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Capital Markets

Structured finance: Thank you Isda

New templates have caused an explosion in synthetic CDOs

(This article appears courtesy of International Financial Law Review,  sign up for a free trial here)

Who says trade groups aren't worth the membership fees? The International Swaps and Derivatives Association (Isda), for one, has proved its value over the last 18 months. By creating model documentation for trading in credit default swaps (CDS) on asset-backed securities (ABS) it has sparked a gold rush in synthetic collateralized debt obligations (CDOs).

Rather than referencing a pool of physical assets such as loans and bonds, as with cash flow CDOs, synthetics pull together a pool of CDS to shift the credit risk of assets into the CDO without transferring the assets themselves. They offer greater flexibility than cash deals and have been popular in Europe for several years, accounting for roughly 90% of the CDO market.

US structured finance
Recommended firms
Tier 1
Cadwalader Wickersham & Taft
Mayer Brown Rowe & Maw
Orrick Herrington & Sutcliffe
Sidley Austin
Skadden Arps Slate Meagher & Flom
Tier 2
McKee Nelson
Thacher Proffitt & Wood
Tier 3
Cleary Gottlieb Steen & Hamilton
Dewey Ballantine
Simpson Thacher & Bartlett
Weil Gotshal & Manges

Synthetics have been slower to take off in the US, where they make up only 9% of new issuance. In June and December of last year, however, Isda published templates for documenting trades of CDS on ABS. One applies to CDS on ABS intended for cash or physical settlement; the other (which appears in two versions) is for use with CDS on ABS employing a pay-as-you-go (PAUG) settlement policy. In June of this year, Isda went on to release a similar template for CDS on CDOs.

The templates were based on a prototype developed by a group of dealers and have proved to be extremely successful in removing barriers to trading. Doing so has attached a rocket to the US synthetics sector, in part by promoting synthetic ABS on CDOs that use the PAUG template, and by enabling larger synthetic buckets in cash/synthetic hybrid CDOs.

According to Dealogic, while in 2003 there were just five synthetic deals, last year there were 57, worth $14 billion. So far this year there have been almost 100 deals, setting course to double last year's total. With the CDS market worth trillions of dollars, the scope for further growth in synthetic CDOs is vast.

The arcane world of credit default swaps and synthetic CDOs yields little information to the outside. Deals are private and difficult to categorize, making keeping track of the market difficult. It is therefore unclear how much work law firms are winning, and who is getting the most. Talking to lawyers reveals a long list of competitors that are active, including big-hitter securitization firms such as Sidley Austin, McKee Nelson and Cadwalader Wickersham & Taft as well as firms with strong corporate groups including Cleary Gottlieb Steen & Hamilton and Schulte Roth & Zabel. It also includes UK firms with New York offices, notably Freshfields, which has used CDO work to spearhead its US structured finance practice. What all firms need, however, is expertise on both derivatives and structured finance.

So far the boom in synthetic CDO work has had little impact in terms of staffing on the established US firms. Those looking to break into the market are taking on board new people, however. For example, Linklaters hired partner Adam Glass, who specializes in CDO work, from Sidley Austin in 2004 and took on board Stan Renas from Cadwalader earlier this year.

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