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The credit guide to credit default swaps
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The credit guide to credit default swaps
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Head office Risk Waters Group Haymarket House 28–29 Haymarket London, SW1Y 4RX United Kingdom Tel +44 (0)20 7484 9700 Editor, Credit David Watts Author Philip Moore Contributor Saskia Scholtes Director of Editorial Services Celia Mather Subeditor Alex Krohn Designer Matt Hadfield Advertising Manager Simon Crabb Publisher Sean O’Callaghan Printed in the UK by Wyndeham Grange, Southwick West Sussex. © Risk Waters Group Ltd, 2003. All rights reserved. No part of this publication may be reproduced or introduced into any retrieval system, or transmitted in any from or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of the copyright owners.
Cover illustration Tan Doan
Editor’s letter
Editor’s letter T
he credit default swap market has been almost doubling annually since it began in earnest in 1996. And there are as yet no signs of a slowdown. With a number of emerging market financial crises, particularly Asia and Russia, and an unprecedented fall in corporate credit quality in both the US and Europe, credit default swaps have been well tested in the past nine years. That is not to say there have not been any difficulties. The industry body tasked with laying down the guidelines for derivatives – the International Swaps and Derivatives Association – has had to revise the CDS contract documentation several times since it was first published in 1998. National Power, a UK energy producer, Railtrack, the now-defunct operator of Britain’s rail network, and Conseco, a US insurance company, have all thrown spanners in the works for the buyers and sellers of CDS protection. And most recently Six Continents, a UK retailer, is doing its best to put the brand new Isda credit derivatives definitions, only published in February, to the test. Nevertheless these simple insurance contracts appear able to evolve and adapt to all that is thrown at them – with the occasional help of a court case. What’s more, credit default swaps have moved well beyond providing simple insurance for lenders. They are now traded in their own right and are used as building blocks for the newest and most innovative structures in the capital markets, including synthetic collateralised debt obligations, credit-linked notes and first-to-default baskets. It will be fascinating to see what the CDS market will grow to become and how else people will put it to use. But in the meantime Credit attempts to take some of the mystique out of these simple contracts and break down some of their uses.
David Watts Credit
www.creditmag.com
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contents
Contents 6
Introduction What everybody ought to know about this credit business Changes in the regulation of the financial services sector and the introduction of a common currency have simultaneously reduced banks’ willingness to hold exposure to corporate risk and investors’ ability to buy that risk. So the business of transferring credit risk is booming.
12 CDS: the basics Which credits are covered by the CDS market? Part of the attraction of credit default swaps is that in terms of pricing and maturity they are not dissimilar to other methods of trading credit risk, such as loans and bonds. This has helped the market quickly understand and adopt them.
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14 Documentation Laying down the ground rules As with any ‘watertight’ contract, holes inevitably appear. And so Isda has been forced to continuously revisit the documentation guidelines on credit default swaps in an attempt to respond to new concerns and the changing market.
19 CDS growth The size of the CDS market From an uncertain inception date, the credit default swap market has blossomed to become a major asset class in the capital markets. For this growth to continue and the market to reach its full potential, certain impediments will need to be removed.
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credit 24 Market indicators The ability to ‘trade rumours’ The credit default swap market has rapidly become recognised as one of the most responsive financial indicators, in some cases foreshadowing even the equity markets. From Ahold to WorldCom, the CDS market has priced concerns in long before other asset classes.
26 Market participants Buyers and sellers of CDSs Greater regulation on the extent to which banks are exposed to corporate clients has meant banks have eagerly adopted credit default swaps to transfer risk, however concerns have been expressed in certain quarters about where the transferred credit risk is going.
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30 New structures CDSs as building blocks Credit default swaps are no longer purely used as a form of insurance for lenders or an alternative method of gaining exposure. Their commonality and tradability has allowed people to create new and innovative financial products.
35 Conclusion Risks to the system With the credit default swap market developing at exponential rates, are the doom-mongers justified in their concerns?
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introduction
What everybody ought to know about this credit business Changes in the regulation of the financial services sector and the introduction of a common currency have simultaneously reduced banks’ willingness to hold exposure to corporate risk and investors’ ability to buy that risk. So the business of transferring credit risk is booming oon after the Second World War, Merrill Lynch sensed – quite rightly – that the US stood on the brink of an equity revolution, and that thousands of small investors could be persuaded to channel their savings into the stock market. To push them on their way, Merrill published a 6,000word advertisement in The New York Times on October 19, 1948 entitled ‘What everybody ought to know about this stock and bond business’. The piece, deliberately couched in layman’s language, proved so popular that over the next three years Merrill printed and distributed around one million extra copies. Over the five decades that followed, equities became a well-understood and popular asset class at both an institutional and a retail level. More recently, investors’ attention has turned with increasing focus towards the market for fixedincome securities in general, and corporate bonds (or ‘credit’ instruments) in particular. By the end of the 1990s, this movement had become so powerful that investor education about the bond market was viewed as being as important as the Merrill-style education about equities had been in the 1950s.
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Credit comes of age A number of influences have driven a shift in asset allocation from equities to bonds at an institutional and retail level. Recently, of course, the poor performance of equities has played an important role in this process, famously encouraging UK pension funds to make a wholesale reallocation of their assets away from equity and into fixed income. But long before the bursting of the equity bubble in early 2000, market dynamics were encouraging an increased supply of bonds. One of these dynamics has been a fundamental change in the relationship between banks and cor6
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porate borrowers. The demise of relationship banking in Europe over the past 15 years is attributable to a number of causes, not least the introduction towards the end of the 1980s of the Basel Accord on bank capital adequacy. Basel I laid down the terms for an agreement among Group of 10 (G10) central banks to apply minimum capital standards to their banking industries that were to be achieved by the end of 1992. The standards almost exclusively addressed the issue of credit exposure, identified in the late 1980s as the principal risk incurred by the global banking sector. In the words of the Bank for International Settlements (BIS), Basel I arose as a reflection of central bankers’ concern that “the capital of the world’s major banks had become dangerously low after persistent erosion through competition”.
Long before the bursting of the equity bubble in early 2000, market dynamics were encouraging an increased supply of bonds The 1988 Accord required internationally active banks in G-10 countries to hold capital equal to at least 8% of a basket of assets measured in different ways according to their risk profile. Under the Accord, assets are classified into four separate buckets of 0%, 20%, 50% and 100%, with exposure to corporates attracting the maximum risk weighting. Reducing exposure to corporate loans was therefore a front-line strategy for banks eager to comply with the minimum capital requirements. Closer financial and regulatory integration arising from European Monetar y Union (EMU) exerted other important pressures on the European banking industr y, in turn further eroding the
introduction importance of relationship banking. In particular, it forced banks to concentrate much more intensively on the delivery of enhanced profitability and return on equity (ROE). This was because the launch of the single currency meant companies across all sectors (financial services included) found they could no longer depend purely on a loyal and unquestioning base of domestic investors. Those same investors were themselves exposed to more competitive pressures as a result of globalisation. They therefore began to compare companies on a cross-border basis, and within the banking sector they encountered very different performance levels. As recently as 1996, for example, publicly quoted banks in the UK enjoyed an average ROE in excess of 20% (and in excess of 30% in the case of Lloyds Bank). By contrast, the average in continental Europe was a little over 11%, with banks in the largest markets posting ROE levels appreciably below this average. In Germany, this was 7.5% in 1996, in France it was 6.9% and in Italy it struggled to reach 3%. Pressure on banks was exacerbated by deregulation and liberalisation of financial services industries throughout Europe, allowing foreign banks to enter markets that had previously been protected with various degrees of intensity from international competition. One net affect of this powerful combination of influences was that the supply of bank loan credit to the corporate sector was either diminished, or provided on a much more selective basis. In turn, companies began to explore alternative sources of funding – with the debt capital market soon identified as one of the most appealing options. In the late 1990s, this emerged as one of the principal driving forces for the arrival of ‘credit’ as an asset class in Europe.
The importance of credit protection Hand-in-hand with the emergence of credit as an asset class in Europe, however, came the recognition that far from being risk-free assets, corporate bonds in particular were hostage to a range of hazards generally referred to as ‘event risk’. One of the principal sources of this event risk was the often frenzied pursuit of shareholder value within the corporate sector, driven largely by the process of privatisation that swept through Europe www.creditmag.com
during the 1990s. The clearest examples of this were provided by the telecommunications and utility sectors. Both had previously been cocooned by state ownership, but in the aftermath of privatisation found themselves pressurised by demanding investors into delivering shareholder value in the form of growth, rather than a predictable if unadventurous stream of dividend income.
Corporate bonds are hostage to a range of hazards generally referred to as ‘event risk’ Both industries responded in a number of ways to the demands of their new investors, but a common feature of their strategies was expansion via acquisition, which had at least two important ramifications for their credit quality. First, especially in the case of the utilities, it encouraged them to look overseas for expansion opportunities, which often meant stepping into riskier emerging markets. Second, as acquisitions needed to be paid for, it exerted new pressures on their balance sheets as they raised funding in support of their growth, dramatically increasing their indebtedness (alternatively known as ‘gearing’ or ‘leverage’). In the case of the telecoms sector, an additional fly in the ointment came in the form of their response to technological progress in general, and in particular to the advent of mobile telephony and the internet. For a large number of European telecoms companies, that necessitated very substantial one-off investment in third generation (3G) licences for which – with the benefit of hindsight – many overpaid.
Credit ratings All these influences had a powerful and negative impact on credit ratings assigned by the three leading rating agencies (Fitch, Moody’s and Standard & Poor’s), which are designed as yardsticks measuring the probability of default. From a global perspective, the telecoms sector provides the most vivid example of declining credit quality. In 1990, 11% of all telecoms issuers rated by S&P were triple-A, with a further 33% rated doubleA and 33% single-A. With an additional 15% rated as triple-B entities, this meant 92% of borrowers credit The ABC of CDS
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introduction within the S&P telecoms universe were classified as investment grade. By 2001, following a decade of privatisation, deregulation, new entrants arriving in the sector and the heavy investment necessitated by technological innovation, the picture was dramatically different. By then, there were no triple-A borrowers left in the sector, while only 2% carried a double-A rating and 6% were rated single-A. The largest concentration of ratings in the telecom sector was in the single-B area (45%) and a large number (19%) were rated D. In other words, by 2001 only 17% of borrowers in the telecoms sector were categorised as investment grade.
The principal source of the event risk in the 1990s was the often frenzied pursuit of shareholder value In the broader credit market, however, the pursuit of shareholder value and increased leverage twinned with a rapidly deteriorating global macroeconomic climate has led to an acceleration in the worsening of credit quality. As S&P advised at the beginning of 2003: “In 2002, EU credit quality plummeted to record lows. The year saw unprecedented levels of rating activity, with a total of 191 ratings actions on a rated population of 539 entities carrying rated long-term debt.” During the year, according to the S&P data, there were 168 downgrades of long-term debt worth close to €750 billion, compared with just 23 upgrades of securities valued at €56 billion.
Has ‘event risk’ receded? In some industries, it would seem that the worst is now over in terms of event risk and credit deterioration, with the telecoms sector probably providing the clearest example. It is highly improbable, for example, that telecoms companies as a group will, in the foreseeable future at least, incur as huge a one-off capital spend as they did to finance 3G licences. It is also clear that the majority of companies in the telecoms sector have learned from previous mistakes and are now paying much more attention to the demands of bondholders through, for example, selling off non-core assets and deleveraging their balance sheets. As a result, 8
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by early 2003 a number of European telecoms companies, such as France Télécom and KPN of the Netherlands, were widely regarded as improving credits. That should not, however, be taken as a signal that event risk in the credit market is a thing of the past. Far from it. Credit risk was identified as the biggest concern faced by the 175 respondents to a survey by the Centre for the Study of Financial Innovation (CSFI). That concern was probably most graphically expressed by the response to the survey given by the representative of a German Landesbank, who said that “asset values do not always collapse in months; they can crumble over years. That is a life-threatening problem, and not just for the banks.” This may be an exaggeration. But if it is accepted that the past few years have exposed the magnitude of the risks inherent in the corporate bond market, it has also become clear that the need to hedge against these risks has become paramount for all participants within the market. One way investors have been able to protect themselves from credit deterioration is through the incorporation of ‘step-up coupons’ into new bond issues, which became especially popular in the newissue market for telecoms bonds in 2000 and 2001. This is a mechanism under the terms of which the borrower agrees to pay a higher coupon to investors in the event of its bonds being downgraded by the leading credit rating agencies. But step-up coupons are of little use when companies rush headlong towards potential default, with the spreads on their bonds widening by several hundred basis points in the process, wiping out many times any compensation that investors will have received in the form of step-ups on coupons.
Transferring credit risk Of the mechanisms available to market participants to protect themselves more comprehensively from these risks, the credit derivatives market in general and the market for credit default swaps in particular have emerged as a favoured option, and bankers believe the acceptance of hedging tools such as these will become increasingly visible across the entire financial services industry. As Goldman Sachs expressed in a bulletin published in May 2001: “We
introduction believe sophisticated use of default swaps will increasingly become a necessary component of a successful portfolio management strategy.” Fundamental to the growing acceptance of credit derivatives is the transfer of risk away from the balance sheets of banks and towards the much broader capital market, which is generally recognised as being more skilled and disciplined in terms of assessing and pricing credit risk. That explains why many commentators choose to describe the credit derivatives sector as the market for ‘credit risk transfer’ (CRT).
Of the mechanisms available to market participants to protect themselves, CDSs have emerged as a favoured option
The concept of CRT, of course, is by no means new, and gathered momentum with the development of the market for asset-backed securities – ‘securitisation’ – in the US in the 1980s. This process began with banks passing the credit risk embedded in their portfolios of residential mortgages to capital market investors. That basic formula has since been applied to a spectrum of other assets capable of generating reliable cashflows – ranging from auto loans and commercial mortgages to receivables arising from sales of champagne and music rights.
Defining the credit default swap In a nutshell, a credit default swap (CDS) is similar to an everyday insurance contract. A key difference between a CDS and an insurance policy is those buying a CDS can trade in and out of their contracts in a way that is not possible in the insurance market. In other words, a CDS is a privately negotiated bilateral contract in which one party, usually known as the protection buyer (or ‘risk shedder’ in the parlance of the BIS), pays a fee or premium to another, generally referred to as the protection seller (described by the BIS as the ‘risk taker’), to protect himself against the loss that may be incurred on his exposure to an individual loan or bond as a result of an unforeseen development. www.creditmag.com
Securitisation versus credit risk transfer A key difference between the securitisation arena and the market for credit risk transfer (CRT) via credit derivatives is that the former is generally described as being a ‘funded’ agreement while the latter is ‘unfunded’. In a funded, or cash, securitisation, the risk of bearing a pool of assets (be they residential or commercial mortgages, credit card or auto loan receivables) is held by investors comfortable that the cashflows of the assets in question are predictable. The transaction is known as ‘funded’ because the investor provides a cash payment to buy a claim related to the underlying cashflows supporting the transaction. Securitisations are not, however, always packaged as funded transactions. In Germany in particular, unfunded or partially funded structures have been especially popular among issuers, principally for tax reasons. In these structures, which are known as synthetic securitisations, assets remain on the issuer’s balance sheet, while credit risk is transferred to third parties by using credit default swaps. This is a helpful way for banks without an urgent funding requirement to use the securitisation market in order to achieve regulatory capital relief. In an unfunded CRT transaction, credit risk is transferred from the buyer of protection (the risk shedder) to the seller (the risk taker) without a funding obligation. In this instance, the taker of credit risk only provides funding to the buyer of protection if a pre-defined credit event takes place. In other words, as a report published by the Bank of England explains, “credit derivatives therefore allow banks to manage credit risk separately from funding. They are an example of the way modern financial markets unbundle financial claims into their constituent elements (credit, interest rate, funding etc), allowing them to be traded in standardised wholesale markets and rebundled into new composite products that better meet the needs of investors.” ■
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introduction This development is usually known as a ‘credit event’, indicating that the borrower (known as the reference entity) on which the CDS has been written is unable (or is rapidly likely to become unable) to pay its debts. If a credit event occurs, the seller of protection will make a payment to the buyer of the contract. Usually, as it is a private arrangement, the terms of a CDS can be renegotiated between the buyer and seller of protection in response to changes in market fundamentals. Also, it may be helpful to split the term ‘credit default swap’ into its three component parts, because in keeping with so many other instruments in the capital market, there are elements of misnomer in the terminology. ● CREDIT: In the context of the capital market, the asset class known as ‘credit’ means different things to different people. But in recent years, it has often been used as a generic term to describe the non-government or non-public sector bond market. In the context of the derivatives market, however, the ‘C’ in CDS can, and often does, refer to issuers of securities that would not fall into this category – such as triple-A rated governments that are prolific and regular issuers in the international capital market. ● DEFAULT: In a sense, the use of the term ‘default’ in the context of the credit derivatives
market can be misleading, since a default is not actually required for a credit default swap to be triggered. The term default is additionally misleading because it implies that the use of instruments such as credit default swaps is restricted to instances in which banks or investors are exposed to highly risky credits. There is also a very active market in CDSs written on individual names or credits in which neither the buyer nor the seller of protection believes there is the remotest possibility of default. In that sense, ‘default’ can often be a misnomer. ● SWAP: The use of the word ‘swap’ can also be misleading, with ‘contract’ perhaps a better way of describing the arrangement reached by the buyer and seller of protection. As a report published in June 2001 by Banc of America Securities explains: “The product name reflects its genesis within traditional (ie, interest rate) swap groups, and their use of traditional swap documents to also document credit default swaps. Nonetheless, the product’s name – credit default swap – is a misnomer… A CDS is not really a swap in the way most of the credit spread markets think of swaps – that is, as swaps of fixed for floating cashflows, as is the case of interest rate swaps. In the case of credit default swaps, there is only a ‘swap’ in the instance when a credit event triggers a compensating payment.” ■
Credit risk transfer with CDSs Step 1*
Step 2
Loan/Bond $5m ‘IOU-1’
Borrower (step 1) (Debts R Us Inc.)
Interest payments
Lender (step 1) & Buyer (step2) CDS protection (Safe investor Inc.)
Provides $5m CDS protection (Reference entity Debt R Us Inc.)
(Insurance Inc.)
Premium (basis points)
Step 3 * Step 1 is not strictly necessary. Money does not need to have been lent in order to buy CDS protection. In a credit event the protection holder can buy debt in the market to deliver under the contract.
Credit Event Protection triggered $5m ‘IOU -1’ loan to Insurance Inc. Cash ($5m) to Safe Investor Inc. Premium payments stop
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CDS: the basics
Which credits are covered by the CDS market? Part of the attraction of credit default swaps is that in terms of pricing and maturity they are not dissimilar to other methods of trading credit risk, such as loans and bonds. This has helped the market quickly understand and adopt them n theory, a CDS can be written on any name, and at any part of the capital structure that has an outstanding obligation in the loan or bond market, from triple-A rated sovereign and supranational borrowers down to corporates and other issuers rated as low as single-C. There is no requirement for the underlying entity to be publicly rated, although the liquidity of CDSs on unrated entities will generally be lower than on rated names. In practice, however, with S&P and Fitch describing a triple-C rated company as one that is “currently vulnerable to non payment”, and where “default is a real possibility”, the pricing on a CDS contract for a distressed borrower in this rating territory would be so prohibitive as to render bilateral negotiations between a buyer and seller of protection pointless. On occasions where credits have plunged from being investment grade to deeply distressed, prices in the CDS market have generally ceased to be quoted by protection sellers. In other words, in the CDS market, deeply distressed credits become uninsurable, in much the same way as unacceptably risky situations become uninsurable in the conventional insurance market. A good example of this process was provided in the summer of 2001, when CDS prices on WorldCom bonds ceased to be quoted long before the company filed for bankruptcy (see page 25).
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Premiums Premium prices – also known as fees or default swap spreads – are quoted in basis points per annum of the contract’s notional value. Usually, predetermined premiums are paid by the buyer of protection to the seller on a quarterly basis, with the contract terminating either at maturity or at the time of a credit event occurring. In the case of 12
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those distressed credits in which the CDS market remains open, however, it has become more usual for sellers of credit protection to demand the payment of an upfront premium as opposed to the standard running spread.
CDS size and pricing There are no predetermined limits on the size or maturity of CDS contracts, which have ranged in size from a few million to several billions of dollars. In general, however, contracts are concentrated in the $10 million to $20 million range with maturities of between one and 10 years, although fiveyear maturities are the most common. Inevitably, the maturity of a CDS will depend on the credit quality of the reference entity, with longer-dated contracts of five years and more only written on the best-rated names.
Pricing is a closely guarded secret for many firms and more of an art than a science In the early days of the CDS market in Europe, pricing of contracts, even on comparably rated reference entities, varied significantly from one provider of protection to the next. As one market participant was quoted as saying in a Financial Times survey in June 1997, “pricing is a closely guarded secret for many firms”, and as another put it, “pricing [credit derivatives] is more of an art than a science”. In recent years, pricing levels have become compressed and much more standardised. That is not to say, however, that the price quoted for credit protection will be the same among all banks or other participants in the market. There may be a range of technical rather than credit-related reasons
CDS: the basics why some banks will quote different CDS prices from their competitors. That means that for buyers of credit protection, it can often pay to ‘shop around’ among sellers for the best price. Broadly, however, all sellers of protection will use similar parameters in reaching a price for a CDS. An analysis published in September 2002 by Dresdner Kleinwort Wasserstein (DrKW) explains that over and above a valuation of credit risk, the likelihood of default, the actual loss incurred and the recovery rate, a range of other considerations come into play when pricing CDSs. “Liquidity, regulatory capital requirements as well as the market sentiment and perceived volatility and shape of the cur ve are usually priced in,” explains the report. “As a result, to price a CDS we need to know the credit, its default probability and recovery rates, which depend on the level of seniority of the debt, plus market information. The rating agencies, and in particular Moody’s, provide a long history of statistical information on one-year and cumulative default probabilities, as well as recovery rates for different periods.” There are now a number of accepted and sophisticated models used for the pricing of CDSs, ranging from structural to transitional and reducedform pricing models.
In what form is compensation made? The form of compensation paid to a buyer of protection if a credit event occurs will depend on whether the original terms of the contract dictate that payment is for a physical settlement or for a cash settlement. In a contract for physical settlement, the seller of protection will agree to buy back the distressed loan or bond at par. This distressed loan or bond is known as the ‘deliverable obligation’. Clearly – given that the trigger event will have reduced the secondary market value of the loan or bond in question – this will result in the seller incurring a loss. This is the most common means of settlement in the credit default swaps market and will generally take place no later than 30 days after the credit event. In a contract for cash settlement, the seller of protection will pay the buyer the difference between the notional of the default swap and a final value for the same notional of the reference obligation. According to a Goldman Sachs analysis, “cash settlement is less prevalent because obtaining precise quotes can be difficult when the reference credit is distressed”. A cash settlement will typically take place within five business days of the credit event triggering payment. ■
More complex examples of CDS applications The CDS is often referred to as a ‘building block’ upon which a number of other successful innovations have been designed, the most wellknown and popular of which are probably portfolio-based products including the collateralised debt obligation (CDO) and creditlinked note (CLN), both of which are defined and discussed in greater detail on pages 30 to 34. Among other applications using the CDS is a ‘first-to-default basket swap’ where investors are exposed to the first default to occur in a welldefined basket of credits. In return, the investor may earn a premium well in excess of that on individual names. First-to-default baskets also offer complete transparency in that the investor selects the names in the basket. According to a report published by Deutsche Bank in February 2002, “for banks in many countries, first-to-
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default baskets provide a more efficient way to deploy capital than individual bonds or loans. In addition, the major rating agencies have developed criteria for rating first-to-default baskets. In many cases these transactions can obtain investment-grade ratings, which make this product accessible to investment-grade investors.” Less common are second- and even third-to-default products, in which payment will only be triggered if a credit event occurs on more than one of the reference entities within the basket. A total return swap, meanwhile, is a customised, off balance sheet transaction that allows for the transfer of the total economic performance of a specific asset or portfolio of assets by the buyer of protection in return for fixed or floating interest payments. ■
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documentation
Laying down the ground rules As with any ‘watertight’ contract, holes inevitably appear. And so Isda has been forced to continuously revisit the documentation guidelines on credit default swaps in an attempt to respond to new concerns and the changing market
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ne critical element that limited the expansion of the CDS market in its early days was the absence of any broadly accepted and standardised documentation clearly defining the precise terms and conditions of contracts. Instead, even after the publication of a 19-page ‘form of confirmation’ by the International Swaps and Derivatives Association (Isda) in 1998, these tended to be negotiated between buyers and sellers of protection on what amounted to an ad hoc basis, which inevitably opened the way for disputes between the two parties when credit events occurred. As the BIS puts it, “risk shedders appear sometimes to have been able to exploit the terms of credit derivative agreements at the expense of risk takers, insofar as payments under CDS contracts are not conditional on actual losses.” The Russian default of 1998 brought some of the disagreements between buyers and sellers of protection into the public eye. As the Bank of England explained in its Financial Stability Review, published in June 2001, one dispute arising from the Russian default concerned a short delay in payments due on the City of Moscow’s debt. “Some
Isda faces the unenviable task of trying to manage conflicts of interest between protection sellers and protection buyers market participants had entered into CDSs that did not include any specific provision for grace periods to allow for technical delays in making payment by the reference entity,” this explained. “The English courts ruled that the delayed payment was a credit event under the terms of these contracts and the protection seller should settle.” An essential breakthrough for the development of the CDS market came in 1999, when, in response to disagreements prompted by the Russian crisis, Isda published its new ‘master agreement’ designed to standardise credit derivatives contracts, formalising 14
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the guidelines on standard documentation originally published at the beginning of the previous year. One year in the making, and applicable to contracts on sovereign and non-sovereign names alike, these guidelines, according to Isda, were “developed by a working group of Isda member institutions, including most of the world’s leading participants in privately negotiated derivatives activity”. Delegates at the Isda conference in Vancouver in March 1999 were given a sneak preview of these new definitions, which were formally unveiled in July the same year. As Isda commented in 1999, the new definitions enshrined within the master agreement were “viewed as critical to the growth in demand for these types of transactions”. While these guidelines represented an important step forward for the CDS market, they did not constitute a watertight and definitive solution applicable to all developments impacting on the market. One example of a situation not decisively addressed by the Isda guidelines came in November 2000 with the demerging of the UK power company, National Power, into two successor entities, Innogy (which focused purely on the UK market) and International Power, which concentrated on business development in all other markets. According to a Fitch analysis, this demerger resulted in a question as to the identity of the reference entity in connection with a number of credit default swaps – given that the Isda definition of a successor company referred to the entity that assumes “all or substantially all of the obligations”. In a market as young, fast-expanding and open to innovation as the CDS market, it is inevitable that determining documentation standards should be a dynamic rather than a static process, and the debate over the status of a successor company provided one good example of Isda’s flexibility in redrafting its guidelines to bring more clarity and transparency to the derivatives market. In this instance, Isda released a supplement on successor events in November 2001, advising that
documentation it was replacing the “all or substantially all” language in its definitions with a numerical threshold. This would determine that if an entity succeeds to 75% or more of the bonds or loans of the original reference entity, “then the sole successor would be that entity”. The same supplement outlined alternative approaches in the event that the 75% threshold is not met. While this supplement clearly removes uncertainties regarding the specific issue of successor obligors, Isda will probably be called upon to publish many more such amendments as additional unanticipated ‘special situations’ emerge in the fastevolving CDS market. A report published by Fitch in October 2002 neatly sums up the problem that Isda has inevitably needed to grapple with in the drafting of watertight documentation standards that are universally acceptable. “In attempting to standardise documentation for credit default swaps, Isda faces the unenviable task of trying to manage conflicts of interest between protection sellers who want the narrowest possible definition of a credit event and the narrowest possible interpretation of deliverable obligation characteristics and protection buyers who need the opposite,” this explains.
Trigger events It is important to recognise that the contractual terms of credit default swaps provide no protection against ‘events’ such as disappointing earnings, rating downgrades and other market-related developments that may lead to spread widening and potential losses for bondholders. Nor, therefore, do credit default swaps provide much of a defence for investors who have simply made a poor investment decision. In broad terms, the events that will trigger a payment by sellers of protection in the CDS market include the following: ● Bankruptcy: this refers to a corporation’s insolvency or its inability to pay its debts, and is therefore the most immediately visible event that would trigger payment on a credit default spread. ● Failure to pay: if after expiration of the applicable grace period, the reference entity fails to make payment with respect to principal or interest on one or more of its obligations. Failure to pay sets a minimum dollar threshold. www.creditmag.com
● Repudiation/moratorium: if the reference
entity or government authority indicates that one or more of its obligations is no longer valid, or if the entity or government stops payment on such obligations. This provision now applies only to sovereign reference entities. ● Obligation acceleration: when an obligation has become due and payable earlier than it would otherwise have been due because of a borrower’s default or similar condition. Like failure to pay, obligation acceleration is subject to a minimum dollar threshold payment amount. ● Restructuring: this has proved to be the most thorny of the credit events originally outlined by Isda, and refers to a change in the terms of a borrower’s debt obligations that are deemed to be adverse for creditors. The sticking point here has often been defining what is or isn’t necessarily ‘adverse’ for bondholders or lenders, which has led to a lively and protracted debate (see below).
Credit event procedures In the event of one of the above developments occurring, a so-called ‘credit event notice’ will be delivered by the protection buyer, protection seller, or both, indicating that a trigger event has taken place and providing two sources of publicly available information describing the occurrence of the credit event.
The debate over restructuring Credit derivatives market terminology would suggest that credit default swaps are contracts that, by definition, provide buyers of protection with a form of insurance against default – that is to say, against the failure of a borrower in the loan or bond market to meet its interest obligations. Although that definition would appear to be clear enough, there have already been a number of well-documented cases where technical loopholes have been exploited by signatories to CDS contracts, in turn forcing a reassessment of accepted definitions among participants in the market. Perhaps the best known of these took place in September 2000, when the US life insurance company, Conseco, announced that it was planning to restructure $2.8 billion of its debt, extending the credit The ABC of CDS
15
documentation maturity of some of its loans and prompting a row between sellers and buyers of protection as to whether or not restructuring qualified as a credit event triggering payment. The squabble over Conseco led to the emergence of what many bankers described as a ‘twotier’ CDS market. One of these tiers, championed by many market participants in the US, adopted the view that the restructuring of bank loans should not represent legitimate triggers for pay-outs on CDS contracts, because restructuring did not always lead to losses for bondholders, and could therefore be unjustifiably exploited by buyers of protection at the expense of sellers. The second tier of the market, resolutely espoused in Europe, maintained that a loan restructuring should still be viewed as a negative credit development, and should therefore remain a trigger event in the terms of CDS contract documentation.
The demise of Railtrack exposed the European CDS market to one of the sternest challenges in its short history Although it may seem curious that, within a global financial services market, there are still differences in opinion about restructuring on either side of the Atlantic, there is an element of logic to this apparent schism in views. US bankruptcy laws enshrined in Chapter 11 legislation are generally much more accommodating towards troubled companies failing to meet liabilities than those in force throughout the UK and continental Europe. The result is that companies entering into restructurings triggered by Chapter 11 proceedings in the US can (and frequently do) emerge relatively speedily from the process as strong and healthy credits. The same cannot be said of companies plunging into bankruptcy in Europe, which has generally protected sellers of protection in the CDS market on this side of the Atlantic. As Fitch explained in an analysis published in October 2002: “Europe has not encountered a restructuring where protection sellers incur losses due to soft credit events, as occurred in the case of Conseco.” Following the Conseco episode, Isda published a ‘modified restructuring clause’ in spring 2001, www.creditmag.com
adding a number of limitations to the 1999 guidelines. One of these was a ‘restructuring maturity limitation’ restricting to 30 months the maturity of obligations that can be delivered following a restructuring, and therefore preventing the delivery of long-dated securities that may be trading at a discount. When the restructuring supplement was published in May 2001, Isda’s chief executive officer, Robert Pickel, announced that “the supplement represents the consensus of a diverse range of constituents in the credit derivatives market, including portfolio managers, credit protection sellers and dealers. Completion of the supplement should help to ensure market integrity, which will promote continued growth in the use of credit default swaps.”
The debate over convertibles Aside from the controversy over the impact of corporate restructuring on the CDS market, another cause célèbre revolving around the terminology of the credit derivatives market unfolded as a result of uncertainty over the status of convertible bonds (fixed-income securities convertible into equity) as deliverable securities following a credit event. In February 2003, Nomura won a landmark ruling against Credit Suisse First Boston when a High Court judge ruled that the buyer of protection (Nomura) was entitled to deliver Railtrack convertible bonds as physical settlement in respect of a CDS transaction. The controversy dated back to Railtrack’s default in October 2001 that, Nomura insisted, qualified as an ‘event’ triggering payment on a credit default contract bought by Nomura from CSFB as a hedging tool. When CSFB refused to accept the validity of this claim, arguing that convertible securities did not qualify as ‘non-contingent bonds’, Nomura exchanged its Railtrack convertibles into straight bonds, which were trading at a more expensive secondar y market level than the convertibles. Nomura was encouraged to pursue its claim when Isda expressed the view that convertibles were eligible for deliverability under the terms of the CDS agreement. The demise of Railtrack exposed the European CDS market to one of the sternest challenges in its short history, with some estimates suggesting that contracts worth in excess of £1 billion had been credit The ABC of CDS
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documentation written on the credit, which would have looked appealing to many sellers of protection because of the perception that it carried an implicit government guarantee. That the vast majority of those contracts were settled quickly and efficiently is a testimony to how far the CDS market has come in so short a time, with the Nomura-CSFB dispute very much the exception rather than the rule. For the two banks concerned in the controversy over the Railtrack CDS, the financial implications of the settlement appeared to be of much less importance than the clear precedent it established for future activity in the CDS market. “This is an excellent result for the credit derivative market and clarifies an important point of interpretation,”
Nomura announced following the conclusion of the case. “Any other decision would have risked the integrity and unity of the market; a risk Nomura was prepared to fight to avoid.” A statement released by CSFB after the ruling, meanwhile, noted that “we are disappointed by the decision, but grateful for the certainty and clarity that we hope the decision will bring to the market.” Isda had already helped provide that level of certainty and clarity in the event of similar future disagreements over CDS documentation. Prior to the settlement, it had recommended that all new CDS contracts included a clause clearly stating whether or not convertible debt would be eligible for delivery in the event of a credit trigger. ■
Key changes to Isda’s credit derivatives definitions Definition of bankruptcy as a credit event
●
Under the new definitions, a bankruptcy can now only be deemed to have occurred if the default due to bankruptcy occurs with respect to the reference entity itself. For all other credit events, the default due to the credit event can occur on any obligation. To reduce subjectivity with respect to identifying a bankruptcy, Isda has removed a clause stating that a bankruptcy can be deemed to have occurred if a company has taken any action towards, or indicated consent to, approval of, or acquiescence in a default. In the new definitions, a written admission of a company’s inability to pay its debts must be made in a judicial, regulatory or administrative filing.
●
Four choices for restructuring Restructuring as a credit event has been one of the most contentious issues in the credit derivatives market, prompting Isda to significantly recast its definitions to offer counterparties four choices when buying/selling CDS protection: ● No restructuring: This option eliminates the possibility of the protection seller incurring losses from a ‘soft’ credit event – one that does not truly constitute a default and would therefore not necessarily result in losses if the investor owned the actual reference obligation. ● Full restructuring: This option allows the protection buyer to deliver bonds of any maturity after any restructuring of debt.
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Modified restructuring: This option has been common market practice in North America since the publication of Isda’s restructuring supplement in 2001. Modified restructuring limits deliverable obligations to bonds maturing in no less than 30 months after a restructuring of debt. Modified modified restructuring: This is a new provision aimed at addressing issues raised in the European market and limits the maturity on deliverable obligations to 60 months after a restructuring of debt.
Definition of deliverable obligations The 2003 definitions allow obligations to be defined to suit the needs of the counterparties. These obligations can be: ● The direct obligations of the reference entity ● The obligations of a subsidiary entity, or “downstream affiliate”. These obligations are known as “qualifying affiliate guarantees”. To qualify as a downstream affiliate, the subsidiary’s voting shares must be more than 50% owned by the reference entity, either directly or indirectly. ● The obligations of third parties guaranteed by the reference entity, known as “qualifying guarantees”. However, these obligations are only deliverable if “all guarantees” is selected in the confirmation. ■
CDS growth
The size of the CDS market From an uncertain inception date, the credit default swap market has blossomed to become a major asset class in the capital markets. For this growth to continue and the market to reach its full potential, certain impediments will need to be removed n the early days of the credit derivatives market, pinning down precise figures for the volume outstanding in the CDS market was notoriously difficult, with trading conducted over-the-counter rather than via an exchange, and banks and other intermediaries reluctant to reveal much detail about their activity in the market. That partly reflected the fact that the CDS market originally evolved as a successor to a series of informal, privately tailored agreements between banks and their customers. Indeed, participants report that in contrast to, for example, the Eurobond market (which has a readily identifiable start date of 1963, when Autostrade launched the first Eurobond) it is impossible to pinpoint precisely when the CDS market was inaugurated. Although as recently as June 2001 the Bank of England was reporting that “comprehensive, global data [on the size of the credit derivatives market] do not exist”, it is self-apparent that information on the size, structure and historical evolution of the market is now much more readily available than it has ever been, with the British Bankers’ Association (BBA) having collated figures on the sector since the mid-1990s. According to that data, the global credit derivatives market was worth $180 billion in 1997. Thereafter it expanded rapidly, to $350 billion in
I
Growth in credit derivatives
No survey conducted
5000 $ billions
4000 3000 2000 1000 0 1997 1998 1999
2000 2001 2002
Source: British Bankers’ Association
www.creditmag.com
2003 2004
1998, $586 billion in 1999, $893 billion in 2000 and $1,189 billion at the end of 2000. Historically, according to the BBA figures, so-called single-name CDSs have comprised the largest share of the overall credit derivatives market, although their share fell from 52% in 1997 to 45% in 2001, reflecting the increased diversification and sophistication of the market. In addition to the absolute figures, the BBA compiles statistics giving important insights into which market participants are the most active in terms of buying and selling protection, as well as forecasts on the outlook for the market.
The most actively traded CDSs are on reference entities that are also the most prolific issuers in the cash bond market Other valuable sources of information on the size of the credit derivatives market are Isda itself and the Office of the Comptroller of the Currency (OCC) in the US, which “charters, regulates and supervises national banks to ensure a safe, sound, and competitive banking system that supports the citizens, communities and economies of the United States”. The OCC started to compile data on the credit derivatives positions of US commercial banks in early 1997, and its statistics put the modest size of the credit derivatives market into vivid perspective. According to its third-quarter review published in December 2002, “86% of the notional amount of derivative positions was comprised of interest rate contracts with foreign exchange accounting for an additional 11%. Equity, commodity and credit derivatives accounted for only 3% of the total notional amount.” According to the BBA’s 2001/2002 analysis, London continues to be the dominant centre in the credit The ABC of CDS
19
CDS growth global credit derivatives market, well ahead of New York and the fragmented Asian financial centres, with a limited amount of trading taking place in Tokyo and Sydney. In terms of market share, the BBA advises, London accounted for 49% of the global market in 2001. It forecasts that the London credit derivatives market will grow to $2,450 billion by the end of 2004, giving the City a global market share of about 51%.
Trends in underlying assets Since the emergence of the credit default swap market in the mid 1990s, there has been a noticeable shift in the types of assets on which protection has been sought. According to the BBA, in 2001 only 15% of products were written on sovereign assets, down from 46% in 1996 when it first conducted the survey. “The vast majority of credit derivatives are now written on corporate assets, with 60% of credit derivatives written on the asset class in 2001,” the BBA noted. “This
trend is expected to continue in 2004.” That trend, of course, reflects the vastly increased size of the corporate bond market since the mid1990s, as well as the deterioration of credit quality that gathered momentum between 1996 and 2001, prompting lenders and investors to seek increased levels of protection. More specifically, research published in March 2003 by rating agency Fitch identifies the most actively traded CDS as being for reference entities that are also the most prolific issuers in the underlying cash bond market, but in which the probability of default is remote in the extreme. According to the Fitch data, the most commonly cited reference entities among respondents to its survey were General Motors, DaimlerChrysler, Ford, General Electric and France Télécom. Beyond these credits, bankers confirm that the diversification of corporate names being traded in the CDS market is on the rise. As a report published by Dresdner Kleinwor t Wasserstein
By-products of liquidity If it is indeed the case that the CDS market is now more liquid than the cash bond market in a number of sectors or individual credits, this implies that pricing in the CDS market provides a more reliable bellwether of credit quality than the cash market. By extension, the CDS market ought to emerge as a more reliable benchmark than the cash market for the pricing of bonds in the primary market. One caveat to this argument is that as the universe of players that have access to the CDS market is smaller than it is in the cash market, volatility can be more acute in the former. Nevertheless, there is little if anything to suggest that other potential guides to fair value in the bond market are more accurate than the CDS market, with the rating agencies often maintaining investment-grade ratings on companies which, according to the CDS market, are heading rapidly towards non-investment grade territory – making them so-called ‘fallen angels’. Pricing in the loan market can also, in theory, be used to assess fair value in the bond market. In practice, however, it is broadly agreed
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that the reliability of the loan market as a pricing indicator for the bond market is seriously flawed. This is chiefly because, in spite of pressures on banks’ capital, loans are seldom priced strictly in accordance with their risk profile. Instead, pricing is based on a bank’s relationship with the borrower and on the ancillary flows of business that the bank believes will flow in more profitable market segments as a result of maintaining that relationship. If there is a negative side effect of the liquidity in the CDS sector, as far as many investors are concerned it is the degree to which the success of the CDS market is now reducing liquidity in the cash market. That can clearly create difficulties for investors who are restricted to investment in the cash bond market and unable to participate in credit derivatives.
Indices and index-based products Solutions, however, are increasingly being provided for those investors unable, for whatever reason, to trade directly in the CDS market. Even for those that may be free to participate in the
CDS growth (DrKW) in November 2002 notes: “According to our credit derivatives desk, around 500 credits, mostly investment grade, are now actively traded.” The same report adds that “the industry distribution is relatively even, with industrials the dominant sector followed by financial services and banks”. This degree of relative diversification within the CDS market in Europe is in marked contrast to the underlying cash market, in which a handful of industries continue to account for a disproportionately high share of the most actively followed benchmarks. For example, according to the figures published by DrKW, as of late 2002, outstanding bonds issued by telecoms companies accounted for 20% of the iBoxx euro corporate bond index, but for only 5% of outstanding CDSs; for autos, the shares were 14% and 4% respectively; and for banks, 20% and 6% respectively. Conversely, while at the same date industrial issues accounted for only 8% of the iBoxx index, they represented 20% of the CDS market.
market, many manage portfolios that may be too small to make direct participation practical. As one investor told Credit in November 2002, while the typical size of a CDS contract is between $5 and $10 million, an institution’s exposure to any given credit might only be in the $1–$5 million range, meaning a CDS contract is too large for hedging the bonds. As this particular investor put it: “Unless you have a large portfolio or a concentrated one then you can’t use them.” Index-based products are being developed to address this particular shortcoming, making the CDS universe more accessible to managers of smaller credit positions. For example, in March 2002, JPMorgan announced the launch of a new European credit index-linked security with the acronym of Jeci. As JPMorgan explained at the time: “The new security, based on 100 of the most actively traded names in the European credit markets, provides investors for the first time [with] the ability to conveniently buy and sell a diversified universe of European credits. The first of its kind, Jeci-100 (pronounced Jessie) is a five-year tradable instrument that can be issued in funded, unfunded, fixed or floating form.”
www.creditmag.com
Growth prospects In its third-quarter review for 2002, the Office of the Comptroller of the Currency reported that the notional amount of credit derivatives reported by insured commercial banks increased by more than 16%. That is a very appreciable rate of growth, and would appear to support the estimates of those who believe the global market will continue to expand at breathtaking speed over the next few years. One of those forecasts, made by the BBA, is that the total market will reach what it describes as a “staggering” $4.8 trillion by 2004. That rate of growth, advises the BBA, could become even more dramatic if and when various uncertainties and legal impediments to the market’s expansion are removed. “Regulatory uncertainty, for instance over the outcome of the Basel II negotiations, constitutes one of the major constraints to the growth of the credit derivatives market,” noted the BBA.
Targeted predominantly at portfolio managers, banks and hedge funds, Jeci is constructed on a rules-based approach by which the 100 most liquid issuers (75 corporate names and 25 financials) are selected from the cash market, with each component weighted to reflect the sector and rating allocation of the cash bond market. The availability of index-based products was further expanded in February 2003, when Deutsche Bank and ABN Amro launched and priced the first two new issues of a family of CDS products linked to the iBoxx indices. The headline iBoxx 100 Note reflects the performance of the top 100 names in the iBoxx euro-denominated corporate index, weighted by their durationadjusted market capitalisation. The iBoxx 100 Corporate Component Note, meanwhile, strips out financial issuers and is made up of the 62 pure corporate names in the iBoxx 100 Note. Both products are in the form of €500 million floating rate notes (FRNs), with both Deutsche Bank and ABN Amro committed to quoting two-way markets for trades up to €50 million at a bid-offer spread of 5bp “under normal conditions”. ■
credit The ABC of CDS
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CDS growth For the time being the jury is out on how the Basel II guidelines on bank capital will affect the credit derivatives market. The principal element of Basel II is that it will impose a risk weighting of 20% for assets rated triple-A to double-A, 50% for those with a single-A rating, 100% for triple-B to double-B rated assets, 150% for those rated below double-B and 100% for unrated assets. The proposed new guidelines, which the BIS describes as being based on a “more risk-sensitive framework”, are intended to “leave the total capital requirement for an average risk portfolio broadly unchanged”. How much of an impetus these measures will have on encouraging participants in the credit market to search for more protection on their exposure is open to question. However, bankers point out that in sharp contrast to, say, the market for interest rate and currency swaps, the potential for the addition of new reference entities in the credit derivatives market represents what is almost a bottomless pit, given that CDSs can be written on any borrower in the bond or loan markets, and that the universe of issuers is constantly expanding.
Liquidity In the immediate aftermath of the Enron crisis at the end of 2001, while liquidity in the cash bond market dried up dramatically, activity in the CDS market remained resilient. Bankers reported that, in turn, this strength in the CDS market helped liquidity to return to the cash market more quickly than would otherwise have been the case, given derivatives’ capacity to allow traders to express long and short views on individual credits. The liquidity and transparency of the CDS market has improved dramatically over recent years as an increasing number of intermediaries have entered the market, quoting indicative two-way (bid and offer) prices for the more actively traded corporates and sovereigns on their websites, as well as on electronic data vendor screens. While those spreads are frequently much wider than those quoted on the underlying cash market, the availability of transparent prices is an important step forwards for the CDS market. The transparency of the market has also been substantially enhanced by credit derivatives brokers such as GFI, which was founded in 1987. GFI’s 22
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credit derivatives data collection includes traded levels as well as bid and offer prices for sovereign and corporate entities from all regions and market sectors. The data is made up of almost 300,000 price points across 1,700 reference entities dating back to 1997, and is made available to subscribers via a web-based portal. “By nature, our credit default swap data provides a forward insight into credit trends before most other indicators,” GFI explains. “This can be used to mitigate credit risk, measure market concentration risk in credits, industries and companies, and maintain a daily market perspective on credit quality across a wide universe of names. In contrast,
After Enron, liquidity in the cash bond market dried up but liquidity in the CDS market remained resilient most other methods rely on historic rates of recovery…and are therefore backward looking and do not reflect current market trends.” Another helpful initiative in terms of liquidity and transparency was the launch of Mark-It Partners in 2001. At launch, the firm explained that “the demand for definitive, transparent credit information is intensifying. Until now, finding data that combines accuracy, range and ease of use has been impossible.” Mark-It describes its service as one that is “revolutionising credit pricing”. The firm offers a “ground-breaking credit pricing concept that offers a total on-line solution for today’s market”.
Understanding the basis The difference between the CDS market price and the credit spread on cash bonds is known as the ‘default cash basis’ or the ‘default swap basis’ – and this ‘basis’, which in the majority of cases is positive, can and does vary appreciably depending on a range of technical and fundamental market circumstances. As a result, exploiting the difference between CDS and cash bond prices, known as ‘trading the basis’, can be a highly effective arbitrage strategy and has become especially popular among hedge funds. ■
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market indicators
The ability to ‘trade rumours’ The credit default swap market has rapidly become recognised as one of the most responsive financial indicators, in some cases foreshadowing even the equity markets. From Ahold to WorldCom, the CDS market has priced concerns in long before other asset classes It is often said that CDS prices are a very telling indicator of the credit quality of their reference entities. But the closeness of the relationship between CDS prices and trends in underlying credit quality is much less frequently proven, even though a cursory retrospective glance at pricing histor y in the CDS market demonstrates ver y clearly that credit derivatives can act as an early warning signal for credit deterioration. By the same token, of course, they can serve as an equally helpful barometer of an improving credit climate for individual reference entities.
Anticipating bad news Historical evidence suggests that the CDS market can anticipate rating downgrades with sometimes uncanny accuracy. In the corporate sector, take the example of the US natural gas company, El Paso. The cost of five-year CDS protection on El Paso more than doubled between September 12 and September 23, 2002, from 575 basis points to 1,250bp. On September 24, Moody’s confirmed what the CDS market had anticipated, putting the company on review for downgrade. Two months later, El Paso was downgraded from Baa3 to B2. Equally striking, in 2001, was the CDS market’s capacity to foretell negative rating action on the US retailer Gap, not once but twice within a few months. In May 2001, CDSs on Gap’s five-year dollar bonds were being offered at just 50bp. Between September 6 and October 11, with the market unsettled by slowing sales, this price leapt from 87bp to 180bp, with Moody’s announcing that it was putting the company on review for downgrade on October 12, subsequently lowering Gap’s rating to Baa2 on October 29. A fortnight later, on November 8, there was another sudden spike in the price of Gap’s CDSs, from 250bp to 315bp within a single trading session. Three days later Moody’s announced a further review for downgrade. Similar trends are clearly detectable in the banking sector, with the behaviour in October 24
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2002 of CDSs on Commerzbank’s five-year euro bonds providing an illustrative example. Within the first week of that month, CDS protection on the troubled German bank almost doubled, from 110bp to 215bp. On October 8, Standard & Poor’s downgraded the bank’s rating from A to A-. At the time, S&P cited Commerzbank’s “further weakened business and risk profile, as the prolonged economic downturn will cause further delays in restoring the bank’s core profitability and improving its capital strength in the medium term.” Although equity markets are generally supposed to discount developments such as this, it is clear that in this instance the CDS market acted as a more reliable indicator of market sentiment, with the Commerzbank share price plunging by more than 7% in response to the S&P announcement, to its lowest level since 1996.
Anticipating good news On a more positive note, the CDS market can also function as an accurate litmus test of the market’s perception of changes in corporate management or strategy leading to an improvement in credit quality. A good example here is provided by the heavily indebted France Télécom, which at the start of October 2002 appointed a new CEO in the form of Thierry Breton, who was well-respected in the market as a specialist in corporate turnarounds. CDS traders clearly responded positively to Breton’s appointment and to the de-leveraging strategy he announced soon after his arrival. Between October 10 and November 1, the offered price of the CDSs on France Télécom’s five-year euro bonds almost halved, from 500bp to 260bp. Again, this trend foreshadowed other key market developments: in December, Moody’s confirmed its Baa3 rating on France Télécom with a stable rating, while between mid-November and the middle of January, the spread on the company’s benchmark 2011 bond fell from 360bp to 264bp over swaps.
market indicators
Inevitably, the CDS market is less effective in predicting sudden credit events, such as the bombshell released on February 24 by Dutch retailer Ahold, which rocked all securities markets when it announced that it had been massively overstating its profits in the previous two years, leading to the resignation of its CEO and finance director. On that day, Ahold’s equity market value collapsed by 63%, while the price of the CDSs on its five-year bonds more than doubled, from 215bp to 500bp. The following day, Moody’s downgraded the company. Probably more revealing than the performance of Ahold’s CDSs on February 24, however, was what the credit derivatives market had been saying about the company over the months leading up to the revelations of February 2003. In this instance, clear and protracted misgivings among CDS traders are detectable over the credit quality of the company which, even after a $5.8bn acquisition spree in the US in 2000 and 2001, was still trading in the 50s at the start of April 2002. Thereafter, the CDS price rose dramatically, marked up from 65bp in early May to 140bp in July. That month, Ahold revised its target of a 15% growth in EPS to a rise of between 5% and 8% – a target which, later in the year, was further revised downwards to minus 6% to minus 8%. July 2002 also saw an announcement from Moody’s that it was putting Ahold on review for a possible downgrade, and in the months that followed, the price of CDSs on Ahold continued to rise, breaking through the 200bp level in early October. The most dramatic movements in the recent behaviour of CDS prices, however, have tended to be those that have preceded bankruptcy, with WorldCom in the US providing a graphic illustration. In June 2001, investors were able to buy protection for their exposure to WorldCom in the CDS market at just 60bp in spite of the company’s mounting debt pile; by early 2002, WorldCom had some $29bn of debt outstanding, much of which was accounted for by a record-breaking $11bn bond it had sold in May 2001. www.creditmag.com
5000 4000 3000 WorldCom (1$bn, 7 7/8% 2003) 2000 1000 0 January
February
March
April
May
Av. yearly cost of CDS protection on $10m of WorldCom debt Insufficient trading
Sudden actions
WorldCom bonds lag behind Spread over government
In other words, the CDS market anticipated both the action of the rating agencies and the performance of France Télécom’s benchmark bonds in the secondary market.
$1,000,000
$500,000
January
February
March
April
May
Source: GFI / Merrill Lynch
A key warning sign for investors in all classes of WorldCom securities came when the company unveiled surprisingly poor revenue and earnings figures on Friday, April 19, 2002. Between the following Monday and Wednesday, its $4bn 7.5% 2011 bonds nosedived from 83 cents in the dollar to 59 cents. Poor sentiment spread across the broader telecoms sector over the following week, with AT&T’s bonds, for example, widening by some 150bp in the fortnight following the WorldCom results. The decline – predictable in hindsight – in WorldCom’s credit quality had been clearly reflected in the price of the credit default swaps on its five-year dollar bonds, which rose from 225bp in early March to 700bp on April 19. On April 23, the day on which Moody’s downgraded the company from A3 to Baa2, bids were put through for WorldCom’s CDSs at 1,000bp, 1,100bp and 1,150bp, and by the end of April, when CEO Bernie Ebbers resigned, they were offered at 1,500bp. By early May, WorldCom’s 2011 bonds were changing hands at 43 cents in the dollar, although by now the CDS market was clearly anticipating the company’s decline into non-investment grade territory, with its CDSs quoted at more than 2,000bp. Towards the end of June, WorldCom continued to shock investors when it announced a $3.9bn accounting fraud. By that time any liquidity in the company’s CDSs had dried up completely, with no trades recorded by GFI after mid-May. ■ credit The ABC of CDS
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market participants
Buyers and sellers of CDSs Greater regulation on the extent to which banks are exposed to corporate clients has meant banks have eagerly adopted credit default swaps to transfer risk, however concerns have been expressed in certain quarters about where the transferred credit risk is going nsurprisingly, commercial banks are the largest players in the CDS market. According to figures compiled by the British Bankers’ Association (BBA), banks accounted for 52% of the protection buyers market and 39% of the protection sellers market in 2001. The BBA expects both these shares to drop by 2004, to 47% and 32% respectively. That would still make banks dominant in the market for protection buying, but in terms of protection selling they would be overtaken by insurance companies, the share of which will remain steady at 33% in 2004 – identical to their share in 2001, according to BBA forecasts.
U
Benefits for banks For banks, one of the most important benefits of credit derivatives in general – and credit default swaps in particular – can be traced back to 1988 and the publication of the Basel Capital Accord which forced many lenders to reappraise the size of their exposure to corporate borrowers, many of whom would have been long-standing customers. For lenders, this presented an obvious conundrum: how could they reduce their exposure (or simply
In many instances loan documentation prohibits lending banks from passing their exposure on to third parties leave their exposure static) to borrowers with whom they had developed close links dating back many decades without seriously jeopardising those relationships? The CDS market provides a valuable solution to that dilemma. For banks with limits on their credit lines to individual borrowers, the credit default swap market is an effective means of transferring risk on outstanding loans without physically removing assets from the balance sheet. Granted, there are alternative means of offloading these assets via, for 26
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example, the secondar y market for syndicated loans. But in the European loans market, secondary trading has yet to take off in a meaningful way. Even if there was a liquid and flourishing market for secondary loan trading in Europe, in many instances loan documentation prohibits lending banks from passing their exposure on to third parties in this way. And even if documentation includes no clause preventing a lending bank from subsequently offloading a facility, the process of selling loans in the secondary market can be one that entails considerable legal and administrative costs for the banks involved. The most powerful incentive for lending banks to use the CDS market as a means of transferring the risk on their loan books, however, is that it allows them to do so without the knowledge of the borrower. This in turn allows them to free up additional lending lines for prized customers that may be very important sources of ancillary business in, say, corporate finance. Alternatively, CDSs can be used as a means of reducing banks’ concentration in individual industrial sectors or geographical regions. Use of the CDS market can therefore help banks to promote as well as to maintain their client relationships, allowing them to open up new credit lines that might otherwise have remained closed.
Room for growth Even though commercial banks are the most active participants in the CDS market, it should be noted that even in the US, where the credit derivatives market is most developed, the market remains dominated by a handful of the largest banks, with JPMorgan, Citibank and Bank of America accounting for the lion’s share of activity. According to OCC statistics compiled in the second quarter of 2002, fewer than 400 of the 2,200 institutions under its supervision held credit derivatives. That suggests that there is room for considerable growth among bank users of the market in the US.
market participants In Europe, according to a report released in March 2003 by the rating agency Fitch, banks have been net buyers of protection via the credit derivatives market to the tune of some €65bn, although only about 30% of European banks active in the market are protection buyers. The report observed that German Landesbanks have become very active players in the CDS market, largely as sellers of protection, although they are by no means alone in this respect. “The conventional view is that banks are primarily net buyers of protection,” the Fitch report notes. “Nearly three-quarters of the banks surveyed are net sellers. The banks are using credit derivatives as an integral part of their revenue-generating business, enabling certain European banks to diversify by gaining exposure to regions and sectors where they are underweighted.” Other sources confirm that European banks’ overall use of the CDS market remains limited, but is growing rapidly. According to a report published in
A number of commentators, have voiced misgivings about banks’ poor disclosure of their precise exposure to credit derivatives January 2003 by the working group established by the BIS Committee on the Global Financial System: “Although the scale of their current involvement in CRT [credit risk transfer] differed greatly across the banks interviewed by the Working Group, almost all stressed its importance and expressed their intention to step up their activities in this area.” However, the same report adds that in total, “the number of institutions actively involved across the range of CRT markets remains quite limited at present. While, for example, the use of ABSs has become more widespread within the banking industry of some countries, the number of institutions using CDSs on any scale is still relatively small.” A number of commentators, including the rating agencies, have voiced misgivings about banks’ relatively poor disclosure of their precise exposure to the credit derivatives market. For example, an analysis of the annual reports of 30 banks in 10 countries by the BIS working group found that none of these www.creditmag.com
made “comprehensive disclosures”. That, adds the report, “may give grounds for concern”.
Conflicts of interest Another cause for concern about the role played in the CDS market by commercial banks that are active participants in the syndicated lending market is the potential for conflicts of interest among these lenders. Some newspapers have alleged that Chinese walls between banking and trading desks have been broken, with lenders privy to much more comprehensive information about their borrowers than investors in the capital market or sellers of protection in the CDS market.
Investment banks Investment banks are also active participants in the CDS market, both as providers of liquidity for their customers and as proprietary traders. The CDS market can offer a highly efficient means of removing assets from the balance sheets of investment banks, an objective that has become more and more important in recent years as the leading investment banks seek to offer a ‘one-stop shopping service’ to their corporate clients. Given the relatively limited size of investment banks’ capital, the CDS market provides them with a useful means of demonstrating their commitment to corporate clients by supporting syndicated lending facilities without exerting unsustainable strains on their balance sheets.
Insurance companies and other investors Insurance companies’ participation in the CDS market, predominantly as sellers of protection, is on the up. While many insurance companies will provide protection as writers of single-name default swaps, they are also active in the market as buyers of CDOs and credit-linked notes (see page 28). It is impor tant, however, to dif ferentiate between the different types of insurance companies active in the CDS market. Life assurance companies, for example, act as an impor tant source of investor demand for ABSs and CDOs. US monoline insurance companies, meanwhile, are pivotal players in the CDS market, often as sellers of credit protection on the senior (or socalled ‘super senior’) triple-A rated notes in structured portfolio transactions. credit The ABC of CDS
27
market participants
Source: Credit survey
28
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Basis trade
Already use
Pricing information
28% No (able to trade CDSs within 12 months)
Would use
20 18 16 14 12 10 8 6 4 2 0
Diversification
16% No (able to trade CDSs within 24 months)
22% Yes
What do you/would you use CDSs for?
Exposure to a basket or index
34% No (don’t know when able to trade CDSs)
But the response to the survey suggested that there is a high awareness of the value of the CDS market even among those institutions that are not yet active in the sector – 10 of the 32 respondents, for example, said that they use the CDS market as an indicator of where prices may be heading in the underlying cash market. In the words of one investor: “We do use CDSs for research purposes, and as the market is more efficient than the cash market, it is a good indicator of where a credit is moving.”
Exposure to a single name
Does your mandate allow you to trade CDSs? If not, when do you expect to be able to use them?
For all but the largest institutional investors, recruiting experienced teams of derivatives experts remains prohibitively expensive
Hedging
A number of insurance companies prohibited from entering into derivatives transactions directly, meanwhile, have addressed this problem by establishing subsidiaries known as ‘transformers’ functioning largely as sellers of credit protection, based in offshore locations, with Bermuda the most popular in this respect. Other mainstream institutional investors, such as pension and investment funds, are less active players in the credit derivatives market. In part, this is because a substantial number of institutional investors in Europe are unable to trade credit default swaps, maybe as a result of direct regulatory prohibition or a lack of the necessary back-office infrastructure or expertise. Demand for skilled credit derivatives technicians comfortably outstrips supply, explaining why derivatives specialists are now among the best-paid professionals in financial centres such as London. For all but the largest institutional investors, recruiting experienced teams of derivatives experts remains a prohibitively expensive exercise. The German Banking Act, for example, restricts German mutual funds from using credit derivatives, while swap contracts and over-the-counter derivatives also remain legally out of bounds for mutual funds in a number of Scandinavian economies. An exclusive survey of 32 credit asset managers in Europe, the results of which were published in the October 2002 edition of Credit,
offered valuable insight into the extent to which fund managers remain restricted from trading CDS contracts. From the survey’s respondents, 22% indicated that they were permitted to invest in CDSs under their current investment mandates, while 28% said that although they were not yet allowed to trade CDSs, they expected to be able to do so within the next 12 months. A further 16% expected to be active in the market within two years, with the remaining 34% unsure as to when they would be free to trade CDSs.
Number of votes
Barriers to involvement
Source: Credit survey
market participants From some other respondents to the same survey, however, came some outspoken criticism of the CDS market. One UK investor felt that “the CDS market does not have any sound economic reason for us to invest in it,” and that “it is not cheap enough. The bid-offer is too wide and the banks rip you off.” However, that seems to be a minority view and it is probable that as the CDS market develops and matures, reservations such as these – already dismissed by intermediar y banks as anachronistic – will recede.
Flexibility for investors Among those investors that are allowed to trade CDSs, perhaps one word sums up most comprehensively the benefits afforded by the market: flexibility. For example, the CDS market has proved to be an especially useful means of taking a bearish position on any individual issuer in the bond or loan market, allowing market participants to go short of credit risk by buying protection using CDSs.
CDSs allow you to trade on a rumour, something that the illiquid bond market and static loan market do not As one market participant points out: “CDSs allow you to trade on a rumour”, something that the illiquid bond market and static loan market do not. But there are numerous other examples of flexibility enjoyed by investors in the CDS market. As Goldman Sachs advised in a report published in May 2001: “Investors who employ default swaps enjoy the flexibility to structure the terms of their investment, including maturity, recovery, call features and coupon type. Default swap overlays provide an efficient tool to reposition an existing bond or loan portfolio – either short or long term – to reflect changing risk requirements or to take advantage of market opportunities.” Nevertheless, mutual funds accounted for just 2% of the market for protection buyers in 2001, according to BBA data, with pension funds accounting for 1%. Both these shares are expected to rise to 3% by 2004. www.creditmag.com
One group of investors that has become markedly active in the credit default swap market in recent years is hedge funds, with the BBA reporting that these funds accounted for 12% of the market for buyers of protection in 2001, a share that is expected to increase marginally to 13% by 2004. In the market for protection selling, the hedge funds’ share is expected to rise from 5% to 7% over the same period.
Alternative means of access for investors For those investors that are still unable to trade credit default swaps directly, a number of proxy products have been developed by intermediary banks allowing for them to enjoy many of the benefits of exposure to the CDS market. For example, in Februar y 2003, JPMorgan announced the launch of Credit Elect, a new derivative trading platform designed for investors unable to trade CDSs outright, “either for regulatory, credit or infrastructure reasons”. Credit Elect is a synthetic balance sheet which provides these investors with a liquid and flexible trading platform actively to manage a portfolio of CDSs. According to JPMorgan: “Credit Elect enables the investor to build and trade a diversified credit portfolio based on the wider universe of names that trade in CDS format. The investor has the ability to go long and short the market in funded format, and trade the basis between CDSs and bonds, loans and equity.”
Other buyers of protection risk Theoretically, CDSs can be used by a number of organisations outside the confines of the financial services industry. Corporates, for example, might use the credit default swap market as a means of insuring themselves against trading with potentially risky commercial counterparties – be it suppliers or customers. In Europe, however, corporate use of the CDS market appears to have remained muted. According to a Bank of England report: “Judging from the Bank’s regular contacts with UK companies and market intermediaries, corporate involvement in the credit derivatives market remains limited to a handful of large multinationals. Intermediaries do, however, see potential for a number of applications as the market matures.” ■ credit The ABC of CDS
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new structures
CDSs as building blocks Credit default swaps are no longer purely used as a form of insurance for lenders or an alternative method of gaining exposure. Their commonality and tradability has allowed people to create new and innovative financial products his guide has focused principally on the singlename default swap, which is commonly described as the ‘building block’ for a number of other products – chiefly for portfolio-based ones such as collateralised and credit-linked instruments, which have become increasingly important products in recent years. In a collateralised obligation of any form, an investor is provided with exposure via a single security to a pool of assets, which may be made up of loans (in a collateralised loan obligation, or CLO), bonds (in a CBO) or, more recently, funds (in a CFO). Securities that are collateralised by a combination of these assets are known more generally as collateralised debt obligations (CDOs), although it has become increasingly fashionable and convenient to use this term to describe the entire asset class. More recent innovations have been the development of collateralised synthetic obligations (or CSOs, described in more detail below), and of CDOs in which the asset pool is made up of other CDOs. Recognisable to plain vanilla bond or equity investors as the equivalent of funds of funds, these are now known as CDOs squared.
T
CDOs were originally a US invention used principally as a means of repackaging high-yield or ‘junk’ bonds An essential and common element of all collateralised obligations is that the asset pool is transferred from the originator to investors via a special purpose vehicle, or SPV. An SPV may equally well be described as a ‘single’ or ‘only’ purpose vehicle: it does not take deposits, lend or invest money, or provide consultancy services of any kind. Its sole purpose is to isolate asset pools from the originator, ring-fencing those assets in such a way as to ensure that their credit quality is to a certain degree 30
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divorced from that of the originator. This explains why SPVs, the majority of which are serviced by skeleton administrative staffs and domiciled in taxefficient offshore locations, are usually described as being ‘bankruptcy remote’.
Collateralised debt obligations CDOs were originally a US invention used principally as a means of repackaging high-yield or ‘junk’ bonds in the late 1980s, with the first recorded transaction generally believed to have been a CBO launched by Kidder Peabody in 1989. The rationale underpinning the expansion of CBOs backed by pools of high-yield bonds in the US in the late 1980s was that they provided investors with exposure to large, diversified portfolios of bonds. That in turn allowed them to access a popular and rapidly expanding asset class without assuming the level of risk that would inevitably have been associated with exposure to single-name issuers. Since the early CDOs, which repackaged higher yielding bonds, the same mechanism has been applied to a broad range of other assets, including asset-backed securities, bank-preferred shares emerging market securities and derivatives products. In a conventional CDO, pools of assets are transferred from an originator to an SPV, removing ownership of the assets from the balance sheet of the originator, which is usually (but by no means exclusively) a bank. The regulatory capital relief achieved as a result of this transfer of credit risk has often been the principal motivation for banks’ release of assets via the conventional CDO market. A typical CDO is structured to appeal to the broadest possible spectrum of investors by offering them a number of differently rated tranches, ranging from low risk triple-A rated notes through to the highest risk equity tranche generally referred to as the ‘first loss’ piece and usually accounting for around 10% of the CDO’s total value. In this way, a hierarchy of cashflow payments to investors is
new structures established – sometimes known as the ‘cashflow waterfall’ – with this process of subordination forming the basis for what is commonly referred to as ‘credit enhancement’, or the provision of added security for investors. The precise details of this subordination structure are clearly set out in the offering circular for each CDO issue. There are a number of other mechanisms aimed at providing credit enhancement for investors in the CDO market, such as the creation of surplus cash reserves from note proceeds that can be earmarked as first loss protection for investors. In the US market, additional credit enhancement for CDO investors frequently takes the form of so-called ‘wraps’ by triple-A rated monoline insurance companies, although this is much less common in Europe.
Constructing a CDO Constructing a CDO is a very detailed exercise involving extensive interaction between its managers and rating agencies, investors and legal counsel. The complexity of this process depends on the nature of the assets gathered together within the CDO. The phase during which the collateral or reference assets of a CDO are accumulated is referred to as the ‘ramp-up period’, which will typically last
between 60 and 180 days after the closing date, although in some European CDO transactions, the ramp-up period has been longer. The year in which a CDO was originally ramped up is known in future years as the ‘vintage’.
Pricing a CDO The price of CDOs in the primary market is usually linked to Libor or, more recently, to Euribor, with pricing based on the rating of each individual tranche. As a recent example of the typical tranching of prices within a CDO, take a transaction such as the Jazz 2 CDO launched in December 2002 by Axa Investment Managers, offering leveraged exposure to a portfolio of principally investment-grade corporates and asset-backed securities. In this €756m structure, the triple-A rated class A notes were priced at three month Euribor plus 75bp, with the doubleA class B tranche offering Euribor plus 115bp. The two class C pieces, both rated A-, were priced at a 220bp spread, while the class D notes, also rated A-, were set at six month Euribor plus 375bp. CDOs generally trade at cheap levels relative to corporate bonds of the same rating, which has prompted some market participants to speak of the ‘free lunch’ available to investors in the CDO market.
Issuers in the CDO market: a brief history According to figures published by the Bond Market Association, total outstanding volumes in the CDO market in the US rose sharply in the middle of the 1990s, from $1bn in 1996 to $19bn in 1997, $48bn in 1998, $85bn in 1999, $125bn in 2000 and $167bn in 2001. European issuance, meanwhile, rose from $42bn in 1999 to $114bn in 2001. The UK’s NatWest Bank is accredited with kick-starting the evolution of the European CDO market in 1996 with its Rose Funding CLO transaction, which was a $5 billion securitisation of more than 200 corporate loans designed to free up credit lines. The landmark CLO deal in Europe in 1998, however, was a Deutsche Bank securitisation of over 5,000 loans to some 4,000 companies worth a total of $2.4 billion (Core 1998–1), which at the time represented the largest number of corporate loans ever packaged together in a European CLO.
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Meanwhile, 1999 saw the process of European banks transferring credit risk through CLOs gathering impressive momentum, with debut transactions from leading banks such as Société Générale, Crédit Lyonnais and Banque Paribas of France, and Italy’s BCI. While banks have spearheaded issuance in the CDO market for readily identifiable reasons, they have not been the only constituents to put the instrument to good effect. In May 2000, Deutsche Bank’s asset management arm, DWS, launched a privately placed €318m CDO, largely intended as a means of expanding its business scope by bringing in new sources of investment cash. Later the same year, Axa Investment Managers launched its first CDO backed by highyield bonds, while other fund management companies to launch CDOs have included M&G, Henderson Global Investors, Pimco and others. ■
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new structures The main reason explaining the price differential between CDOs and comparably rated corporate bonds is the much greater liquidity available in the cash bond market. There is virtually no secondar y market for lower-rated and equity tranches of CDOs, which tend to appeal to buy and hold investors. There is more liquidity in the higher-rated tranches of CDOs, although this is generally confined to transactions arranged by banks on a so-called ‘reverse enquiry’ basis. Reverse enquiry refers to
Collateralised synthetic obligations have quickly become an important part of the European landscape the process by which investors approach banks or issuers with specific details of securities tailored to their specific requirements.
Collateralised synthetic obligations The high liquidity levels in the CDS market have given rise in Europe to the rapid evolution of CDOs that are backed not by cash bonds or loans, but by credit default swaps. These are known as ‘synthetic’ CDOs or collateralised synthetic obligations (CSOs), and have quickly become an important part of the European landscape. While the assets remain on the originator’s balance sheet in a CSO, the credit risk does not. By ver y logical extension, if the regulator acknowledges that the risk of exposure to credit has been removed from the originator’s balance sheet, it stands to reason that the transaction should allow the originator to achieve regulatory capital relief. This technique has become especially popular among continental European banks, with German Landesbanks, for example, active users of the synthetic CDO market as a means of transferring large blocks of lumpy and illiquid credit risk through portfolios of shipping or aircraft loans, or commercial real-estate exposure.
CDO credit quality and product development Although CDOs are bankruptcy remote from their originators, this does not mean that they are immune from credit deterioration. Far from it. 32
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The ratings of CDOs remain inextricably linked to the credit performance of the underlying reference entities within the CDO, and are therefore hostage to declining credit quality in the global credit market. A study published by Moody’s in February 2003 found that between 1991 and 2002, CDOs had an “extremely high downgrade rate (10.9%) and a very low upgrade rate (0.6%)” which, the agency explained, is “primarily due to the extraordinary number of downgrades and defaults in the corporate bonds that underlie these securities”. Declining credit quality in the market has encouraged extensive adaptation and innovation among issuers and managers of CDOs. “The susceptibility that some earlier synthetic CDOs have shown to negative rating action has not led to the demise of the product,” explained an analysis published in November 2002 by Dresdner Kleinwort Wasserstein (DrKW). “But waning investor demand has prompted banks to look more closely at how transactions are structured,” continues the report. “As a result, we are seeing structural evolution and a new generation of deals has begun to emerge. These structures seek to address the weaknesses of their predecessors and incorporate features designed to make them more robust in the current environment.” Specifically, the DrKW repor t added, this development has led to the emergence of static por tfolios that are much more granular and diverse in their construction. It has also encouraged the more frequent use of structures in which reference portfolios are much more actively managed – “the theory being that a good manager can avoid the downgrades and defaults that might occur in a static deal and thereby potentially outperform.”
CDO volumes In 2002, according to figures published by Standard & Poor’s, publicly rated CDO volumes (including CBOs and CLOs), fell by 5% to end the year at $51.4 billion, compared with $54.3 billion in 2001. In the publicly rated domain, according to the same source, a total of 116 transactions closed in 2002 compared with 62 in the previous year, while the average transaction size fell to $0.5 billion compared with $0.8 billion in 2001. An
new structures important caveat to these figures, S&P pointed out, was that “a number of large, privately rated, pure synthetic CDO transactions were executed over the course of 2002,” which were not included in the agency’s statistics. According to S&P, “this masks the true size of the market and understates its real growth.” “Publicly rated volumes for 2002 were relatively flat, but a privately rated, synthetic market existed in tandem,” said S&P. “Privately rated, synthetic issuance using credit derivative technology will continue to drive the CDO market in the year ahead as more and more European originators seek cost-effective platforms to manage balance sheet objectives….An increased number of originators are taking this route as the structures can realise greater flexibility in terms of risk management.” This anticipated expansion in synthetic structures, added S&P, will inevitably place an increased emphasis on the quality of the collateral manager, with only a small number of European managers having extensive CDO experience. “Managed synthetic CDOs require the involvement of a collateral manager that understands the intricacies of combining CDO techniques with the credit default swap market,” S&P said. “The expertise of trading desks at large financial institutions in the credit default swap market makes them strong candidates for both structuring and managing synthetic CDOs in particular.”
Credit-linked notes A credit-linked note (CLN) is a structured note combining both a debt instrument and a CDS. As research published in September 2002 by DrKW puts it, a CLN can be thought of as a note with an Growth in the US CDO market 180 160 140 120 100 80 60 40 20 0
embedded CDS, or as a collateralised CDS with the investor receiving a payoff that is dependent on the performance of one or more reference credits. If a credit event on one of the reference credits occurs, redemption for the CLN investor is equal to par minus the loss on the defaulted credit. “This is the basic design,” said the report, “but a CLN can be structured with additional features according to investor requirements. It could be principal protected, meaning the investor is repaid par at maturity regardless of whether a credit event has occurred or not. A credit event would simply mean that the coupon stops being paid. Alternatively it could be structured with coupon protection instead. Other variations include linking a CLN to credit spreads rather than credit events as
CLNs can provide investors prohibited from investing directly in CDSs with an effective means of accessing exposure to the market such, or referencing it to an equity or a commodity index.” Clearly, then, a large attraction of CLNs is their extreme flexibility and adaptability to suit a broad range of investors and to cater to a wide spectrum of circumstances. Theoretically, CLNs look and behave like bonds and are typically structured in one of two ways. In a euro medium-term note (EMTN) CLN the note is issued directly by a bank or corporate, exposing the investor to the credit risk of the issuer and the reference credits. In a SPV CLN, the notes are issued by a special-purpose vehicle and reinvested in toprated collateral – generally triple-A rated government bonds or, in the case of German issuers, triple-A Pfandbriefe (bonds collateralised by public sector loans or mortgages).
Pros and cons
$1bn
1997 1996
1997
1998
Source: Bond Market Association
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1999
2000
2001
CLNs owe much of their popularity to their capacity to open up a much broader range of opportunities for investors in at least three ways. First, for those that are constrained by ratings considerations, they can offer exposure to lesser rated assets (or to unrated assets) via a triple-A instrument. Following the Mexican financial crisis in 1995, for example, notes were structured to allow investors credit The ABC of CDS
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new structures
34
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Does your mandate allow you to invest in CLNs?
28% Yes (and do)
56% No
16% Yes (and do not) Source: Credit survey
corporate loans into publicly tradable instruments, non-listed companies gain indirect access to capital markets.” According to KfW, meanwhile, “German investors in particular, but also investors from other European countries and Japan, value the CLNs as a diversified, high-yield investment product.” Theoretically, given that they are constructed to look and behave like bonds, CLNs can be traded actively in the secondary market. In practice, trading in CLNs is patchy in the extreme. Indeed, a survey of investor attitudes towards the credit derivatives market published in Credit’s October 2002 issue found that 56% of respondents are not allowed to invest in CLNs and a further 16% choose not to. Illiquidity in the market was highlighted by 45% of respondents as the main reason they did not invest in CLNs. ■
What benefits do you see in CLNs? CLN users
12
CLN non-users
10 8 6 4 2
Increase yield
Specify risk parameters
Create portfolio without mismatches
Hedging
0 Find credit quickly
Number of votes
unable to invest directly in the country to express a bullish view on Mexico’s longer term prospects via the CLN market. Second, CLNs can provide investors prohibited from investing directly in credit derivatives with an effective means of accessing exposure to the market. And third, CLNs can give investors exposure to assets that might not otherwise be accessible to them – either because they are sourced from a borrower that has not issued securities in a format or maturity they can buy, or because the assets referenced in the CLN are too small, fragmented or illiquid. A good recent example of securitisation programmes that combine all three of these advantages are the Promise and Provide platforms, initiatives launched by Germany’s 100% state-owned development bank, Kreditanstalt für Wiederaufbau (KfW), which is rated triple-A and which enjoys an explicit guarantee of its existing and future obligations from the Federal Republic of Germany. As a zero-weighted borrower, KfW has increasingly been seen by international investors as an effective proxy for German government bonds (Bunds). Via these programmes, fragmented portfolios of loans to small and medium-sized companies (SMEs) or residential mortgages are bundled together by KfW, with the risk transferred to a special purpose vehicle which then transfers some of that risk to the capital market through the issuance of tranched credit-linked notes. KfW is paid a fee for its intermediation services by the originating bank which, according to KfW, need not be a German entity. Promise (the acronym for KfW’s Programme for Mittelstand Loan Securitisation) was launched in December 2000, with IKB Deutsche Industriebank the first to use the platform as a means of securitising almost 2,300 loans to small businesses worth €2.583 billion. As IKB Deutsche Industriebank explained soon after its second Promise deal, “thanks to this CLO transaction, IKB, acting in co-operation with KfW, has succeeded in structuring a large number of unrated Mittelstand loans into individual tranches, and then having them rated separately. The resulting risks will be placed with German and international investors. These investors would otherwise have no opportunity to invest in Germany’s medium-sized companies, few of which turn directly to the capital market for their financing needs… By transforming conventional
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conclusion
Risks to the system With the credit default swap market developing at exponential rates, are the doommongers justified in their concerns?
T
his guide has focused exclusively on the evolution, structures and benefits of the market for credit default swaps – of which there are clearly plenty. As with any relatively new product, however, widespread concern has been expressed about the broad credit derivatives market, and those concerns appear to be mounting rather than receding, with Warren Buffet, for one, famously describing derivatives as financial weapons of mass destruction in March 2003. Most market analysts attributed Buffet’s diatribe to his personal unhappy experience with derivatives. But a number of far more objective observers have also expressed reservations over the development of the CDS market. For example, in a survey of potential banana skins facing banks, published in February 2002, the London-based Centre for the Study of Financial Innovation (CSFI) identified “complex financial derivatives” as the fourth most worrying threat on the horizon for the banking industry – up from tenth in 2000. That, explained the CSFI at the time, “reflects sharpening concern about credit derivatives, which are increasingly seen as a potential rogue product, little understood and capable of transmitting risk to all sorts of unwitting parts of the financial system.” Others within the financial services industry have also expressed wider concerns about the apparent opacity of the market, with a report published by Fitch in March 2003 calling for “increased transparency in the credit derivatives market” and for the need to “achieve a better understanding of financial institutions’ total net credit derivative exposure”. In making that call, the rating agency seemed to be echoing the misgiving voiced by a spokesman for the UK financial regulator at a seminar in September 2002: “We acknowledge the credit risk is transferred away through the use of credit derivatives, but we still want to know where it ends up.” Certainly there have been instances in which banks have publicly acknowledged the perils of overexposure to the credit derivatives market. In June 2001, for example, US financial services group
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American Express, announced that it had incurred substantial losses on its investments in CDOs. Perhaps more important, its chairman was quoted at the same time as very frankly conceding that the group “did not comprehend the risk” of the CDO exposure it had built up during the 1990s. At a wider level, however, a number of influential commentators have expressed their satisfaction with the way in which the credit derivatives market is helping to disperse risk in the financial services sector. An IMF Global Financial Stability report has advised that “particularly as the markets mature and grow over time, credit risk transfers have the
Credit risk transfers have the potential to enhance the efficiency and stability of credit markets overall potential to enhance the efficiency and stability of credit markets overall and improve the allocation of capital. By separating credit origination from credit risk bearing, these instruments can make credit markets more efficient. They can also help to reduce the overall concentration of credit risk in financial systems by making it easier for non-bank institutions to take on the credit risks that banks have traditionally held.” Scepticism has been articulated in some quarters that the credit derivatives market would be unable to withstand the pressures exerted by multiple defaults and an economic crisis. But even against the backdrop of a very weak global macroeconomic climate exacerbated by accounting scandals and characterised by plummeting credit quality, the CDS market appears to have proved its resilience and efficiency. Many agree that the losses sustained as a result of defaults ranging from Argentina to Enron and WorldCom were all minimised as a direct consequence of the expansion of the credit derivatives market, which has helped to disperse the concentration of risk highly effectively. ■ credit The ABC of CDS
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index A Ahold 24, 25
International Power 14 International Swaps and Derivatives Association (Isda) 14, 15, 17, 18, 19
B Bank for International Settlements (BIS) 6, 9, 14, 22, 27 Bank of England 9, 14, 19, 29 Bankruptcy 12, 15, 17, 18, 25, 30, 32 Banque Paribas of France 31 Basel I & II 6, 21, 22, 26 BBA 19, 20, 21, 26, 29, 35
J Jazz 2 CDO 31
K Kidder Peabody 30
M C Cashflow waterfall 31 CDO 13, 27, 30, 31, 32, 33, 35 CLO 30, 31, 32, 34 CSO (Synthetic CDO) 30, 32 Commerzbank 24 Conseco 15, 17 Convertible bond 17, 18 Credit enhancement 31 Crédit Lyonnais 31 CRT 9, 27 CLN 13, 33, 34 CSFB 17, 18
Managed synthetic CDO 33 Mark-it Partners 22 Master agreement 14 Modified restructuring clause 17, 18 Monoline insurance 27, 31
N National Power 14 Nomura 17, 18
O Obligation acceleration 15 Office of the Comptroller of the Currency (OCC) 19, 21, 26
D DaimlerChrysler 20 Default swap basis 22 Default cash basis 22 Deutsche Bank 13, 21, 31 DWS 31
P Promise and Provide 34
R
El Paso 24 EMU 6
Railtrack 17, 18 Ramp-up period 31 Repudiation/moratorium 15 Restructuring 15, 17, 18 Rose Securitisation (NatWest) 31
F
S
Failure to pay 15 First loss 30, 31 First-to-default basket 13 France Télécom 8, 20, 24, 25
Special purpose vehicle (SPV) 31, 34 Synthetic CDO (see CSO) 30, 32
E
T Total return swap 13
G Gap 24 GFI 22, 25
V
I
W
IMF 35 Innogy 14
WorldCom 12, 25, 35 Wraps 31
36
credit The ABC of CDS
Vintage 31
