange for the protection seller paying the subscription price for the CLNs. Ti e amount of principal and interest that the protection seller receives under the CLN will be dependent upon the performance of the underlying reference obligation. Unlike a more vanilla bond, the obligation under a CLN to pay interest and/or repay principal can be reduced (potentially to zero), without any recourse to, or liability on, the protection buyer, following the occurrence of a credit

• event. In essence, each payment received by

the protection buyer is matched by a payment

• bligation to the protection seller. In return

for assuming the credit risk on the underlying reference obligation, the investor receives a higher yield than it would receive if the bond did not allow for principal write-down. Since, in most cases, the protection seller buys the CLNs for cash on issuance, the protection buyer is free of credit risk from both the underlying asset (the economic risk is with the protection seller) and the protection seller (who has already fulfi lled its payment obligations). Ti ese factors help to make CLNs eff ective risk transfer devices under Basel II.

TOTAL RETURN SWAPS (‘TRS’)

TRS is a type of derivative instrument where the total return of the reference entity is exchanged for a stream of LIBOR/ EURIBOR-based cash fl

• ws. An eff

ect

• f a TRS is to transfer the entire risk in a

reference obligation to the protection seller. Unlike a CDS which provides protection against a specifi c list of credit events, the TRS provides protection against any negative movements in value, whether resulting from a payment default, drop in market value or other general market conditions, such as interest rate

• movements. Under the swap documentation

(based on ISDA form), the protection buyer pays to the protection seller the entire cashfl

• w

received from the reference obligation together with an amount equal to any increase in the market value of the reference obligation. In return, the protection seller makes regular interest type payments (a pre-agreed fi xed return to the protection buyer), together with an amount equal to any decrease in the market value of the reference obligation.

ISSUES IN SYNTHETIC TRANSACTIONS

Although taking synthetic exposure to a reference obligation transfers the credit risk, it is a common misconception that synthetic exposure puts the protection seller in the same position as if it legally owned the reference obligation. Ti ere are signifi cant diff erences (and additional risks) owning synthetic exposure to, for example, CMBS and owning the CMBS bond:

• Ti

e protection seller does not receive any

• f the rights granted to the holder of the

underlying bond, such as voting rights, and is not entitled to receive noteholder reports.

• Whilst the holder of a bond may not

lose more than the principal amount, that same bond could be the reference

• bligation for a CDS with a notional

amount several multiples of that principal

• amount. Ti

is can make a deal vulnerable to performance cliff s, where seemingly small changes in the performance of the underlying reference credits translate into large performance diff erences in the synthetic CMBS. Accordingly, such deals arguably demand a greater measure of expertise from investors because the consequences of mistakes can be amplifi ed.

• Payments on a PAUG CDS do not

necessarily match the losses, shortfalls or reimbursements that a cash investor in the bond would have incurred. For example, an erosion of over-collateralisation on a bond or a ratings downgrade may not cause loss to the bond holder but would trigger payment to the protection buyer on a CDS. Ti is is known as basis mismatch risk that could provide a windfall to one side or the

• ther (usually to the protection buyer).
• Whilst a bond holder is subject to the

risk of the underlying bond performing, the protection seller on a CDS is not only subject to the credit risk of the reference entity but also to counterparty risk, ie the risk that the protection buyer doesn’t meet its payment obligations. However, despite these diff erences, synthetic credit exposure does have indisputable advantages:

• With no requirement for actual transfer of

assets, synthetic risk transfer can be useful when there are underlying restrictions on assignment, transfer taxes, secrecy issues

• etc. Further credit risk transfer, can be

achieved under appropriately structured derivative contracts, hence circumventing the costly true-sale procedure. As already discussed, synthetic risk transfer allows investors to gain exposure to otherwise inaccessible assets.

• A CDS contract does not require an

initial investment. Ti erefore, it is cheaper to synthetically take the risk on a reference entity than to actually buy it.

• A CDS allows for credit risk to be isolated

from other risks that aff ect spreads, such as interest rate risk and market risk, allowing asset managers to express pure credit-driven views when trading CDS

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THE SYNTHETIC TOOLBOX: UNLOCKING LIQUIDITY

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without being overly concerned about these other risk factors.

• Investing in a cash asset was historically a

long-only investment, whilst through the use of CDS an investor can synthetically go short of the market. Ti is allows asset managers to take views on a sector, an asset class or a servicer and also provides

• pportunities to trade the arbitrage between

credit spreads and spreads on cash bonds.

CONCLUSION

With growth opportunities limited and spreads tightening, the European CRE fi nance market may well be at the mature stage of the credit cycle. Ti rough product innovation, synthetic structures off er an attractive and economically viable alternative to traditional methods of transferring or mitigating credit risk, resulting in the pace of synthetic activity accelerating over recent years. Ti e development of the PAUG form and its variants illustrate how market participants have responded to the growth of the synthetic

• market. One particular example can be seen in

the introduction by Standard and Poor’s, in June 2006, of a revised CDO Evaluator rating model (version 3.2) updated in line with current market perception with respect to correlation, default and recovery rates. Ti e model provides more favourable rating treatment for certain types of reference portfolios which by extension creates greater investment opportunities for synthetic

• CDOs. Ti

e future is also expected to witness an increase in the use of synthetic products referencing synthetic loan portfolios. Indeed, the recent publication of ISDA’s European and US loan-only CDS formats are expected to lead to a signifi cant rise in trading synthetic protection as an attractive alternative to physical methods of transferring loans. As a result, new and exotic asset classes are being presented to an ever growing investor base, including investors who may not have been previously involved in the synthetic loan market. And so it is clear that the synthetic CRE derivatives market, because of its ever expanding toolbox, is here to stay.

• FINANCE PARTIES AND OPTION AGREEMENTS

(1) BRITISH ENERGY POWER & ENERGY TRADING LIMITED (2) EGGBOROUGH POWER (HOLDINGS) LIMITED (3) EGGBOROUGH POWER LIMITED V (1) CREDIT SUISSE (2) AMPERE LIMITED (3) AMPERE 1 LIMITED [2007] EWHC 1428 (COMM) (LANGLEY J)

Whether Credit Suisse as a bank was bound by the terms of option agreements entered into by Barclays Bank PLC (‘Barclays’) as agent and security trustee for the banks.

BACKGROUND

Eggborough Power Limited (‘EPL’) owns the business and assets

• f a power station. Ti

e claimants are referred to collectively as ‘British Energy’. In September 2004, British Energy entered into fi nance agreements – restated credit agreement, share option agreement, asset

• ption agreement and restated intercreditor agreement – as part of a

debt restructuring programme. In return for writing off existing debt, British Energy agreed to grant the options to purchase the shares in or assets of EPL. Credit Suisse is the successor to the rights and

• bligations of almost 90 per cent of the interests of the banks under the

credit agreement. Ampere Limited and Ampere 1 Limited (together ‘Ampere’) are companies incorporated to consolidate sub-participation rights in relation to the facilities granted by the banks to EPL. Ti e option agreements contained restrictions on transfer or

• ther dealing with the option rights. British Energy contends that

as Barclays entered into the option agreements ‘as agent and security trustee’ for the banks, Barclays bound all the banks to the terms of the agreements. Credit Suisse and Ampere contend that the words are no more than descriptive of Barclays’ role and Barclays alone is bound by the restrictions.

CONCLUSIONS

Ti e share option agreement contains a restriction that Barclays as agent and security trustee may not enter into any agreement or other arrangement that relates to the exercise of any of its rights under the

• agreement. Ti

is clause provides extra protection for British Energy. Credit Suisse and Ampere had entered into an arrangement whereby (a) Credit Suisse must do as Ampere dictates as regards the

• ption agreements and (b) Credit Suisse must instruct Barclays to

exercise the share option by no later than 31 August 2009. British Energy would have no commercial interest in restricting assignment by Barclays, or transfer of rights held by Barclays, but not restricting assignment by the banks (including Credit Suisse). Ti e share option agreement plainly intends to provide protection for British Energy by restricting rights to dispose of the power station and the rights granted by the options. If the banks were free to do as they pleased the protections are virtually illusory. British Energy could expect banks to be far more circumspect in exercising options than a competitor of British Energy or a less risk-averse entity. Barclays did not enter into the option agreements only as principal. Where an agreement is executed by X as agent for Y, Y is a party to and bound by the rights and subject to the obligations of the agreement. Credit Suisse is a party to the option agreements and bound by their restrictions. Jonathan Lawrence, K&L Gates jonathan.lawrence@klgates.com, www.klgates.com