Cash, Synthetic or Hybrid CDOs 

Cash CDOs involve assets that are typically securities, such as bonds, but can also include bi-lateral or multi-lateral debt contracts, such as loans.  The assets are transferred to a bankruptcy remote special purpose entity (“SPE”) as the registered owner and are paid for by the selling of liabilities (or notes).  The assets often do not have the same terms with regard to payment dates, redemption schedules or maturity dates. Hence much of the structuring of the CDO involves matching certain characteristics of the liabilities with certain characteristics of the assets.

 

By contrast, synthetic CDOs are based on the transfer of risk, typically by the use of credit derivative contracts (usually using standardised terms from the International Swap Dealers Association (“ISDA”)). The underlying assets/contracts that they refer to may be held by a sponsor bank or other financial institution but, increasingly, are sourced from the credit derivatives market.  The underlying contracts usually have the same terms with regard to payment dates, and maturity dates, so there is little or no mismatch between the risk and the protection.A cash transaction has a more complex “Priority of Payments” (colloquially called a “waterfall”), than a synthetic transaction. Synthetic CDOs or CSOs normally rely solely upon subordination to support the credit ratings of the notes; hence why they are sometimes referred to as “write down” structures.


Cash-flow transactions typically have covenants regarding interest coverage (i.e., interest income versus interest liability servicing) and over-collateralisation coverage (i.e., assets to liabilities ratio).  Failure of these covenants diverts income from the assets due to the junior notes to accelerate the senior notes.  These covenant tests effectively provide contingent additional subordination so that the initial subordination in a cash-flow transaction is usually less than the subordination on a synthetic transaction on an equivalent portfolio. In addition, cash flow CDOs often require additional structuring to address risks that are not present in synthetic CDOs, such as interest timing mismatches, currency risks, prepayment risks and reinvestment risks.


In a synthetic (or “write-down”) structure, the notes are used to support the credit protection sold. Once a claim on that credit protection is made, the notional of the note is reduced by the default amount and is written-down immediately.  Recoveries (if any), when they are realised, are used to pay down the super senior swap.  This payment effectively increases the detachment point of the most junior swap by the recovery amount.  In contrast to a cash flow transaction, the notes are not written down until the maturity of the transaction because losses can be redeemed from excess interest proceeds.Hybrid transactions incorporate both synthetic and cash CDO features and allow for both cash assets and synthetic securities, and cash and synthetic liabilities.  Additionally, hybrid transactions allow for the ratio of cash and synthetic assets and liabilities to change.  Because many cash flow transactions allow for a bucket of 10 to 20 per cent synthetic securities, in order to be considered truly hybrid a transaction typically has more than 20 per cent synthetics.  Additionally, many hybrid transactions allow for “short” buckets as well, which means that the SPE can effectively hedge risk positions by buying protection on obligors. This also allows for “basis trades”.

 

Basis trades are long-short positions on the same obligor risk where the “long” default risk is completely offset by a short “protection” position, ideally at a lower spread. This allows for an earned income that is independent of the underlying credit risk, although there is still, typically much lower, risk from counterparty credit.