Lehman closes $500 million Asian investment-grade arbitrage synthetic CDO

Lead manager Lehman Brothers said today it has closed a $500 million five-year Asian investment-grade arbitrage synthetic collateralised debt obligation (CDO) through special-purpose vehicles Asia IG CDO Limited and Asia IG CDO LLC. The portfolio manager is PCI Investment Management, a unit of Hong Kong’s Pacific Century Insurance Holdings.

“This is the first time an Asian ex-Japan investment-grade synthetic CDO has been completed,” Greg Donohugh, senior vice-president, head of Lehman’s CDO group for Asia ex-Japan, told RiskNews.

The transaction is referenced on a portfolio of 100 credit default swaps with a notional amount of $5 million each, where Asia IG CDO, the issuer, is offering protection on the 100 credits to Lehman, the CDS counterparty, and Lehman pays Asia IG CDO a premium for the protection.

The portfolio has an Asia-Pacific exposure of about 63%, including Japan, Australia and New Zealand, and the remainder comes from the US and Europe. The investment-grade portfolio has an average credit rating from Moody’s Investors Service of Baa1 and has received a diversity score of 55 from Moody’s. The portfolio includes five sovereign credits and includes 23 different industries, Moody’s said, with the top industries being banking (20%), telecommunications (14%), electronics (8%), buildings (7%) and oil and gas (7%).

Donohugh said that Lehman was able to do the transaction thanks to its "very active secondary credit default trading book, enabling us to include credits that are not generally liquid. If you aren't able to source a diverse credit portfolio, you can't do the transaction.”

As part of the transaction, Asia IG CDO is issuing three classes of notes maturing on November 20, 2007 and rated Aaa to Baa2 by Moody’s. Asia IG CDO has sold $33.25 million of Class A floating-rate notes rated Aaa, $22.5 million of Class B floating-rate notes rated Aa2 and $17.5 million of Class C floating-rate notes rated Baa2. Moody’s said in a statement released today that it “does not rate the subordinated Class D floating-rate notes”.

In terms of pricing, Lehman didn’t disclose the coupons for each tranche, but Donohugh noted that the transaction was “priced competitively on the market”. More than 90% of the transaction was sold in Asia, with interest seen among banks, insurance companies, corporates and asset managers, Donohugh said.

Donohugh declined to give the size of the equity tranche, but noted that the super-senior tranche is about 80% of the total size. One investor, who looked at the deal in an earlier form, noted that the equity tranche was less than 1% of the transaction.

Asia IG CDO achieved a Aaa rating on its senior note, not only thanks to the underlying investment-grade credits, but also thanks to a payment guarantee provided by monoline insurer Ambac Assurance Corporation.

Moody’s also added in its press release that the ratings are based on “the CDS premium payable in advance to the issuer by Lehman Brothers Special Financing Inc. (the “CDS counterparty”)” as well as “the credit enhancement provided to each of the Class A, Class B and Class C notes and their respective payment and loss allocation priority” and “the retention of excess spread as additional credit enhancement”.

Proceeds from the notes will be invested with Ambac Capital Funding. Interest from the investment and the CDS premiums from the portfolio will be used to pay certain senior fees and expenses, portfolio management fees, premium payments to the senior swap counterparty and interest payments on the notes, explained Moody’s. The credit rating agency added that excess cash from the investments and CDS premiums will be set aside in an account that will be used as credit enhancement.

However, Moody’s warned that its “ratings address only the credit risks associated with the transaction. Other non-credit risks, such as those associated with the timing of principal prepayments, have not been addressed and they may have a significant impact on the yield to investors.”

Wider Asian credit default swap spreads have meant that Asian fund managers are increasingly looking at being portfolio managers of arbitrage synthetic CDOs to enhance returns amid the low interest rate environment.

At the same time, “synthetic CDOs are attractive to investors due to the relatively higher spread, high rating, short maturity and diversity of credit exposure compared to alternative fixed-income investments”, said Donohugh.

According to market sources, at least four fund managers in the region – two in Hong Kong and two in Singapore – are looking at, or are in the process of, structuring Asian arbitrage synthetic CDOs in the near term. Market sources say that two global deals with a large Asian exposure could close before the end of the year, one with a size of about US$500 million and another with a size of US$440 million. Looking ahead, a US$500 million all-Asian investment-grade CDO could be launched within six months by a European fund manager.