In addition to the benefits described above for single bond default swaps, portfolio defaults swaps offer investors relative value and a unique type of leverage. More over, investors cannot economically replicate portfolio default swaps in the cash markets.
■ An Example
The most common application of portfolio default swaps is the purchase of second loss protection on large loan portfolios by commercial banks. Although not necessarily explicitly rated AAA, these second loss tranches are structured to achieve premium investment grade ratings. Commercial bank buyers retain the first loss exposure to reduce the cost of the hedge that is purchased to reduce the regulatory equity supporting the portfolio. In the table below, we detail a number of these structures that have been recently transacted, referred to in the marketplace as "synthetic CLOs".
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Portfolio default swaps segment the risk associated with a portfolio of credits linked to several credits among multiple investors. Portfolio default swaps are broken down into two main
categories: 1) first loss swaps; and 2) first-to-default swaps. First loss default swaps measure realized losses in dollars while first-to-default swaps measure losses in discrete events.
Portfolio default swaps can be traded outright or can be embedded in special purpose vehicles to create a funded asset. Default swaps based on portfolios use technology originated in the Collateralized Debt Obligation ("CDO") markets. The first-to-default or first loss swaps can be compared to the "equity" portion of a CDO. The second-to-default and second loss tranches of portfolio default swaps are analogous to the senior tranche of securitizations such as CDOs.
Buyers of portfolio default protection are motivated to retain a portion of the risk in existing portfolios and to reduce the absolute cost of hedging existing credit risk. Sellers of portfolio protection are attracted to the customized risk/return profile of the resulting exposure - the non-recourse, convex, enhanced spread of first loss positions and the over-collateralized low-risk nature of second loss positions.
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