Cdo Creative Balance Sheet Risk Management: Value Creation?

Traditional Securitization

An originator repackages a pool of assets and sells them to a SPV that issues tradable securities and sell them to investors. Assets are removed from the originator's balance sheet through a true sale, hence their credit risk is transferred. However, if the originator goes bankrupt, the SPV will not be held liable and vice verse.

Synthetic Securitization

With synthetic securitizations assets still remain in the originators balance sheet, however; the risk associated with them is transferred. This is done through utilizing credit derivatives such as CDS. There are two types of synthetic securitization - arbitrage and balance sheet. Asset management complexes and insurance companies use arbitrage securitizations with the intent of exploiting a yield mismatch. Alternatively, banks use balance sheet securitizations to manage their regulatory and risk-based capital utilize.

Motives of Securitization (See Appendix A)

• Improved liquidity

• Diversification of funding sources

• Better interest rates

• Improved risk management

• Accountancy-related advantages

• Earnings

Impact of Securitization on Regulatory Capital Requirements

Securitization reduces regulatory capital requirements. With traditional securitization assets are removed from the balance sheet, thus regulatory capital, economic capital and credit risk are reduced. Synthetic securitizations don't require a true sale of assets; the risk attached to them is transferred to counterparty. Since Basel II allows IRB, it could be easily proven that risk has decreased. However, synthetic transactions have a higher capital relief than traditional CDOs. With traditional securitization, the bank is required to hold 100% of the capital adequacy ratios against corporate exposure. In contrast, synthetic securitizations require less capital since they are backed up by CDS or government securities.

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