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Wednesday, December 19, 2007

Synthetic CLO seen as new growth product in Europe - Reuters

some people just don't learn....

Synthetic CLO seen as new growth product in Europe

Wed Dec 19, 2007 5:37am EST

By Jane Baird

LONDON, Dec 19 (Reuters) - Bankers foresee the rise next year of a new instrument in Europe -- synthetic collateralised loan obligations (CLOs) -- even as investors in the thick of the credit crisis are wary of complex, structured products.

Banking sources say the Carlyle Group [CYL.UL] is marketing the first managed synthetic CLO in Europe via Goldman Sachs (GS.N: Quote, Profile, Research). Both institutions declined to comment.

Synthetic CLOs are portfolios of loan credit default swaps (LCDS), which are bets on whether companies will default on bank loans that financed mostly leveraged buyouts.

These portfolios are divided into slices by degree of risk. The riskiest tranche is exposed to the first few percent of losses from any LCDS in the pool, and the safest tranche at the top loses only after the lower tranches go under.

"That's the new product growth area in '08," said Steve Lobb, ABN AMRO's global head of credit and alternative derivative marketing.

"You can create custom deals, and you don't have to go through all the headaches of a normal managed full-capital structured deal," he added, referring to traditional CLOs based on portfolios of cash leveraged loans.

Still, innovation in any structured product is surprising at a time that many investors are steering clear of collateralised debt obligations (CDOs) and the like.

"The near-term growth in the corporate CDO market is going to be synthetic CLOs," said a leading LCDS dealer in Europe, adding that putting together a cash CLO now is not easy.

WHY SYNTHETIC WORKS

In today's market, the bank or investor that wants to structure a cash CLO has to contend with the fact that spreads have jumped and prices of existing loans have fallen below par.

Meanwhile, banks are not yet making new loans at the higher spreads as they struggle to sell on about $350 billion worth of pre-crisis loans.

For a cash CLO to work, the structurer needs the loans' coupon payments to cover the cost of his capital, but the benefit of a discount comes down the road when the loan gets repaid.

"If you buy a loan at 94 (cents on the dollar) that pays Libor plus 200 (basis points), you don't get the benefit of that 6 point discount. You would rather buy an asset at par that pays Libor plus 300," the dealer said.

"However, you can make it work in LCDS," he said, because the bank can write new LCDS contracts at current market spreads.

One drawback for investors in a synthetic CLO, on the other hand, is that they cannot get access to key information about underlying borrowers, many of which are private companies.

They must have confidence in a manager such as Carlyle based on its track record and holdings of cash loans, which give it access to the necessary information, bankers say.

The LCDS market also lacks another development in Europe -- the introduction of trading in tranches on LCDS indexes, which would provide support for synthetic CLOs by giving investors a way to hedge tranche risk.

Trading in tranches of the U.S. indexes began in October, and a trader said they have been surprisingly successful. The first synthetic CLOs in the United States got underway in 2006.

Barclays Capital strategists, in a recent report, saw potential also for bespoke synthetic CLOs. In these made-to-order products, the investor can choose the underlying loans and the tranche he wants.

"Synthetic CLOs allow investors to take exposure to leveraged loans in a clean, efficient and highly customisable fashion," they wrote, adding that potential takers could be hedge funds or investors who already own leveraged loans or cash flow CLOs.

Bankers said a few such bespoke deals have already been completed in Europe.

"Synthetic CLOs might be an interesting market relative to the more traditional CLOs," said Anthony Robertson, a senior portfolio manager at Britain's BlueBay Asset Management (BBAY.L: Quote, Profile, Research) who has so far avoided structured products.

"But it's still too early, and the (underlying LCDS) market is not sufficiently developed or liquid enough for us to justify pursuing opportunities," he added. (Reporting by Tessa Walsh; Editing by David Cowell)

© Reuters 2007. All rights reserved. Republication or redistribution of Reuters content, including by caching, framing or similar means, is expressly prohibited without the prior written consent of Reuters. Reuters and the Reuters sphere logo are registered trademarks and trademarks of the Reuters group of companies around the world.

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