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February 2002

Bankers fight for CDO supremacy


The fastest-growing part of the credit markets is not bonds, loans or commercial paper. It is a curious hybrid of credit derivatives and securitization. The market in synthetic CDOs is growing at an explosive rate and making investment banks plenty of money in the process. But just as the fight for leadership is getting most intense, the most lucrative days of this market may be behind it.




       
David Peacock
The market for synthetic collateralized debt obligations (CDOs), which did not exist five years ago, is now fast growing and lucrative. It is also, however, one of the most opaque and unquantified areas of the financial markets. Even two years ago, no more than a handful of banks could truly claim to understand the basic structure of the synthetic CDO.
Now that secret recipe has become public knowledge, with a large array of institutions doing synthetic CDOs of one kind or another. And growing numbers of these deals are being done publicly, or at least semi-publicly. That has allowed researchers to put better numbers on the market and start to get a sense of which banks have the largest market share.
The tables shown here, compiled by research firm Creditflux, are the first full-year league tables for the synthetic CDO market. They give a breakdown for a market that has grown by more than 50% in 2001 to reach $130 billion of issuance in terms of notional exposure. But the full size of this market remains far from clear, since some banks are unwilling to disclose their deals.
In simple terms, a synthetic CDO is a form of securitization. But it is one that uses credit derivatives, rather than the actual sale of assets, to transfer credit risk from an originator to end investors such as bondholders. Put another way, it is a credit derivative that has as its reference not one credit but a large basket of different names.
Leading arrangers: all synthetic CDOs
  $mn % No. deals
1 Morgan Stanley 22,963 17.6 14
2 Deutsche Bank 18,826 14.5 11
3 Goldman Sachs 12,377 9.5 8
4 ABN Amro 11,160 8.6 1
5 Abbey National 10,000 7.7 1
6 Bank of America 9,458 7.3 15
7 BNP Paribas 9,355 7.2 5
8 Bear Stearns 4,358 3.3 4
9 HypoVereinsbank 3,856 3 4
10 Lehman Brothers 3,076 2.4 2
Others 24,762 19  
Total 130,192 100  
 
Balance sheet, excluding self-led
1 Deutsche Bank 7,281 36.8 6
2 Goldman Sachs 4,930 24.9 1
3 Bear Stearns 2,500 12.6 2
4 Credit Suisse First Boston 1,608 8.1 2
5 Commerzbank 1,377 7 1
6 JP Morgan 761 3.8 1
7 Merrill Lynch 500 2.5 1
8 Citigroup 427 2.2 1
9 HypoVereinsbank 408 2.1 1
Total 19,792 100 16
 
Portfolio trades
1 Morgan Stanley 12,609 12 27.3
2 Deutsche Bank 7,836 4 17
3 Goldman Sachs 7,447 7 16.1
4 Bank of America 7,208 9 15.6
5 BNP Paribas 6,454 4 14
6 Lehman Brothers 3,076 2 6.7
7 Bear Stearns 858 1 1.9
8 IntesaBCI 690 1 1.5
9 JP Morgan 45 1 0.1
Total 46,222 41 100
 
Leading arrangers: managed synthetics
1 Bank of America 2,250 30.2 6
2 Citibank 1,006 13.5 1
3 Bear Stearns 1,000 13.4 1
4 Credit Suisse First Boston 1,000 13.4 1
5 Dolmen Securities 901 12.1 1
6 JP Morgan 446 6 1
7 Robeco 446 6 1
8 Morgan Stanley 400 5.4 1
Totals 7,449 100 13
 
Source: www.creditflux.com

The market divides into three distinct parts. The oldest type of synthetic CDO is the balance-sheet or regulatory capital deal. Banks started to issue these in 1997, realizing that they could reduce their regulatory capital charge by hedging the high-grade loans sitting on their balance sheets.
Most large banks, especially those in the US, have now done CDOs on the bulk of the suitable assets on their books. As a result, the number of regulatory capital CDOs has flattened off. In 2001, banks issued some $77 billion-worth of synthetic CDOs that fall under the broad category of balance-sheet management deals. This is a slight decrease on the total for 2000.
The balance-sheet deals being done now tend to involve smaller banks and more obscure assets. "European banks have taken up some of the slack left by US banks who have virtually exited the regulatory-capital-driven part of the market," says Lang Gibson, head of structured credit products research at Bank of America in New York. "And banks in Europe are applying the synthetic CDO techniques to a growing range of different assets such as mortgages and lower-rated loans."
This business has also become less attractive to the investment banks that previously arranged such deals on behalf of commercial banks. "More and more banks feel that they have the expertise to arrange their own synthetic balance-sheet trades," says one arranger. As a result, fees are not as juicy as they once were. "The balance-sheet deal is turning into a hard sell," admits another CDO banker.
The explosive growth in the CDO market in 2001 has not come from deals associated with bank capital but from a different sort of arbitrage. Credit derivative bankers have discovered that they do not need a book of commercial loans in order to put together a synthetic CDO. They can simply source the assets in the single-name credit default swap market.
In what is often called a portfolio credit default swap or simply a portfolio trade, the credit derivative desk of a bank might enter into 100 $10 million standard five-year credit default swaps. Each contract would have an individual investment-grade corporate as the reference entity. The dealer acts as a seller of protection on these names: in other words, it buys the credit risk. The bank then sells that $1 billion-worth of credit risk in four or five tranches of increasing seniority. The tranches might be public bond issues, credit default swaps or a combination of both.
Because it is cheaper to hedge the credit risk in portfolio form than it is to buy it individually, there is money to be made. The dealer takes a fee, and any upside goes to the investor who buys the riskiest tranche of the structure - often the dealer itself.
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