Synthetic Securitization in China

China recently launched two offerings of asset backed securities ('ABS') in its interbank market after several years of preparation and planning. On Dec. 9, 2005, China Construction Bank ('CCB') issued 2.9 billion yuan ($360 million) of debt securities in China's first residential mortgage-backed securitization, and on Dec. 12, 2005, China Development Bank ('CDB') issued 4.2 billion yuan ($500 million) of debt securities backed by unsecured loans from the telecommunications, energy, utility, and transportation industries. To facilitate ABS offerings, China's regulatory agencies have promulgated rules to govern ABS issuances, including the Administrative Rules for Pilot Securitization of Credit Assets, promulgated by the People's Bank of China ('PBOC') and China Banking Regulatory Commission ('CBRC') on April 20, 2005, the Rules for the Information Disclosure of Asset-Backed Securities, promulgated by the PBOC on June 13, 2005, and Rules for Regulating Financial Institution's Securitization, promulgated by the CBRC on Dec. 1, 2005.

Despite China's significant progress in creating a legal framework for securitization, traditional securitization still faces numerous legal and operational obstacles in China. Significant restrictions on the transfer of financial assets remain. Certain fundamental bankruptcy issues relating to substantive consolidation and true sale remain to be addressed. The process to foreclose upon and liquidate collateral in mortgage-backed securitizations is not securitization-friendly. Borrowers must be notified before a mortgage can be assigned to a trust. Requiring a bank to sell its loans to a third-party special purpose vehicle ('SPV') is a fundamental requirement for a securitization to occur, but under Chinese business practices, doing so may compromise a bank's customer relationships.

This article discusses synthetic collateralized debt obligation ('CDO') technology as a possible way for Chinese banks to achieve certain benefits of securitization while circumventing many of the problems associated with a traditional securitization in China.

What Is a Synthetic CDO?

The synthetic collateralized debt obligation structure, or simply the synthetic CDO, has grown in popularity since its inception in 1997. Since its inception, the credit derivatives market has expanded exponentially and has grown to more than $12 trillion measured on a notional amount basis. Fitch Ratings Ltd., Credit Events in Global Synthetic CDOs: 2005 Update (March 14, 2006). A synthetic CDO is a structure that can transfer the credit risk of financial assets from a sponsor to a SPV without an actual transfer of ownership or true sale of such financial assets. In a synthetic CDO, the SPV sells credit protection to the sponsor through a contract known as a credit derivative instrument. A credit derivative instrument is a contract whose value (or the payment obligation of one or more parties) is 'derived from' the performance of one or more specific reference obligations of one or more third parties or by the change in the credit quality of one or more third parties as evidenced by the occurrence of certain specified credit events. The credit derivative transfers credit risk from the sponsor to the SPV, and the SPV passes this risk to investors in the securities issued by the SPV.

The sponsor buys credit protection under the credit derivative, and, in return for paying premiums to the seller of credit protection, is entitled to a payment from the credit protection seller if a credit event occurs. The SPV is the credit protection seller, and receives the premiums for providing the credit protection, and is required to make payments to the credit protection buyer after the occurrence of a credit event.

Credit derivatives have the following features:

• a reference entity, which is the third party whose performance will impact payment under the credit derivative instrument;
• reference obligations, which may be bonds, loans, or other obligations of the reference entity;
• credit events, which are events that trigger payment obligations under the credit derivative instrument. Typically, credit event definitions are based on the 2003 International Swaps and Derivatives Association ('ISDA') credit derivative definitions including the supplemental amendments published by ISDA;
• a settlement mechanism which can be cash settled or physically settled; and
• if physical settlement is selected, a deliverable obligation, which is the bond, loan, or other obligation that the protection buyer delivers to the protection seller upon the occurrence of a credit event.

Practical Application of Synthetic CDO Technology Under the Current Chinese Legal Framework

Under the current Chinese legal framework, Chinese financial institutions are authorized to engage in derivative transactions. The CBRC promulgated Interim Measures for the Management of the Dealings of Derivative Products of Financial Institutions (the 'Interim Measures') on Feb. 4, 2004, followed by the Circular of China Banking Regulatory Committee on Risk Reminding in the Dealings of Derivative Products of Chinese-funded Bank (together with the Interim Measures, the 'Derivative Rules'). The Derivative Rules provide that financial institutions in China may engage in derivative product transactions subject to certain administrative requirements prescribed by the CBRC. The CBRC in promulgating its Derivative Rules looked to the definition of 'derivatives' provided by the Basel Committee on Banking Supervision, which defines a derivative as a kind of financial agreement whose value is determined by reference to one or more underlying assets or indices. The Derivative Rules define derivatives to include forwards, futures, swaps, and options, as well as structured financial products with features similar to forwards, futures, swaps, and options.

The Derivative Rules prescribe the procedures that financial institutions in China are required to follow before entering into derivative product transactions. A financial institution is required to provide the following materials to the China Securities Regulatory Commission ('CSRC'):

• an application for carrying on deri-vative products transactions, a feasibility report, and a business plan;
• the financial institution's regulations and rules concerning the internal risk management of derivative product transactions;
• the accounting framework for repor-ting the derivative product transactions entered into by the financial institution; and
• any other materials required by the CSRC.

In addition, the Derivative Rules require that the financial institution employ qualified and experienced personnel to conduct any such derivative product transactions.

Two of China's largest commercial banks, China Minsheng Bank and Bank of Beijing have already engaged in derivative transactions as part of their banking business. China Minsheng Bank has entered into credit default swaps as a seller of credit protection under bilateral contracts between the bank and transaction counterparties which contracts provide that upon the occurrence of certain credit events, including a material debt default, bankruptcy, or debt restructuring, China Minsheng Bank must make credit protection payments to the transaction counterparty. Similarly, the Bank of Beijing has issued credit-linked notes documented as 'wealth management service agreements' which provide investors return linked to the performance of certain specified reference entities.

The Benefits of the Synthetic CDO Structure

A properly structured synthetic CDO could allow Chinese banks to achieve many benefits of traditional securitizations. A synthetic CDO could allow Chinese financial institutions to redistribute risk while receiving favorable regulatory capital treatment. China requires its banks to follow the international standards on regulatory capital treatment, as set out in the Bank for International Settlements Basel Capital Accord of 1988 (the 'Basel Accord'). The Basel Accord requires a financial institution to maintain a percentage of its assets in accordance with their 'risk weight' equal to a minimum of 8% of the value of its assets. For example, a loan of $100 million by a Chinese bank to a state-owned enterprise (assigned a risk weight of 100%) would require that the Chinese bank set aside $8 million of capital. Under either a traditional securitization structure or a synthetic securitization structure, a Chinese bank could possibly achieve favorable regulatory capital treatment. In a synthetic CDO, instead of physically transferring a pool of loans to a SPV (often the first step of a traditional securitization), a Chinese bank could enter into a credit derivative transaction with a SPV to transfer the risk of loss on the pool of loans to the investors in the SPV. If the Chinese bank retained a 1% equity interest in the SPV and the SPV invested the proceeds received from its investors in 0% risk weighted assets (such as cash, sovereign debt, or other such cash substitutes), the resulting capital charge could be reduced to 1% (rather than the 8% capital charge if the risk of loss on the pool of loans were retained).

In addition to favorable capital treatment, a synthetic CDO structure can provide Chinese banks with an efficient way to transfer credit risks to the capital markets. To date, the Chinese economy has relied heavily on bank financing. Diversifying Chinese banks' credit risk can benefit the banking system's long-term well-being, and the Chinese economy's sustained growth. A synthetic CDO structure is a 'pure play on credit' and helps a financial institution isolate the credit risk of a bond or loan from other risks such as interest rate risk. Ownership of a financial asset generally includes the following risks: market risk, interest rate risk, currency risk, liquidity risk, and credit risk. An investor in a synthetic CDO transaction only assumes the credit risk on the reference financial assets. Accordingly, without selling its loans off its balance sheet, a Chinese bank could transfer the credit risk on such loans to investors through a synthetic CDO transaction. In this manner, synthetic securitization can help Chinese banks to transfer their credit risk on their asset portfolios to the capital markets.

Synthetic CDO Structure May Be Superior to a Traditional Securitization Structure Under the Current Chinese Legal Framework

Chinese banks that structure traditional securitizations face legal and operational limitations that may be avoided by using synthetic CDO structures. Future legislation to China's bankruptcy laws will be required to address and clarify certain bankruptcy issues relating to substantive consolidation and true sale to provide needed legal predictability and certainty surrounding the legal transfer of ownership of assets in China. These issues are avoided with the synthetic CDO structure since this structure does require the transfer of ownership of the underlying assets of the originating bank.

Similarly, traditional securitization structures require the SPV to administer the financial assets transferred from the sponsor, including to foreclose upon and to liquidate the financial assets when necessary. Chinese law requires that holders of residential mortgage loans provide new housing to defaulting borrowers before foreclosing upon the mortgage loan. Additionally, any time a lender assigns its rights, it is required to notify the borrower, or the assignment is ineffective. These liquidation and assignment restrictions can add a significant administrative burden and cost to a traditional securitization transaction. These issues are not present in the synthetic CDO structure because underlying assets remain on the balance sheet of the sponsoring bank.

A synthetic CDO structure can also satisfy the operational and practical concerns that transferring assets off of the balance sheet of the sponsoring bank may compromise a sponsoring bank's customer relationships.

It should be noted that one benefit of a traditional securitization not generally present in a synthetic CDO structure is the ability to boost a bank's liquidity by accessing the capital markets as a funding source for the bank. However, because of the high savings rate in China and China's largest banks with balance sheets ripe with cash, liquidity and access to funding may not be a primary consideration for securitization by Chinese banks.

Possible Structure of a Synthetic CDO Transaction Sponsored By a Chinese Financial Institution

A hypothetical representative structure for a synthetic CDO transaction sponsored by a Chinese bank seeking to securitize a portfolio of corporate loans is illustrated in Exhibit 1 below. In this fully funded synthetic CDO structure, a domestic SPV issues three classes of notes in an aggregate principal amount equal to approximately 100% of the reference pool of assets. The notes are tranched according to credit quality and their senior/subordinated priority in receiving interest and principal payments. The notes are sold to third-party investors in China's interbank bond market, with proceeds invested by the SPV in a portfolio of highly rated securities such as sovereign debt and other cash equivalents (the 'Eligible Investments'). The Chinese bank, as the sponsoring institution and the lender of the corporate loans, enters into a credit default swap with the SPV. Under the credit default swap, the Chinese bank buys credit default protection referencing the portfolio of corporate loans in return for a premium that compensates the investors of the notes for the default risk on the portfolio of corporate loans. Under the credit default swap, the sponsoring bank retains a first-loss position equal to 1% of losses on the portfolio of corporate loans, which is economically similar to an insurance deductible. This equity piece retained by the sponsoring bank determines the adjusted capital charge to be incurred by the sponsoring bank.

The investors receive interest payments equal to the yield received on the Eligible Investments plus the credit default swap premium received under the credit default swap. If the Chinese bank fails to pay the premium due to investors under the credit default swap on any payment date, for example because it becomes insolvent, then the credit default swap is terminated and the Eligible Investments are liquidated and the investors receive back the liquidation proceeds as an early repayment of principal. In this manner, investors are not exposed to the insolvency risk of the Chinese bank.

Upon the occurrence of an applicable credit event with respect to one or more of the designated corporate loans in the portfolio of corporate loans of the sponsoring bank, (assuming a cash settlement structure) the SPV would be required to make a payment to the sponsoring bank equal to the notional amount of the particular corporate loan that suffered a credit event minus the then-current market value of such corporate loan (such amount, the 'Loss Amount'). The procedure for determining the market value would be set forth in the credit default swap. Such Loss Amount would be absorbed first by the first loss position retained by the sponsoring bank. If losses on the portfolio of corporate loans exceeded such first loss position, remaining losses would be allocated from the most junior tranche of notes to the most senior tranche of notes until the cumulative Loss Amounts were fully allocated.

For purpose of an example, assume that the SPV issues $100 million of notes comprised of $95 million of class A notes with an 'AAA' rating, $3 million of class B notes with an 'AA' rating and $2 million of class C notes with an 'A' rating, and that the originating bank retains a $1 million subordinated tranche notional amount under the credit default swap. In this case, $2 million in principal amount of corporate loans in the reference portfolio would need to experience a credit event before the most junior class of rated notes would be affected, assuming that the market value of each of the loans that suffered credit events were equal to 50% of their original market value. If an additional $2 million in principal amount of the loans in the portfolio experienced a credit event, again assuming the market value of each of the loans were equal to 50%, then the SPV would be required to liquidate $1 million of the Eligible Investments, the liquidation proceeds of which would be paid to the originating bank under the terms of the credit default swap, and the principal amount of the class C notes would be reduced by 50%.

On the maturity date of the notes, the Eligible Investments would be liquidated, and the liquidation proceeds distributed in order of seniority to the class A notes, then the class B notes, and then finally to the class C notes, and the credit default swap would be terminated. The mechanics of this representative balance sheet synthetic CDO transaction are illustrated in Exhibit 1 below.

Conclusion

Given the legal and operational obstacles for a traditional securitization in China, synthetic CDO technology provides Chinese banks with a feasible and in some cases superior structure that can circumvent certain obstacles while achieving many of the benefits of a traditional securitization. The synthetic CDO structure can help China's banks to better manage their balance sheets and to redistribute and allocate credit risk through the capital markets and benefit China's bond markets and, as such, will serve to be another milestone achievement for China's growing securitization market.

[IMGCAP(1)]

Richard M. Schetman is a partner, Edwin C. Jean is special counsel, and Jian Wang is an associate in the Capital Markets Department of Cadwalader, Wickersham & Taft LLP. David Potterbaum also contributed to this article. For additional information about the firm, visit http://www.cadwalader.com/.

China recently launched two offerings of asset backed securities ('ABS') in its interbank market after several years of preparation and planning. On Dec. 9, 2005, China Construction Bank ('CCB') issued 2.9 billion yuan ($360 million) of debt securities in China's first residential mortgage-backed securitization, and on Dec. 12, 2005, China Development Bank ('CDB') issued 4.2 billion yuan ($500 million) of debt securities backed by unsecured loans from the telecommunications, energy, utility, and transportation industries. To facilitate ABS offerings, China's regulatory agencies have promulgated rules to govern ABS issuances, including the Administrative Rules for Pilot Securitization of Credit Assets, promulgated by the People's Bank of China ('PBOC') and China Banking Regulatory Commission ('CBRC') on April 20, 2005, the Rules for the Information Disclosure of Asset-Backed Securities, promulgated by the PBOC on June 13, 2005, and Rules for Regulating Financial Institution's Securitization, promulgated by the CBRC on Dec. 1, 2005.

Despite China's significant progress in creating a legal framework for securitization, traditional securitization still faces numerous legal and operational obstacles in China. Significant restrictions on the transfer of financial assets remain. Certain fundamental bankruptcy issues relating to substantive consolidation and true sale remain to be addressed. The process to foreclose upon and liquidate collateral in mortgage-backed securitizations is not securitization-friendly. Borrowers must be notified before a mortgage can be assigned to a trust. Requiring a bank to sell its loans to a third-party special purpose vehicle ('SPV') is a fundamental requirement for a securitization to occur, but under Chinese business practices, doing so may compromise a bank's customer relationships.

This article discusses synthetic collateralized debt obligation ('CDO') technology as a possible way for Chinese banks to achieve certain benefits of securitization while circumventing many of the problems associated with a traditional securitization in China.

What Is a Synthetic CDO?

The synthetic collateralized debt obligation structure, or simply the synthetic CDO, has grown in popularity since its inception in 1997. Since its inception, the credit derivatives market has expanded exponentially and has grown to more than $12 trillion measured on a notional amount basis. Fitch Ratings Ltd., Credit Events in Global Synthetic CDOs: 2005 Update (March 14, 2006). A synthetic CDO is a structure that can transfer the credit risk of financial assets from a sponsor to a SPV without an actual transfer of ownership or true sale of such financial assets. In a synthetic CDO, the SPV sells credit protection to the sponsor through a contract known as a credit derivative instrument. A credit derivative instrument is a contract whose value (or the payment obligation of one or more parties) is 'derived from' the performance of one or more specific reference obligations of one or more third parties or by the change in the credit quality of one or more third parties as evidenced by the occurrence of certain specified credit events. The credit derivative transfers credit risk from the sponsor to the SPV, and the SPV passes this risk to investors in the securities issued by the SPV.

The sponsor buys credit protection under the credit derivative, and, in return for paying premiums to the seller of credit protection, is entitled to a payment from the credit protection seller if a credit event occurs. The SPV is the credit protection seller, and receives the premiums for providing the credit protection, and is required to make payments to the credit protection buyer after the occurrence of a credit event.

Credit derivatives have the following features:

• a reference entity, which is the third party whose performance will impact payment under the credit derivative instrument;
• reference obligations, which may be bonds, loans, or other obligations of the reference entity;
• credit events, which are events that trigger payment obligations under the credit derivative instrument. Typically, credit event definitions are based on the 2003 International Swaps and Derivatives Association ('ISDA') credit derivative definitions including the supplemental amendments published by ISDA;
• a settlement mechanism which can be cash settled or physically settled; and
• if physical settlement is selected, a deliverable obligation, which is the bond, loan, or other obligation that the protection buyer delivers to the protection seller upon the occurrence of a credit event.

Practical Application of Synthetic CDO Technology Under the Current Chinese Legal Framework

Under the current Chinese legal framework, Chinese financial institutions are authorized to engage in derivative transactions. The CBRC promulgated Interim Measures for the Management of the Dealings of Derivative Products of Financial Institutions (the 'Interim Measures') on Feb. 4, 2004, followed by the Circular of China Banking Regulatory Committee on Risk Reminding in the Dealings of Derivative Products of Chinese-funded Bank (together with the Interim Measures, the 'Derivative Rules'). The Derivative Rules provide that financial institutions in China may engage in derivative product transactions subject to certain administrative requirements prescribed by the CBRC. The CBRC in promulgating its Derivative Rules looked to the definition of 'derivatives' provided by the Basel Committee on Banking Supervision, which defines a derivative as a kind of financial agreement whose value is determined by reference to one or more underlying assets or indices. The Derivative Rules define derivatives to include forwards, futures, swaps, and options, as well as structured financial products with features similar to forwards, futures, swaps, and options.

The Derivative Rules prescribe the procedures that financial institutions in China are required to follow before entering into derivative product transactions. A financial institution is required to provide the following materials to the China Securities Regulatory Commission ('CSRC'):

• an application for carrying on deri-vative products transactions, a feasibility report, and a business plan;
• the financial institution's regulations and rules concerning the internal risk management of derivative product transactions;
• the accounting framework for repor-ting the derivative product transactions entered into by the financial institution; and
• any other materials required by the CSRC.

In addition, the Derivative Rules require that the financial institution employ qualified and experienced personnel to conduct any such derivative product transactions.

Two of China's largest commercial banks, China Minsheng Bank and Bank of Beijing have already engaged in derivative transactions as part of their banking business. China Minsheng Bank has entered into credit default swaps as a seller of credit protection under bilateral contracts between the bank and transaction counterparties which contracts provide that upon the occurrence of certain credit events, including a material debt default, bankruptcy, or debt restructuring, China Minsheng Bank must make credit protection payments to the transaction counterparty. Similarly, the Bank of Beijing has issued credit-linked notes documented as 'wealth management service agreements' which provide investors return linked to the performance of certain specified reference entities.

The Benefits of the Synthetic CDO Structure

A properly structured synthetic CDO could allow Chinese banks to achieve many benefits of traditional securitizations. A synthetic CDO could allow Chinese financial institutions to redistribute risk while receiving favorable regulatory capital treatment. China requires its banks to follow the international standards on regulatory capital treatment, as set out in the Bank for International Settlements Basel Capital Accord of 1988 (the 'Basel Accord'). The Basel Accord requires a financial institution to maintain a percentage of its assets in accordance with their 'risk weight' equal to a minimum of 8% of the value of its assets. For example, a loan of $100 million by a Chinese bank to a state-owned enterprise (assigned a risk weight of 100%) would require that the Chinese bank set aside $8 million of capital. Under either a traditional securitization structure or a synthetic securitization structure, a Chinese bank could possibly achieve favorable regulatory capital treatment. In a synthetic CDO, instead of physically transferring a pool of loans to a SPV (often the first step of a traditional securitization), a Chinese bank could enter into a credit derivative transaction with a SPV to transfer the risk of loss on the pool of loans to the investors in the SPV. If the Chinese bank retained a 1% equity interest in the SPV and the SPV invested the proceeds received from its investors in 0% risk weighted assets (such as cash, sovereign debt, or other such cash substitutes), the resulting capital charge could be reduced to 1% (rather than the 8% capital charge if the risk of loss on the pool of loans were retained).

In addition to favorable capital treatment, a synthetic CDO structure can provide Chinese banks with an efficient way to transfer credit risks to the capital markets. To date, the Chinese economy has relied heavily on bank financing. Diversifying Chinese banks' credit risk can benefit the banking system's long-term well-being, and the Chinese economy's sustained growth. A synthetic CDO structure is a 'pure play on credit' and helps a financial institution isolate the credit risk of a bond or loan from other risks such as interest rate risk. Ownership of a financial asset generally includes the following risks: market risk, interest rate risk, currency risk, liquidity risk, and credit risk. An investor in a synthetic CDO transaction only assumes the credit risk on the reference financial assets. Accordingly, without selling its loans off its balance sheet, a Chinese bank could transfer the credit risk on such loans to investors through a synthetic CDO transaction. In this manner, synthetic securitization can help Chinese banks to transfer their credit risk on their asset portfolios to the capital markets.

Synthetic CDO Structure May Be Superior to a Traditional Securitization Structure Under the Current Chinese Legal Framework

Chinese banks that structure traditional securitizations face legal and operational limitations that may be avoided by using synthetic CDO structures. Future legislation to China's bankruptcy laws will be required to address and clarify certain bankruptcy issues relating to substantive consolidation and true sale to provide needed legal predictability and certainty surrounding the legal transfer of ownership of assets in China. These issues are avoided with the synthetic CDO structure since this structure does require the transfer of ownership of the underlying assets of the originating bank.

Similarly, traditional securitization structures require the SPV to administer the financial assets transferred from the sponsor, including to foreclose upon and to liquidate the financial assets when necessary. Chinese law requires that holders of residential mortgage loans provide new housing to defaulting borrowers before foreclosing upon the mortgage loan. Additionally, any time a lender assigns its rights, it is required to notify the borrower, or the assignment is ineffective. These liquidation and assignment restrictions can add a significant administrative burden and cost to a traditional securitization transaction. These issues are not present in the synthetic CDO structure because underlying assets remain on the balance sheet of the sponsoring bank.

A synthetic CDO structure can also satisfy the operational and practical concerns that transferring assets off of the balance sheet of the sponsoring bank may compromise a sponsoring bank's customer relationships.

It should be noted that one benefit of a traditional securitization not generally present in a synthetic CDO structure is the ability to boost a bank's liquidity by accessing the capital markets as a funding source for the bank. However, because of the high savings rate in China and China's largest banks with balance sheets ripe with cash, liquidity and access to funding may not be a primary consideration for securitization by Chinese banks.

Possible Structure of a Synthetic CDO Transaction Sponsored By a Chinese Financial Institution

A hypothetical representative structure for a synthetic CDO transaction sponsored by a Chinese bank seeking to securitize a portfolio of corporate loans is illustrated in Exhibit 1 below. In this fully funded synthetic CDO structure, a domestic SPV issues three classes of notes in an aggregate principal amount equal to approximately 100% of the reference pool of assets. The notes are tranched according to credit quality and their senior/subordinated priority in receiving interest and principal payments. The notes are sold to third-party investors in China's interbank bond market, with proceeds invested by the SPV in a portfolio of highly rated securities such as sovereign debt and other cash equivalents (the 'Eligible Investments'). The Chinese bank, as the sponsoring institution and the lender of the corporate loans, enters into a credit default swap with the SPV. Under the credit default swap, the Chinese bank buys credit default protection referencing the portfolio of corporate loans in return for a premium that compensates the investors of the notes for the default risk on the portfolio of corporate loans. Under the credit default swap, the sponsoring bank retains a first-loss position equal to 1% of losses on the portfolio of corporate loans, which is economically similar to an insurance deductible. This equity piece retained by the sponsoring bank determines the adjusted capital charge to be incurred by the sponsoring bank.

The investors receive interest payments equal to the yield received on the Eligible Investments plus the credit default swap premium received under the credit default swap. If the Chinese bank fails to pay the premium due to investors under the credit default swap on any payment date, for example because it becomes insolvent, then the credit default swap is terminated and the Eligible Investments are liquidated and the investors receive back the liquidation proceeds as an early repayment of principal. In this manner, investors are not exposed to the insolvency risk of the Chinese bank.

Upon the occurrence of an applicable credit event with respect to one or more of the designated corporate loans in the portfolio of corporate loans of the sponsoring bank, (assuming a cash settlement structure) the SPV would be required to make a payment to the sponsoring bank equal to the notional amount of the particular corporate loan that suffered a credit event minus the then-current market value of such corporate loan (such amount, the 'Loss Amount'). The procedure for determining the market value would be set forth in the credit default swap. Such Loss Amount would be absorbed first by the first loss position retained by the sponsoring bank. If losses on the portfolio of corporate loans exceeded such first loss position, remaining losses would be allocated from the most junior tranche of notes to the most senior tranche of notes until the cumulative Loss Amounts were fully allocated.

For purpose of an example, assume that the SPV issues $100 million of notes comprised of $95 million of class A notes with an 'AAA' rating, $3 million of class B notes with an 'AA' rating and $2 million of class C notes with an 'A' rating, and that the originating bank retains a $1 million subordinated tranche notional amount under the credit default swap. In this case, $2 million in principal amount of corporate loans in the reference portfolio would need to experience a credit event before the most junior class of rated notes would be affected, assuming that the market value of each of the loans that suffered credit events were equal to 50% of their original market value. If an additional $2 million in principal amount of the loans in the portfolio experienced a credit event, again assuming the market value of each of the loans were equal to 50%, then the SPV would be required to liquidate $1 million of the Eligible Investments, the liquidation proceeds of which would be paid to the originating bank under the terms of the credit default swap, and the principal amount of the class C notes would be reduced by 50%.

On the maturity date of the notes, the Eligible Investments would be liquidated, and the liquidation proceeds distributed in order of seniority to the class A notes, then the class B notes, and then finally to the class C notes, and the credit default swap would be terminated. The mechanics of this representative balance sheet synthetic CDO transaction are illustrated in Exhibit 1 below.

Conclusion

Given the legal and operational obstacles for a traditional securitization in China, synthetic CDO technology provides Chinese banks with a feasible and in some cases superior structure that can circumvent certain obstacles while achieving many of the benefits of a traditional securitization. The synthetic CDO structure can help China's banks to better manage their balance sheets and to redistribute and allocate credit risk through the capital markets and benefit China's bond markets and, as such, will serve to be another milestone achievement for China's growing securitization market.

[IMGCAP(1)]

Richard M. Schetman is a partner, Edwin C. Jean is special counsel, and Jian Wang is an associate in the Capital Markets Department of Cadwalader, Wickersham & Taft LLP. David Potterbaum also contributed to this article. For additional information about the firm, visit http://www.cadwalader.com/.