1. MONDAY, JANUARY 29TH, 2007 CONFERENCE DAILY
Developments in hybrid CDO liquidity
By Richard M. Schetman, partner, Cadwalader, Wickersham & Taft LLP New York
T he expansion of synthetic
buckets in CDOs and the
growth of hybrid CDOs cre-
ate new inefficiencies in the typical
fully funded CDO structure. So long
CDS, the CDO issuer uses the per-
mitted investments held in the
reserve account to satisfy its obliga-
tions to make payments to the CDS
counterparty. When the synthetic
purchase of notes by variable fund-
ing note purchasers bear interest at a
spread above Libor and are repaid in
a senior position in the indenture
waterfall, above the other classes of
agency concerns at a reduced cost is
to allow the CDS counterparty
(rather than the CDO issuer) to
assume the credit risk of the liquid-
ity provider. In this structure the
as rating agency concerns are ade- CDS matures, any remaining cash senior notes and below amounts CDS counterparty agrees that it will
quately addressed, the solution to and permitted investments set aside owing to the CDS counterparty. not terminate the synthetic CDS
these inefficiencies may lie in the for synthetic CDS exposure would This structure allows the CDO with the CDO issuer if the CDO
various liquidity structures used in generally be released back into the issuer to issue or incur additional issuer fails to make payments to the
recent CDO transactions. structure as principal proceeds. senior liabilities on an “as needed” CDS counterparty due solely to pay-
Historically, the typical cash This structure, however, has eco- basis to meet the required payments ment default by the liquidity
CDO issuer has generally been a nomic inefficiencies. The short- to the CDS counterparty and there- provider. Because the risk of syn-
fully funded structure; specifically, if term, highly rated permitted invest- by reduces the negative carry creat- thetic CDS termination due to liq-
a CDO issuer acquires a billion dol- ments reserved against the potential ed by funding a reserve account for uidity provider credit is mitigated,
lars of assets at closing, the CDO exposure of the CDO issuer under the maximum CDS exposure. rating agency concerns may be sim-
issuer raises proceeds of approxi- the synthetic CDS generally accrue However, by adding a liquidity ilarly alleviated and collateraliza-
mately a billion dollars. Although interest at a rate lower than the sen- provider to the structure, this con- tion, prefunding and replacement
provisions eliminated or made more
By adding a liquidity provider to the structure, this contingent acceptable to third party liquidity
providers.
liquidity structure creates additional rating agency concerns. A second method to address rat-
ing agency concerns with the liq-
the ratio of CDO assets to CDO lia- ior CDO liabilities. This negative tingent liquidity structure creates uidity structure involves complete-
bilities will change over the term of carry is not a major structural prob- additional rating agency concerns. ly eliminating the third party liq-
a transaction (ideally, the value of lem if the basket of synthetic CDS Because the CDO issuer depends on uidity provider and have the CDS
CDO issuer assets will increase rela- assets is small relative to the amount the liquidity provider to meet its counterparty assume all of the liq-
tive to the amount of CDO issuer of cash assets held by the CDO obligations to the CDS counterparty, uidity risk. In this structure, pay-
liabilities to allow for the exercise of issuer. However, if the structure has the rating agencies have concerns ments in respect of “pay as you go”
the call by the equity or subordinat- a significant amount of synthetic (similar to those which apply to events and credit events are only
ed debt), the CDO issuer typically CDS assets, the need to finance a other third party transaction partici- due to the extent the CDO issuer
continues to invest in additional CDS reserve may result in significant pants such as interest rate and basis has available funds (with unpaid
assets on a fully-funded basis. economic inefficiencies. swap counterparties) regarding how amounts bearing interest at an
In the fully funded CDO, if syn- One solution to this inefficiency the CDO issuer will meet its obliga- agreed spread above LIBOR). The
thetic CDS represent an insignificant
component of the asset structure, the The rating agency collateralization/prefunding and replacement
liability structure remains unchanged
by the presence of synthetic CDS or triggers and constraints may increase the cost of the third party
similar unfunded derivative contracts.
For example, if a CDO issuer enters
liquidity structure and potentially limit the universe of potential
into a synthetic CDS with a notional
amount of one million dollars in
liquidity providers.
which the CDO issuer sells credit is to add a liquidity swap counter- tions under the synthetic CDS trans- CDO issuer makes payments to the
protection on an MBS reference obli- party or committed variable funding actions or other unfunded derivatives CDS counterparty at a level senior
gation, the CDO issuer generally note purchaser to the hybrid CDO contracts if the liquidity provider to the rated notes but the CDS
sets aside one million dollars in a structure. This party receives a com- fails to perform. To protect the CDO counterparty is, in effect, providing
reserve account or similar account. mitment or similar fee and in issuer against this risk, the rating liquidity to the CDO issuer (in
The CDO issuer invests amounts in return, is obligated to make pay- agencies commonly require a combi- addition to its explicit role as a
the reserve account in permitted ments under the related liquidity nation of collateralization/prefund- buyer of credit protection from the
investments. While the synthetic swap agreement or purchase agree- ing and or liquidity provider CDO issuer).
CDS is in effect, the CDO issuer ment. Payments are made to the replacement triggers.
receives a premium or fixed pay- CDO issuer to the extent the CDO The rating agency collateraliza- Richard M. Schetman, a partner in the
ments from the CDS counterparty issuer has insufficient principal col- tion/prefunding and replacement New York office of Cadwalader, Wickersham
(which, together with reinvestment lections or other available funds to triggers and constraints may & Taft LLP, concentrates in the areas of secu-
income on permitted investments in pay amounts due to the CDS coun- increase the cost of the third party ritization, derivative and credit products, and
the reserve account, would be treated terparty in respect of a “pay as you liquidity structure and potentially other types of capital markets financings.
as interest proceeds). To the extent go” event or a credit event. Any limit the universe of potential liq- Special Counsel Michael J. Southwick and
“pay as you go” events or credit amounts paid by the liquidity swap uidity providers. One structure that associate Maggie L. Wickes assisted with the
events occur under the synthetic provider to the CDO issuer or the has developed to address rating preparation of this article.
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