Led by JPMorgan and DBS, pre-marketing of a $224 million ($121 million) synthetic CLO will begin on Monday for pricing about a week-and-a-half later. The multi-tranche issue is being largely targeted at a domestic audience and as the first of its kind in non-Japan Asia, incorporates a number of investor-friendly features that are not typically seen in Europe and the US where there has been billions of dollars of issuance since JPMorgan first introduced the structure in December 1997.
In essence, the deal will enable DBS Bank to manage its capital adequacy ratios more efficiently as the 100% risk weighting of a portion of its corporate loan portfolio will be reduced by moving credit risk off-balance sheet and into an SPV, which then sells a credit-linked note to investors. As a result, the bank will have to commit less capital to cover default risk on the loans and in the process can improve its capital ratios through enhanced capital treatment.
The assets themselves, however, remain on DBS's balance sheet and the bank itself raises no new funds, as proceeds from the notes are used to purchase collateral underlying the SPV. As a capital management tool rather than a funding tool, the structure differs from a normal cash securitization, whereby whole asset classes are moved off-balance sheet and used as the collateral to raise new funds.
Because of the small size of the transaction, the amount of capital released will be relatively small. Observers say that DBS, therefore, views the issue as a fine-tuning exercise that will also help it prepare for Basel 2, set to be enforced in 2005. Currently, all bank loans have to be given a 100% risk weighting, which means that a bank must set aside $1 of capital for every $1 of a loan. Under Basel 2, risk weighting will vary subject to the individual ratings of each loan. This means that a triple-A rated loan might, for example, only require a 20% risk weighting, while a double-B rated loan might require a 200% risk weighting.
"This CLO has been examined by three rating agencies which have come into DBS, looked at the bank's internal credit controls and done a mapping analysis of the strengths and weaknesses of its loan portfolio," one observer explains. "This is hugely valuable for DBS in the run up to Basel 2 as it allows the bank to refine and re-evaluate its credit models."
The CLO has three main features - a first loss tranche, which is retained by DBS itself, a mezzanine tranche, which is sub-divided into four separate tranches and a super senior tranche. The nominal amount of the loan portfolio is S$2.8 billion ($1.52 billion) and DBS will enter into a credit default swap with the SPV (Alco 1 Ltd) to effect the transfer of credit risk. Much like an insurance policy, DBS will pay Alco a premium for taking on the credit risk of the portfolio.
The key consideration for investors is how much they are willing to pay for the likelihood of default. The first loss tranche, amounting to S$126 million represents 4.5% of the total portfolio. To protect investors, any loan losses up to this amount will be borne by DBS itself, since it retains the first loss tranche.
Should the portfolio suffer losses in excess of this amount, the next tranche to be hit will be the lowest rung of the Mezzanine tranche, which is being sold into the capital markets. This comprises S$42 million of Class D notes, which represent 1.5% of the portfolio and were assigned a BBB rating by Standard & Poor's yesterday (Thursday).
The next rung is S$56 million of Class C notes, which represent 2% of the portfolio and carry a single-A rating. There is also S$42 million of Class B notes, which represent 1.5% of the portfolio and carry a double-A rating and S$84 million of Class A notes, which represent 3% of the portfolio and carry a triple-A rating. In total, the Mezzanine tranche represents 8%.
Over an above this is one super senior tranche, which is essentially risk free. As one observer explains, "This essentially gets sold to one single investor such as a re-insurer or monoline agency. Because the risk is so small, the return is likewise and the amount has to be fairly large to enable the investor to generate any kind of return."
Proceeds from the transaction will be used to invest in collateral (Treasury bills or Singapore Government Securities). The collateral is included as additional protection and should loan losses start to eat into the BBB tranche, collateral will be re-paid to service the losses. Interest payments on the notes will also be funded by a combination of interest received on the collateral and the premium paid by DBS to Alco.
Should DBS fail to make any of its quarterly premium payments to the SPV, the collateral will be sold to a put option provider (JPMorgan) at a price of par plus accrued interest and proceeds will be used for the full redemption of the transaction. Interest rate and foreign currency risk has also been removed through two swap agreements between DBS and the SPV.
The issue has been structured with a final maturity of eight years to maximize capital release for regulatory purposes, but has an effective life of four years because of a put option in 2005 when Basel 2 kicks into effect. The underlying portfolio contains loans with a maximum maturity of 15 years, of which 80% of expose is to Singaporean credits and 20% to credits in Hong Kong, Malaysia, Japan, Taiwan, Korea and Australia. Over 80% of the portfolio also originates from countries with a foreign currency rating of double-A or higher.
Observers also note that 55% of the loans are also secured, which makes the likelihood of default much lower. In its rating assessment, S&P also highlighted the fact that the transaction has "significantly higher recovery rates and lower net losses on the reference portfolio compared to standard Credit Default Swap (CDS) transactions."
Observers say that the issue of higher potential recovery rate is one of the more interesting tweaks in the transaction. In most standard CDS transactions, recoveries are based on very short settlement periods - say three months - which gives the bank in question little chance to work out a recovery. In what is believed to be a first, this structure gives DBS until final maturity to recover loan losses.
In terms of pricing, success is likely to be gauged by how closely each tranche comes to the trading levels of comparable plain vanilla bonds in the Singaporean market. However, the structured nature of the transaction and the fact that investors do not have access to names of individual credits in the loan portfolio will necessitate some form of a premium.
As an example, three-year and seven-year paper issued by triple-A rated Singapore Power is trading at about 10bp to 15bp over swaps in the domestic market on a fairly flat curve. In the international markets, triple-A rated synthetic CLO's tend to trade at about 45bp to 50bp over Libor, roughly the same level on a Singapore swap basis.
For the single-A tranche, Singapore Air has been cited as the nearest comparable although some bankers argue that the airline deserves a double-A rating on a fundamentals basis. The group's recent 10-year deal is said to be trading at about 90bp over swaps, while single-A rated CLO paper trades at about 125bp to 175bp over Libor in the international markets.
For investors, the two main pricing considerations are likely to be recovery rates on potential losses and credit events, which could lead to early redemption. Some CLO's incorporate up to five credit events. This transaction is viewed as less risky, because it only incorporates two - failure to pay and bankruptcy.
Securitization experts will now be watching to see what risk weighting the MAS will allow DBS to assign to the loans included in the transaction. From DBS's standpoint, the value of the transaction was underscored yesterday when Moody's downgraded its Bank Financial Strength rating to B- from B.
The bank's acquisitive trail across Asia has severely depleted previously high capital ratios and it has worked hard to find innovative ways to replenish them. As a result of its recent share offering, the bank now has a tier 1 ratio of 11.9% and a total CAR of 16.8%, well above the MAS's 12% minimum. Were it to fully account for its acquisition of Dao Heng Bank, however, tier 1 would fall to 8.3%, only marginally above an 8% minimum.