Structured Products and Related Credit Derivatives: A Comprehensive Guide for Investors

CHAPTER 16

Synthetic CRE CDOs

Brian P. Lancaster

Senior Analyst

Wachovia Capital Markets, LLC

Anthony G. Butler, CFA

Senior Analyst

Wachovia Capital Markets, LLC

In the rapidly changing world of commercial real estate collateralized debt obligation (CRE CDOs), the application of synthetic CDO (SCDO) technology to commercial real estate assets, be they commercial mortgage-backed securities (CMBS), real estate investment trusts (REITs), on balance-sheet commercial real estate loans or even other cash CRE CDOs, is generating great interest from issuers and investors alike. Starting as a convenient tool for banks to hedge unwanted risk in their corporate loan portfolios or to obtain regulatory capital relief in the late 1990s, SCDOs have become a common fixture in the arbitrage market. Today, the application of this technology to the commercial real estate markets is likely to lead to a similar dominance in the CRE CDO market.¹

Three key factors have led to the creation of the CRE SCDO market and continue to drive its rapid expansion. First, the creation of a super-senior tranche significantly reduced the cost of liabilities in CRE SCDOs and permits these securities to thrive even when the economics of a cash-based transaction had been less attractive. Second, the development and standardization of credit default swap (CDS) contracts on CMBS markets and technology has allowed disparate market participants to communicate more efficiently, ramp collateral faster, and hedge more efficiently ...