Synthetic balance sheet CDOs differ from the cash funded variety in several important ways. First, cash funded CDOs are constructed with an actual sale and transfer of the loans or assets to the CDO trust. Ownership of the assets is transferred from the bank's balance sheet to that of the CDO trust. In a synthetic CDO, however, the sponsoring bank or other institution transfers the total return profile of a designated basket of loans or other assets via a credit derivative transaction, usually a credit default swap or a credit return swap. Therefore, the bank transfers its risk profile associated with its assets, but not the legal ownership of assets.
Second, in a cash flow CDO, the proceeds received from the sale of the CDO securities are used to purchase the collateral for the CDO trust. The cash flows from the collateral held by the CDO trust are then used to pay the returns on the CDO securities. Conversely, the cash proceeds from a synthetic balance sheet CDO are usually invested in U.S. Treasury securities. The interest received from these securities is used to fund the swap payments to the bank.
Third, a synthetic balance sheet CDO can use leverage. The use of leverage can boost the returns received by the CDO investors, thereby increasing the attractiveness of the CDO securities.
Last, a synthetic balance sheet CDO is less burdensome in transferring assets. Certain commercial loans may require borrower notification and consent before being transferred to the CDO trust. This can take time and increases the administration costs.
Exhibit 7 demonstrates a synthetic balance sheet CDO. Assume that a bank establishes a SPV in the form of a trust for a balance sheet CLO. The bank wishes to reduce its exposure to a basket of loans on its balance sheet.3
3 We omitted the asset manager and trustee from this exhibit to make the diagram less cluttered. These two entities are still used, but are not crucial to our example.
Exhibit 7: Synthetic Balance Sheet CLO
The CLO trust issues medium term notes to investors that the trust records on its balance sheet as a liability and the investors record on their balance sheets as a privately issued 144A security.4 The proceeds from the sale of the CLO securities are used to purchase U.S. Treasury securities with the same maturity as the CLO securities. The CLO securities receive an investment-grade credit rating because they are backed by default-free U.S. Treasury securities.
Next the SPV enters into a total return swap with the bank where the SPV will pay to the bank LIBOR + 100 basis points in return for receiving the total return on the referenced basket of bank loans. The total return from the bank loans includes both interest payments plus any appreciation or depreciation of the loan value. The SPV in turn passes through to the CLO security holders the total return from the loan portfolio.
Notice that the CLO security holders are insulated from the derivative transaction with the bank. The CLO trust acts as a middleman or buffer between the CLO security holders and the bank so that the CLO investors do not have to enter a swap directly with the bank. This could be problematic for certain pension funds or endowment funds that do not have the authority to negotiate swap agreements.
Assume that the CLO trust sells $100 million of securities to institutional and high net worth investors and that the trust securities mature in four years. The CLO trust uses the $100 million to purchase U.S. Treasury notes that mature in four years and accrue interest at 6% annually. In addition, the CLO trust enters into a 4-year total return swap with the bank where the CLO trust will pay to the bank LIBOR + 100 basis points annually, and the bank will pay the CLO trust the total return on its loan portfolio. The notional value of the swap transaction is $400 million. The average annual interest rate earned on the bank loans is LIBOR + 250 basis points.
In Exhibit 7, the notional value of the total return swap does not equal the face value of CLO trust securities sold. This is a demonstration of the leverage that can be applied in a synthetic balance sheet CLO compared to the cash funded CLO discussed earlier. Under the swap agreement, the CLO trust agrees to pay the bank LIBOR + 100 on a notional value of $400 million, while receiving from the bank the total return on a $400 million basket of loans. The total return on the loan basket equals the average interest payment of LIBOR + 250, plus any price appreciation or depreciation associated with the bank loans.
Take a moment to review all of the cash flows for the bank displayed in Exhibit 7. All of the cash flows net out to a single fee of 100 basis points for the bank. The bank receives $400 million from the capital markets and uses this cash to build a commercial loan portfolio. The bank pays for its funding at straight LIBOR. From the commercial loans, the bank receives LIBOR + 250 in interest payments plus any appreciation or depreciation in the value of the loans (together the interest payments plus any change in loan value equals the Total Loan Return).
4 These private securities are typically offered in the form of SEC Rule 144A. Under this rule, the securities do not need to be registered with the SEC via a registration statement, but may be sold only to Qualified Institutional Buyers.
The bank passes on the interest payments and any appreciation or depreciation to the CLO trust under the terms of the total return swap agreement. The CLO trust agrees to pay the bank LIBOR + 100 which covers the banks funding costs at LIBOR plus adds 100 basis points.
Exhibit 8 demonstrates that all of these inflows and outflows cancel out leaving the bank with 100 basis points times the notional value of the swap, or an annual cash flow of $4 million.
The CLO investors receive the return on all of the CLO trust's assets and contractual agreements. This includes the net income on the swap agreement of 150 basis points plus any increase or decrease in the value of the basket of bank loans plus the interest earned on the U.S. Treasury securities. If there is no change in the value of the loans, then at maturity of the CLO securities, investors will receive the 4-year Treasury rate plus 150 basis points on a notional value of $400 million.
This highlights the use of leverage in the synthetic balance sheet CLO. Investors in the CLO trust committed only $100 million of capital but received 150 basis points of income on $400 million of bank loan exposure. This is equivalent to earning 600 basis points on $100 million. Plus the investors in the CLO trust receive the return earned on the 4-year U.S. Treasury notes. Therefore, investors in the CLO trust receive a rate of return that is 600 basis points greater than a comparable Treasury note. The ability to add 600 basis points of credit spread return on an investment grade security far exceeds the return that an investor could earn if it purchased the loans outright from the bank.
If this sounds like a great deal for the investors, it is even a better deal for the bank. Not only does the bank reduce its risk exposure to a basket of bank loans, it also frees up regulatory capital associated with these risky assets because it has transferred the risk (but not the assets) to the CLO trust. On top of this risk reduction, the bank receives a swap fee of $4 million per year. In other words, through a synthetic balance sheet CLO, the bank is paid to reduce its risks. The bank gets its cake and eats it too.
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