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Cash-funded vs. syntethic CDO (borrower consent/notification)


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Hi All,

I wanted to raise the following topic and share my insights about Cash-funded vs. syntethic CDO and whether one of these requires the borrower notification/obtaining borrower consent? This could be of one of these tricky questions in the exam (similarly engineered questions have turned up at the exam in Nov. 2016)

David, it would be much appreciated if we can have your take on this? (Perhaps you have came across something in Tavakoli's book?). I know you like her book and fully agree it's much more precise than Crouhy.

  • Mark Anson 'Handbook of Alternative Assets' writes (p. 439):

"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'

This is statement is indicating that under a syntethic structure (where credit risk is temporarily removed from the balance sheet of the bank), loans MAY require borrower notification and consent, so it is a possibility but not an obligation.

  • Fabozzi 'Capital Markets: Institutions, Instruments & Risk Management' (p. 987) writes:

'There are two problems with cash-CDO's. If a loan is transferred into a CLO, borrower notification and borrower consent are required. Because borrowers do not always understand the motivation for the bank selling their loan, the potential for deterioration in customer relationship may make a bank reluctant to sell or transfer a loan'

  • Fabozzi 'The Handbook of Fin. Instruments' (p.497-8) offers the following:

'What is the motivation for the creation of synthetic CDOs? By embedding a credit default swap within a CDO structure, financial institutions can shed the economic risk of assets without having to notify any borrowers, or worse, seek borrowers’ consent to put their loans into “other hands.” In traditional balance sheet collateralised loan obligations (CLOs), transfer of a loan to any special purpose vehicle (SPV) requires at least customer notification, and often customer consent. Thus synthetic CDOs were initially set up to accommodate European bank balance sheet deals, as it is considered particularly bad form and poor customer relationship management on that continent to sell customer loans.'

The CAIA offers the following bullet points (insights)

  • Cash-funded CDO: 1. selling the loan to the CDO trust 2. entails the decrease in credit exposure 3. entails decrease in reg capital 4. preservation of client relations (why are they preserved if the loan has been sold to the trust?) 5. permission from borrower required
  • Syntethic CDO: 1. no asset transfer (only risk-weighted assets are reduced) 2. use of leverage 3. less bankruptcy remoteness 4. gives investors access to scarce credit-risky assets
So, I am wondering what is true now? Does a synthetic structure (under certain circumstances - in case of a syndicated loan - require the bank to notify their borrowers (to whom the bank has issued the loans), as M. Anson writes?

In short, according to the above statements (correct me if I am wrong here):

  • cash-funded CDO (true sale): requires borrower consent (which simultaneously implies/ goes hand in hand with notification)
  • syntethic CDO: neither borrower consent nor borrower notification required (except under certain conditions, but what are the circumstances M. Anson is pointing towards?)

Any input/thoughts are very much appreciated!

Thank you!
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