What is synthetic securitisation?

Stock Market

Securitization can be in a classic form. It is also called “real securitisation” or “cash flow securitisation”. But securitisation can also be synthetic. Indeed, since 1995, banks and financial institutions have sought to reduce credit risk. With traditional securitisation, banks lost the flow generated by securitised assets and lost money because of the cost of managing the securitisation vehicle. In addition, some assets cannot be transferred as credits to companies because of clauses prohibiting their transfer. They have therefore created synthetic securitisation, which is simpler to manage and less expensive. In this case, the income-generating assets will not be transferred, they will be legally retained by the originator. Only the credit risk associated with the asset pool will be transferred. Hedging financial instruments are used: credit derivatives such as CDSs. In this case, the investor will remunerate the asset holder in the event that the credit risk on the asset materializes. That is, if the credit event takes place, the CDS seller pays the CDS buyer the value of the receivables or securities on which there is a default less their recovery value. Thus, the assets covered by a CDS become risk-free. In return, the asset holder pays a premium (quarterly, semi-annual or annual). There is no issue of financial securities, just buy a CDS. The SPV uses an exchange contract or swap to carry out the securitisation process without actually holding the assets. The first synthetic CDO was named BISTRO and was produced by JP Morgan in 1998.

Very often synthetic securitization arrangements are more complex. They generally use a securitisation vehicle in their process. A synthetic CDO (Synthetic CDO) does not contain assets but a credit hedge on an asset portfolio. But there are also hybrid CDOs (Hybrid CDOs) that contain both assets and credit derivatives. The synthetic CDO issues tranches and buys protection from these tranches.

These may be partially funded synthetic CDOs. We will take the example of a bank with a $10 billion portfolio of corporate loans. It wishes to protect itself against credit risk but wishes to keep its portfolio on its balance sheet for the reasons mentioned above. If it decides to buy a CDS without using a securitisation vehicle, it will have to pay a high premium. To reduce its costs, it decides to use a structure that uses a securitisation vehicle. She divides her portfolio in two. A portfolio of $8.5 billion with the good quality debt it has, which is therefore rated AAA, and a portfolio of $1.5 billion composed of low quality debt with a higher credit risk profile. It buys a CDS for its $8.5 billion AAA-rated portfolio, which is called a “super senior”. It therefore protected the $8.5 billion in its portfolio and at a lower cost. Indeed, the premium to be paid is between 3 and 10 basis points because the receivables are of good quality. For the second $1.5 billion portfolio, it uses a securitization vehicle and therefore splits its portfolio into four tranches: one of $750 million with an AA rating, one of $375 million with an A rating, another of $150 million with a BBB rating that are transferred to the securitization vehicle and a final tranche of $225 million equity tranche that is kept by the bank. In this portfolio, it also buys a CDS from the securitisation vehicle called junior CDS, which is subordinated to the super senior CDS. But since investors buy securities backed by the three tranches, they are the ones who retain the credit risk. The bank recovers $1,275 million through the issuance of the tranches and with this amount it acquires risk-free securities. Thus, in the event of a loss on the equity tranche retained on its balance sheet, it sells its securities without risk in order to recover the amount lost.

If the losses are:

  1. under 225 million dollars it is the bank that supports them.

  2. between 225 million and 375 million dollars it is the investors of the tranche with the BBB rating who support them

  3. between 375 million and 750 million dollars it is the investors of the tranche with the rating A who support them

  4. between 750 million dollars and 1.5 billion dollars it is the investors of the tranche with the AA rating who support them

  5. between 1.5 billion dollars and 100 billion it is the bank that sold the CDS that supports them.

But they can also be fully funded synthetic CDOs. The originator buys a CDS from the securitisation vehicle on a benchmark portfolio. There is then a default swap. The securitisation vehicle does not pay for the acquisition of the asset portfolio, it just receives premiums. The securitisation vehicle issues CDOs in the same amount as the benchmark portfolio. Investors pay for the acquisition of these securities. With this amount, the securitisation vehicle purchases risk-free assets that will act as collateral. Investors are remunerated with CDS bonuses and remuneration for risk-free assets. If the credit event occurs, the securitisation vehicle will have to sell its assets without risk and investors will have to incur losses depending on the seniority of their tranche.

But it is possible to carry out the transaction without using collateral and therefore in this case a securitization vehicle is not necessary. These are unfunded synthetic CDOs (un-funded synthetic CDOs). The bidder buys a CDS and issues CDO tranches. The premiums paid are distributed to investors according to the seniority of their tranche. In the event of a credit event, investors will then have to compensate the originator according to their tranche. However, this will also depend on the creditworthiness of investors.

Unfunded synthetic CDOs have been very successful, especially for one category of these CDOs: single tranche CDOs. According to Standard and Poor’s, they accounted for 90% of the synthetic CDOs issued between 2003 and 2004. They are indeed very flexible. The other synthetic CDOs require that each tranche find its investor. If one of the slices cannot be sold, the assembly cannot take place. While in the assembly of STCDOs or called synthetic CDO bespoke, only one slice is sold. The problem of finding an investor for each tranche no longer arises. The initiator issues a single tranche with the attachment points he wants. The investor can thus choose the level of subordination of the tranche as well as its size. He or she chooses the level of risk he or she is willing to take and the compensation he or she wants. The benchmark portfolio as well as the attachment and exhaustion points must be negotiated. Once the characteristics of the tranche are traded, the rating agency rates the tranche and the originator generally buys a CDS to protect itself. The advantage for the initiator is a reduction in costs. It saves the investment costs of the tranches and the costs of canvassing.

If the losses are:

  1. under 225 million dollars it is the bank that supports them.

  2. between 225 million and 375 million dollars it is the investors of the tranche with the BBB rating who support them

  3. between 375 million and 750 million dollars it is the investors of the tranche with the rating A who support them

  4. between 750 million dollars and 1.5 billion dollars it is the investors of the tranche with the AA rating who support them

  5. between 1.5 billion dollars and 100 billion it is the bank that sold the CDS that supports them.

But they can also be fully funded synthetic CDOs. The originator buys a CDS from the securitisation vehicle on a benchmark portfolio. There is then a default swap. The securitisation vehicle does not pay for the acquisition of the asset portfolio, it just receives premiums. The securitisation vehicle issues CDOs in the same amount as the benchmark portfolio. Investors pay for the acquisition of these securities. With this amount, the securitisation vehicle purchases risk-free assets that will act as collateral. Investors are remunerated with CDS bonuses and remuneration for risk-free assets. If the credit event occurs, the securitisation vehicle will have to sell its assets without risk and investors will have to incur losses depending on the seniority of their tranche.

But it is possible to carry out the transaction without using collateral and therefore in this case a securitization vehicle is not necessary. These are unfunded synthetic CDOs (un-funded synthetic CDOs). The bidder buys a CDS and issues CDO tranches. The premiums paid are distributed to investors according to the seniority of their tranche. In the event of a credit event, investors will then have to compensate the originator according to their tranche. However, this will also depend on the creditworthiness of investors.

Unfunded synthetic CDOs have been very successful, especially for one category of these CDOs: single tranche CDOs. According to Standard and Poor’s, they accounted for 90% of the synthetic CDOs issued between 2003 and 2004. They are indeed very flexible. The other synthetic CDOs require that each tranche find its investor. If one of the slices cannot be sold, the assembly cannot take place. While in the assembly of STCDOs or called synthetic CDO bespoke, only one slice is sold. The problem of finding an investor for each tranche no longer arises. The initiator issues a single tranche with the attachment points he wants. The investor can thus choose the level of subordination of the tranche as well as its size. He or she chooses the level of risk he or she is willing to take and the compensation he or she wants. The benchmark portfolio as well as the attachment and exhaustion points must be negotiated. Once the characteristics of the tranche are traded, the rating agency rates the tranche and the originator generally buys a CDS to protect itself. The advantage for the initiator is a reduction in costs. It saves the investment costs of the tranches and the costs of canvassing.

Magalie THEVENET


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