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Studies and Scientific Researches. Economics Edition, No 22, 2015 http://sceco.ub.ro
32
CASH vs. SYNTHETIC CDOs
Silviu Eduard Dinca
University of Craiova
silviu@dinca.biz
Abstract
During the past few years, in the recent post-crisis aftermath, global asset managers are
constantly searching new ways to optimize their investment portfolios while financial and
banking institutions around the world are exploring new alternatives to better secure their
financing and refinancing demands altogether with the enhancement of their risk management
capabilities. We will exhibit herewith a comparison between the true-sale and synthetic CDO
securitizations as financial markets-based funding, investment and risks mitigation techniques,
highlighting certain key structuring and implementation specifics on each of them.
Keywords
true-sale CDO securitization; synthetic CDO securitization; credit derivatives; cash asset-
backed CDO securities; synthetic asset-backed CDO securities
JEL Classification
E44; F30; G15
1. CDO Securitizations
Collateralized debt obligations (CDOs) are asset-backed securities whose underlying
collateral is formed of a diversified pool of cash-flow generating obligations. CDOs
are part of an ongoing structured finance’ evolutionary trend that is providing
advanced methods of converting financial risks into freely marketable and tradeable
commodities. This revolutionary process started with the short-term ABCP and
longer-term ABS securitizations and it found support and further catalysts with the
development of financial engineering and financial derivatives along with the
expansion of the overall global securitization markets.
A) CDOs Family Tree
There are multiple types of CDO classes and structures in the marketplace today,
which can be differentiated based on the various classification criterions one might
use to sort them out. The main forms of CDOs can be broken down by:
a) Aim of Transaction (Initiator’s Motivation)
Balance sheet management (balance-sheet CDOs): they are implemented to
optimize initiators’ balance sheet management. They are both true-sale (cash-flow)
based CDOs, credit-derivatives based (synthetic) CDOs and hybrid CDOs
(combination of cash and synthetic);
Arbitrage opportunities (arbitrage CDOs): they are employed to capture the various
arbitrage opportunities existing in the global financial markets. They are cash-flow
CDOs and market-value CDOs based on both true-sale and synthetic structures.
b) Securitization Technique
True-sale CDOs: the transaction follows the true-sale implementation principles.
They consist of both balance-sheet CDOs and arbitrage CDOs;
Synthetic CDOs: the transaction follows the credit derivatives implementation
principles. They contain balance-sheet CDOs as well as arbitrage CDOs.
CASH vs. SYNTHETIC CDOs
33
c) Source of Funds for Principal and Interest Payments
Cash-flow CDOs: the repayments are based on the ability of the cash-flows
generated by the underlying assets to fully service the principal and interest payments
of the newly issued CDOs. They comprise balance-sheet CDOs as well as arbitrage
CDOs on both true-sale and synthetic forms;
Market-value CDOs: the repayments are based on the ability of the marked-to-
market value of the underlying assets to fully service the principal and interest
payments of the newly issued CDOs. They include mostly arbitrage CDOs on both
true-sale and synthetic forms;
Hybrid CDOs: they are a combination of cash-flow and market-value CDO
structures. They cover balance-sheet CDOs and arbitrage CDOs on both true-sale and
synthetic forms.
d) Funding Technology (Liabilities Distribution)
Cash-based (true sale) CDOs: the transaction is based on the true-sale
securitization principles of risk transfers and funding. They contain both balance-
sheet CDOs and arbitrage CDOs;
Synthetic (credit derivatives based) CDOs: the transaction is based on the credit
derivatives (synthetic) securitization principles of risk transfers and funding and can
be further divided into fully-funded synthetic CDOs, partially-funded synthetic CDOs
and fully-unfunded synthetic CDOs. They contain balance-sheet CDOs as well as
arbitrage CDOs;
Hybrid CDOs: the transaction is a mixture of cash and synthetic securitization.
They cover balance-sheet CDOs and arbitrage CDOs.
e) Collaterals Management Style
Actively managed (dynamic) CDOs: they are actively traded by the collateral
managers. They include mostly arbitrage CDOs on both true-sale and synthetic forms;
Passively managed (static) CDOs: they are traded under very limited conditions by
the collateral managers. They include mostly balance-sheet CDOs on both true-sale
and synthetic forms.
f) Composition of the Underlying Assets (the Reference Portfolio)
They can differ widely, but the majority of CDOs consist of one or a combination of
the following: (a) loans (commercial, middle-market, corporate/SME,
secured/unsecured junior/senior, distressed and nonperforming, emerging markets,
leveraged and high-yield, leases, PIKs, trade receivables - factoring and forfeiting
based, revolving credit lines, mezzanine, municipals, project finance, syndicated,
bilateral); (b) bonds (corporate investment grade & high yield, sovereign investment
grade & high yield, convertible, emerging markets, distressed and nonperforming,
mezzanine, secured/unsecured junior/senior, municipals, project finance); (c)
collateralized debt obligations (loans & bonds); (d) mortgage-backed securities
(commercial & residential); (e) financial derivatives; (f) hedge funds, private equity,
REITs; (g) private placements, equity, trust preferred securities; (h) asset-backed
securities (various collaterals); (i) structured finance securities. They cover balance-
sheet CDOs and arbitrage CDOs on both true-sale and synthetic forms.
g) Product (Deal) Types
Depending on the combination of the underlying assets and collateral types, one can
find different types of CDO transaction structures, such as: collateralized debt
obligations (CDOs); collateralized loan obligations (CLOs); collateralized bond
obligations (CBOs); collateralized synthetic obligations (CSO), or synthetic CDOs;
collateralized fund obligations (CFOs); collateralized insurance obligations (CIOs);
commercial real estate CDOs (CRE CDOs); collateralized equity obligations (COEs);
structured finance CDOs (SFCDOs), which includes CDOs of ABSs, MBSs, REITs,
CDOs; etc. They include balance-sheet CDOs as well as arbitrage CDOs on both true-
sale and synthetic forms.
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B) CDOs Structuring Specifics
Any CDO securitization is carried out by means of a bankruptcy-remote special
purpose vehicle (SPV), called the CDO vehicle, which issues asset-backed securities
(the CDOs) to the institutional investors. The eligible collaterals mixture backs these
CDOs, which are issued in several classes, each class being formed of several
tranches, whereas each tranche is featuring different risk/reward profiles associated
with the underlying assets pool. Hence, the CDO vehicle is able to shape its liabilities
to comply with a broader range of risk/return investors’ profiles.
By implementing the tranching process a CDO securitization undertakes the
redistribution and reallocation of the underlying portfolio’s credit risks and returns to
the CDO investors. Thus, CDO vehicle’s liabilities are segregated and dispersed into
various tranches, each tranche having a different credit quality and a distinct return
level, realizing in this way a structural subordination within the CDO transaction.
Consequently, CDOs’ debt servicing relies not only on the underlying collaterals’
diversification and credit quality, but additionally and foremost it entrusts on the
transaction’s inbuilt seniority/subordination, overcollateralization and structural
protection mechanisms of credit enhancement and liquidity support (either cash-flow
or market-value protection and support schemes).
Following the source of funds for principal and interest repayments principles, one
can divide the credit and liquidity quality of CDOs based on either cash-flow structure
or market-value structure. Thus, in case of a market-value CDO structure, the
protection mechanisms’ quality derives from transaction’s ability to liquidate its
assets and repay fully and timely entire debt tranches; while in case of a cash-flow
CDO structure, the quality of protection mechanisms relies on the size of
subordination and the degree of overcollateralization, which must be larger enough so
that the after-default cash-flows of the underlying assets to fully cover all debt
tranches.
Therefore, the most important structural features of a CDO securitization could be
summarized as: (a) securitization technique (true-sale or synthetic); (b) source of
funds for principal and interest repayments (cash-flow or market-value); (c) funding
technology (cash based or credit derivatives based); (d) collaterals management style
(actively managed or passively managed); (e) transaction’s cash-flow and loss
allocation system (CDO securitization waterfall); (f) transaction’s credit and liquidity
enhancements; (g) transaction’s degree of seniority/subordination,
overcollateralization, reserve accounts, excess spreads; (h) transaction’s hedging
mechanisms (credit, currency, interest-rate hedging).
Figure 1 Simplified generic CDO Securitization transaction structure
Source: Author’s representation
CASH vs. SYNTHETIC CDOs
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The CDO structuring process generates a multiple set of asset-backed securities,
called tranches, each of them having different exposures to underlying assets’ risks,
different credit ratings, different payment seniorities and different rates of return.
Generally, a CDO structure comprises of (super) senior tranches, mezzanine tranches,
subordinated tranches and equity tranches. The waterfall structure rules that the equity
tranche (usually unrated) represents the first-loss position and it is the first to absorb
losses in the CDO structure. If losses exceed the value of the equity tranche, they are
absorbed by the subordinated (non-investment-grade credit rating) and mezzanine
tranches (investment-grade credit rating). Finally, the (super) senior tranches (highest
credit rating) are the last to be affected by any losses and only in the case that such
losses have not been absorbed entirely by the other lower-level tranches.
Nevertheless, the waterfall structure stipulates as well the rates of return for each of
these tranches, which is opposed to their credit standing: equity tranches carry the
highest returns, subordinated tranches and mezzanine tranches lower yields than
equity tranche and the (super) senior tranches are compensated with the lowest returns
in the CDO structure.
The cash-flows/losses allocation of a CDO securitization is based on a sequential
distribution scheme (the waterfall principle) depending on the seniority of tranches
within the capital structure of the CDO structure. The payments (both repayment of
the principal and payment of the interest) are prioritized firstly to the highest tranches
(highest credit rating and lowest returns), with the remaining to be paid out to
tranches located progressively lower in the CDO transaction hierarchy (lower credit
rating but higher returns). Hence, this subordination of the CDO structure allows, on
the one hand, the investors to select the level of exposure that fits better to their
risk/reward profiles/appetites and, on the other hand, the issuance of asset-backed
securities with different coupons reflecting the various levels of seniorities, risks and
returns according to the underlying assets (reference portfolio) structuring particulars.
C) Motivations of CDO Securitization Transactions
Originators and sponsors involved in the broader CDO securitization transactions
benefit of multiple key motivations, including: (a) to secure alternative cheaper
sources of funding, risks transfer and refinancing; (b) to improve the overall balance
sheet management; (c) to employ an effective tool for regulatory and economic
capital management; (d) to enhance further the regulatory capital relief; (e) to
generate additional fee income; (f) to improve the risk management by reducing the
overall credit exposures or adjusting certain risk stratification particulars; (g) to free
up lending capacity with respect to certain categories of borrowers or economic
sectors and industries; (h) to benefit from additional capital arbitrage returns; (i) to
enhance the liquidity management; (j) to access additional means to enhance the
overall capital structure arbitrage; (k) to enhance the minimum regulatory capital
arbitrage; (l) to make use of an efficient tool for capital ratio management; (m) to
improve return on equity and return on assets ratios; (n) to attain portfolios’ risk
adjusted performance; (o) to augment credit limit management; (p) to monetize
illiquid on-balance sheet assets and to improve their market value; (q) to expand the
volume of assets under management; (r) to raise the total valuation of a CDO issuer;
(s) to increase the equity capital by means of issuing trust preferred securities; etc.
Broader CDO securitization is providing institutional investors with abundant
motivations, including: (a) it provides portfolio diversification by means of multiple
industries, sectors and borrowers of interest; (b) it facilitates access to different and
better-quality risks adjusted returns profiles; (c) it allows the ability to tailor
risk/return profiles by providing better risk/reward performances; (d) it diversifies the
overall portfolio risk exposures; (e) it provides a highly versatile and comprehensive
tool for portfolio investment management; (f) it upgrades the portfolio risk
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management; (g) it supplies investment portfolio diversification into new asset
classes; (h) it delivers portfolio diversification by investing along a wider credit
spectrum; (i) it supplies considerable volume and liquidity of highly rated securities
that may not be available in the markets otherwise; (j) it supplies higher yields and
risk-adjusted returns relative to other instruments of comparable credit quality; (k) it
is offering better perspectives to achieve portfolios’ alpha returns; (l) it facilitates
portfolio’s arbitrage opportunities among various asset classes; (m) it provides
enhanced portfolio’s leverage; etc.
We will emphasize hereafter some CDO essentials from the securitization technique
perspective providing a brief comparative analysis between true-sale and synthetic
CDOs.
2. True-Sale CDO Securitizations
In a true-sale (or cash-funded, or traditional, or conventional) CDO securitization the
ownership of the underlying assets being securitized, along with their related financial
risks, is legally transferred, by means of a true-sale operation, from the transaction
sponsor to the bankruptcy-remote SPV, whereas the SPV issues CDO securities
backed by these (transferred) assets which are distributed to institutional investors.
Hence, the acquisition of the underlying assets involved in a true-sale CDO
securitization is fully cash-funded by the proceeds generated by the issuance of CDO
vehicle’s asset-backed securities and, conversely, the repayment of CDO securities is
straightly linked to the cash-flows generated by the underlying assets.
Since the underlying assets are sold, in exchange for cash, to the CDO vehicle, they
are actually completely removed from the sponsor’s balance sheet, altogether with
their associated financial risks, hence cash-based CDO securitizations represent both a
funding tool as well as an on-balance sheet’ risks transfer operation.
Figure 2 Simplified generic True-Sale CDO Securitization transaction structure
Source: Author’s representation
From sponsors’ motivation perspective, cash CDO securitizations are implemented
both as balance-sheet management transactions (cash-flow balance-sheet CDOs) and
as arbitrage opportunities transactions (cash-flow arbitrage CDOs). From repayments’
source of funds standpoint, cash CDO securitizations are mostly cash-flow
transactions whereas the assets are not usually marked-to-market, however market-
CASH vs. SYNTHETIC CDOs
37
value cash CDOs are quite common transactions especially in the case of true-sale
arbitrage CDOs. While the funding technology is exclusively cash-based (true-sale),
the cash CDOs are featuring mostly a passively managed (static or limited-trading)
collaterals management style, whereas the composition of the underlying assets
consist of any assets types common in CDO transactions combined in a large variety
of CDO transaction structures.
Originators and sponsors involved in true-sale CDO securitizations benefit of multiple
key motivations additional to those specific to generic CDOs, including: (a) to
achieve off-balance sheet treatment; (b) to enhance the liquidity management and
assets valuation; (c) to improve return on equity, return on assets, return on
economic/regulatory capital, risk-adjusted return on capital ratios; (d) to augment
credit limit management, capital capacity and financial flexibility; (e) to allow access
to new investors base; (f) to improve asset-liability management by means of a new
alternative for asset/liability divestitures; (g) to improve the balance-sheet
management in terms of exposures, concentration, diversification, credit spread,
capital cost, balance-sheet reduction; (h) to provide access to trade the arbitrage
spread opportunities; (i) to earn the spread between return on the invested assets and
the costs of the CDO transaction; (j) to exploit yield mismatches and differences in
funding costs between assets and liabilities; (k) to achieve funding through the
issuance of debt securities and equity; (l) to capitalize on perceived discrepancies
between the market-value and the theoretical-value of the risky assets; (m) to improve
return on assets ratio; etc.
True-sale CDO securitizations are providing institutional investors with plentiful
motivations additional to those specific to generic CDOs, including: (a) it delivers
portfolio diversification through investments on a broader credit spectrum and long
terms to maturity; (b) it provides exposures to the high-yield market via credit rated
instruments; (c) it achieves a leveraged return between yield on assets and the
financing cost of transaction; (d) it provides investment strategies in opportunistic
arbitrage-based products; (e) it monetizes the diversification benefits of uncorrelated
assets classes; (f) it monetizes the relative value opportunities for less liquid assets;
(g) it achieves higher returns for investments in the same level of credit rated
securities; etc.
3. Synthetic CDO Securitizations
A synthetic (or credit derivatives based) CDO securitization represents a financial
engineered structure where the credit risks associated with an on-balance sheet assets
pool (reference portfolio) are transferred by transaction’s sponsor from itself, either
directly or via an SPV, to the institutional investors by means of the credit derivative
instruments. Consequently, the originator is considered as credit protection buyer
while the investors are deemed as credit protection sellers.
Given that a synthetic CDO securitization facilitates originators to separate credit
risks trading from balance sheet funding, the transfer of credit risks is achieved
synthetically, by means of credit derivatives, rather than by a true-sale operation as in
the case of cash CDOs. Since the synthetic CDO securitizations enable the removal of
associated credit risks without any assets transfer, the underlying assets (reference
assets) are not actually removed off the sponsor’s balance sheet and thus synthetic
CDOs are mainly employed as financial risks transferring tools rather than balance-
sheet funding operations.
Hence, by means of financial derivatives replication, a synthetic CDO carries
collateral’s risks/returns characteristics (transferring the credit risks of a pool of
reference assets, or transferring the total return profile of the reference assets) to the
CDO vehicle without conveying also the actual assets to the SPV as well, the
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originator remaining thus their legal and beneficial owner. Nevertheless, in a synthetic
CDO the cash-flows on the reference assets are transferred to the CDO vehicle by
means of credit derivatives as an alternative way of on-balance sheet asset divestiture.
In turn, the SPV issues the asset-backed securities that are placed with the CDO
investors. According to the funding scenario selected by the originator and to the deal
structuring particulars, synthetic CDOs can be issued by means of a fully-funded,
partially-funded or fully-unfunded securitization structure, whereas different types of
credit derivatives (funded CLNs, unfunded CDSs/TRSs) are used to implement each
type of synthetic CDOs transaction.
Figure 3 Simplified generic Fully-Funded CDO Synthetic Securitization
transaction structure
Source: Author’s representation
Figure 4 Simplified generic Partially-Funded CDO Synthetic Securitization
transaction structure
Source: Author’s representation
CASH vs. SYNTHETIC CDOs
39
Figure 5 Simplified generic Fully-Unfunded CDO Synthetic Securitization
transaction structure
Source: Author’s representation
From sponsors’ motivation perspective, synthetic CDO securitizations are
implemented both as balance-sheet management transactions (synthetic balance-sheet
CDOs) and as arbitrage opportunities transactions (synthetic arbitrage CDOs). From
repayments’ source of funds standpoint, synthetic CDO securitizations are both cash-
flow transactions as well as market-value CDOs. While the funding technology is
exclusively synthetic (credit derivatives based), from collaterals management style
approach, synthetic CDOs are both actively managed (dynamic) and passively
managed (static) CDOs, whereas the composition of the underlying assets consist of
any assets types common in CDO transactions combined in a large variety of CDO
transaction structures.
Originators and sponsors involved in synthetic CDO securitizations benefit of
multiple key motivations additional to those specific to generic CDOs, including: (a)
to allow the securitization of credit products (unfunded assets, guarantees, undrawn
exposures, credit lines, derivative positions, loans with restrictions on assignment and
transferability) that may otherwise be unsuitable for true-sale securitization or for off-
balance sheet funding; (b) to allow asset managers to take both long and short views
on asset classes, economic sectors/industries without removing the respective assets
from the balance sheet; (c) to allow the trading of pure credit-driven views; (d) to
allow the transfer of credit risks related to partial claims on a specific reference asset;
(e) to exploit arbitrage opportunities between cash and synthetic products; (f) to
accomplish a greater flexibility to accommodate tailor-made solutions for credit risk
requirements through the use of credit derivatives; (g) to achieve lower closing costs
than cash CDO securitizations; (h) to facilitate the avoidance of true sale treatments;
etc.
Synthetic CDO securitizations are providing institutional investors with further
motivations in addition to those specific to generic CDOs, including: (a) it allows
investors to take synthetically long and short positions over the market; (b) it allows
investors to gain exposure to otherwise inaccessible assets classes; etc.
4. True-Sale vs. Synthetic CDO Securitizations
The interplay between True-Sale and Synthetic CDO Securitizations is inspiring for
the particular opportunities that each type of transactions provides to both sponsors
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and investors alike. As per above details, one can note that equally cash and synthetic
CDOs are featuring meaningful funding, refinancing, investing and risks management
advantages to all transactions’ participants, however each category of CDOs is
providing some particularities which can be optimally engaged following specific
originators’ motivations and objectives.
We will sketch herewith further distinctive features of cash vs. synthetic CDOs from
the practical transaction’s perspective:
Table 1 Comparison synopsis between True-Sale and Synthetic CDO
Securitizations outlining the main attributes of Cash vs. Synthetic CDOs
FEATURES
TRUE-SALE CDO
SECURITIZATION
SYNTHETIC CDO
SECURITIZATION
Transaction objectives
Funding and transfer of the
financial risks (in all cases).
Both true-sale and synthetic
securitizations enable the
same volume of credit risks
to be transferred to the
CDO investors
Transfer of the financial
risks (in all cases) and
funding (just in case of
funded and partially funded
transactions). Both true-sale
and synthetic securitizations
enable the same volume of
credit risks to be transferred
to the CDO investors
Underlying assets and
related risks treatment
Assets are sold to the SPV
and all related risks are
hence transferred to the
SPV. The SPV becomes
assets’ owner
Only financial risks are
transferred via credit
derivatives to the SPV, or
directly to the investors (in
case of non-SPV
transactions). Originator
remains assets’ owner
Underlying assets regime
Become off-balance sheet
assets related to the
originator. Transaction
reduces the originator’s
balance-sheet size (i.e. the
volume of total on-balance
sheet assets)
Remain on-balance sheet
assets related to the
originator. Transaction does
not reduce the originator’s
balance-sheet size (i.e. the
volume of total on-balance
sheet assets)
Carrying out transaction
objectives
Originator acts as seller of
the on-balance sheet assets
Originator acts as protection
buyer for the on-balance
sheet assets
Ramp-up period
1-6 months
1-2 months
Aim of transaction
Balance sheet management;
arbitrage opportunities
Balance sheet management;
arbitrage opportunities
Securitization technique
True-sale
Synthetic
Source of funds for
principal and interest
payments
Cash-flow structures;
market-value structures
Cash-flow structures;
market-value structures
Funding technology
(liabilities distribution)
Cash-based (true sale)
Synthetic (credit derivatives
based): fully-funded,
partially-funded, fully-
unfunded
Collaterals management
style
Actively managed
(dynamic); passively
managed (static)
Actively managed
(dynamic); passively
managed (static)
Source: Author’s representation
CASH vs. SYNTHETIC CDOs
41
5. Conclusions
Both true-sale and synthetic CDO securitizations constitute the most efficient secured
funding and investment alternatives available to asset managers, banking and
financial institutions in the global capital markets. The ability to raise more stable
medium and long-term funding at very competitive terms, to access a broader pool of
global investors, to increase the supply of liquidity to financial institutions, to
diversify anyone investment portfolios and to enhance the risk-adjusted returns of
assets portfolios are the main advantages to sponsors, originators and investors
involved in asset-backed securities programs.
In order to capture all the benefits emerging from true-sale and synthetic CDO
securitizations, financial institutions should run in parallel, simultaneously both true-
sale and synthetic securitization programs since they are complementing all together,
allowing originators and investors to effectively manage the investments, fundraising
and risks management aspects by optimally interconnecting local asset markets with
global financial and capital markets.
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