loan-only credit default swaps

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1 Orrick, Herrington & Sutcliffe LLP is an international law firm with approximately 900 lawyers located in Europe, North America and Asia. We focus on complex and novel finance and innovative corporate transactions as well as antitrust, litigation and arbitration disputes. To support the demands of its clients, Orrick has made seamless client service its number one goal across the firm. European lawyers can call on the substantial resources of Orrick s other offices around the world to provide clients with the expertise required loan-only credit default swaps about orrick to support their transactions. The firm focuses on transactional matters (including the full range of sophisticated finance and corporate transactions) and litigation (including employment, intellectual property, securities, and commercial disputes). In addition to advising a wide array of public companies, Orrick acts for virtually every major investment bank. transactional litigation Structured Finance Outsourcing and Technology Product Liability Litigation Leveraged Finance Transactions Securities Litigation Mergers and Acquisitions Energy and Project Finance Intellectual Property Capital Markets Bankruptcy and Debt Restructuring Commercial Litigation Public Finance Investment Funds White Collar Defence Compensation and Benefits Real Estate Employment Law Emerging Companies Real Estate Finance International Dispute Competition Banking and Finance Resolution Tax e u ro pe beijing h o n g ko n g london milan los angele s shanghai m os cow n e w yo r k pacific nort h we s t silicon vall e y n o rt h a m e r i c a pa r i s ta i p e i tokyo rom e o ra n g e co u n t y s ac ra m e n to wa s h i n g to n d c s a n f rancisco orrick, herrington & sutcliffe a sia loan-only credit default swaps martin bartlam and karin artmann

2 Loan-Only Credit Default Swaps MARTIN BARTLAM KARIN ARTMANN 2006

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4 Table Of Contents Introduction to Loan-Only Credit Default Swaps 5 The Documentation for Loan-Only Credit Default Swaps 11 Loan-Only Credit Default Swaps and Basis Risk 21 3

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6 Introduction to Loan-Only Credit Default Swaps What is an LCDS? An LCDS is a credit default swap (CDS) where the underlying is a syndicated secured loan rather than any other asset class (e.g. bonds (corporate or sovereign), unsecured loans, asset-backed securities, etc). Even in the fast-growing derivatives market (total notional amount valued at approximately US$283 trillion for the first half of 2006 of which US$26 trillion relates to credit derivatives) this is a product which is set to have a significant impact on the financial market. An LCDS is a contractual arrangement pursuant to which one party (protection seller) promises the other party (protection buyer) to take on the risk of default or non-performance (Credit Event) usually Failure to Pay, Bankruptcy and sometimes Restructuring - of a specified entity (Reference Entity) in respect of its obligations under an underlying asset or a portfolio of assets (Reference Obligation(s)). Following the occurrence of a Credit Event and the satisfaction of certain pre-determined conditions (Credit Event Notice, Notice of Physical Settlement (NOPS) (if any) and Notice of Publicly Available Information (if any)) (Conditions to Settlement), the protection seller is required to make a payment to the protection buyer in accordance with a pre-determined formula. If the LCDS stipulates Physical Settlement - the protection seller pays an amount equal to the notional amount (i.e. the amount of the Reference Obligation to be covered by the LCDS) (Notional Amount) multiplied by the reference price (Reference Price) which is usually 100%, against delivery by the protection buyer of an obligation with pre-determined characteristics (Deliverable Obligation). If Cash Settlement is stipulated - the protection seller pays the protection buyer an amount equal to the Reference Price minus the recovery rate on the Reference Obligation following the Credit Event (Final Price) multiplied by the Notional Amount. In return for the protection offered, the protection buyer promises to pay the protection seller a fixed premium at pre-determined intervals up to the termination date of the LCDS (Termination Date). It may all sound like insurance but it is not the contract is based on a formulaic pay out on the occurrence of certain pre-determined events and does not require the protection buyer to own the assets for which protection is provided, nor to have suffered a loss. Derivative contracts are generally concluded on the standard 1992 or increasingly the 2002 Master Agreement as amended and supplemented by a Schedule (together, ISDA Master) each as published by the International Swaps and Derivatives Association, Inc. (ISDA). Pursuant to the terms of such ISDA Master, the parties can enter into any number of transactions each of which will be documented by a confirmation which incorporates the 2003 ISDA Credit Derivatives Definitions as amended and/or supplemented from time to time (Credit Derivatives Defi nitions). This sets out the specific terms of each such transaction and any amendment and/or supplements to the ISDA Master. Template forms of LCDS documentation have been prepared for the US LCDS market and were published by ISDA on 8 June Template forms of LCDS documentation in draft form have been prepared for the European market and were last circulated by ISDA on 2 May

7 Periodic payments under CDS prior to a Credit Event. Protection Buyer Premium Physical Settlement of a CDS following a Credit Event Protection Buyer Deliverable Obligation Notional Amount x Reference Price Cash Settlement of a CDS following a Credit Event Protection Buyer Reference Price Final Price x Notional Amount Protection Seller Protection Seller Protection Seller 6

8 What are the motivations of participants in the LCDS market? LCDS provide the same general benefits as plain vanilla CDS for bonds, namely, to short credit positions for hedging and speculation, to create synthetic long credit positions as an alternative to long cash or loan positions and a combination of long/short portfolio strategies. It is however important to recognise features of the structure of the LCDS that can lead to pricing and return differences compared to the underlying cash instrument. Before examining these aspects in more detail, it is helpful to have a look at the motivations and market forces that relate to the development of LCDS. European LCDS and US LCDS are, strictly speaking, not comparable instruments or at least, a strict comparison is not necessarily particularly helpful. The reason for this is that the LCDS in the US was designed as a trading product whereas European LCDS was created to provide banks with a hedging product. The difference in approach may arise from the fact that institutional investors which tend to dominate the US market use LCDS to make a return as part of a particular investment strategy whilst in Europe, the development of the European LCDS is being driven by banks which are still the main users of the products. As originators of syndicated secured loans, banks are focused on ways to manage their loan books and reduce regulatory capital, particularly in light of the introduction of Basel II which potentially increases capital charges for certain classes of syndicated secured loans. The US LCDS is documented to facilitate liquidity in the market, looking at the creditworthiness of the Reference Entity generally. This enables both sides of the trading market to trade the product effectively and efficiently to generate income. US LCDS have, e.g., no Restructuring Credit Event or Cancellability. This makes the US LCDS a more commoditised product. The US LCDS as we shall see later does not end following the repayment, redemption or other discharge in full of the underlying syndicated secured loan. Whilst this makes perfect sense in a trading context where the derivative is somewhat de-linked from the underlying cash instrument, it is less useful in the end-user market context where participants seek to hedge and/or gain exposure to the actual cash instrument, i.e. look through the Reference Entity to the underlying syndicated secured loan. The latter strategy requires the LCDS to more or less behave like the underlying cash instrument. Whilst the LCDS will never do so perfectly, the desire of end-users is to obtain as good a match as possible. This desire has to be weighed up against the need of participants in the trading market to find sufficient liquidity to be able to supply the end-user market with the hedge/protection products that they require. This tension between the end-user market and the trading market is stimulating discussion and negotiation in the European, particularly the London market, and the outcome will shape the final form of the European LCDS. One view is that the European markets will go for a compromise by using the non-cancellable LCDS but quote for the cancellable LCDS as well. This would take the form of an additional premium to be funded upfront in respect of the prepayment risk of the Reference Obligation. 7

9 What are market forces behind the growth of LCDS? There are four main factors behind the growth of LCDS: (1) rapid growth in the syndicated secured loan market driven by a surge in leveraged buy-outs; (2) the introduction or anticipated introduction of standard industry-wide documentation, syndicated secured loan specific indices and the focus of financial services providers on the syndicated loan market; (3) new business opportunities and the need to refine lending activities to maximise returns following the introduction of regulatory requirements such as Basel II and (4) the activities of certain market participants such as hedge funds and the managers of collateralised loan obligations (CLOs). Growth in syndicated secured lending in leveraged buy outs Syndicated loan volumes have skyrocketed on both sides of the Atlantic in recent years. Global issuances reached a level of approximately billion in 2005 and were, by September 2006, already at about 328 billion for the year. Syndicated secured loans make up over one-third of total US syndicated lending. The growth of non-bank lenders is changing the nature of the loan market, with CLOs and hedge funds now consuming the bulk of leveraged loan paper. Even though still small in comparison to bond trading volumes, secondary loan market activity is growing steadily as is the junior debt or second-lien/mezzanine market both in Europe and the US. The holder of a first lien retains priority over the collateral securing a syndicated secured loan which is shared with a second lien holder who in turn retains priority over any third lien holder or any other subordinated debt holders or unsecured creditors to the extent of the available collateral. Whilst market activity in the secured loan market is increasing, European syndicated secured loans are considered a highly attractive asset class with traditionally high historic recovery rates (depending on the relevant jurisdiction s attitude to debtor/creditor protection) and such assets are therefore closely held by existing market participants. Unless an investor obtains access to these loans as part of a syndicate or in the secondary market, the only other way to obtain exposure is synthetically, through an LCDS. Standardised industry-wide documentation and loan indices The new ISDA standard documentation is already existing in the US and is being developed for European LCDS. Whilst the loan credit default swap index LCDX in the US (to contain 100 names) is still awaiting launch, the senior index itraxx LevX Senior Index, which comprises 35 equally weighted LCDS referencing first lien loans launched on 30 October. Its other component, the itraxx LevX Subordinated Index comprising 35 equally weighted LCDS referencing second and third lien loans launched on 13 November, Both, standard documentation and the introduction of indices will further improve the trading infrastructure for LCDS and help liquidity, as the experience with indices and index-linked products in the CDS market and a trading volume of US$1.3 billion on the launch date of the itraxx LevX Senior Index has shown. 8

10 The benefit of indices is that they enable investors to utilise their investment resources more efficiently by increasing, amongst other aspects, transparency. itraxx LevX will be split into senior secured (fi rst-lien) and senior subordinated (second-lien and third-lien) debt with about 35 credits in each categories comprising the most liquid high yield European corporate names ranked by trading volumes based initially on dealer polls. The constructor of the LCDX index, CDS Index Co., is also working with DTCC (a matching service providing a solution for derivatives post-trade processing) to introduce operational efficiency in the LCDS market. This has already been introduced in the CDS market through DTCC and T-Zero (system enabling investment banks and their clients to affirm derivatives trade details and incorporate accurate data to support all downstream operational processes). Using the T-Zero platform in conjunction with DTCC and the more recent link-up with Thunderhead (document generation platform for over-the-counter derivative trade confirmations) gives dealers the ability to produce paper documentation and match derivatives trade confirmations in real-time, reducing both operational costs and risks. Other contributors to market efficiency are companies such as Markit Group Limited, a provider of independent pricing, reference data, portfolio valuations and over-the-counter derivatives trade processing for financial and commodities markets. New regulatory standards The recent dramatic growth in credit derivatives has partly been generated by banks desire to shift risk off their balance sheets to comply with international regulatory standards. With new capital rules for banks coming in next year, the most obvious buyers of LCDS protection (provided the LCDS has a scheduled maturity date of one year or more) may well be banks, since Basel II is designed to better match the capital that banks are required to hold with the risks that they take. Banks return on capital may suffer in some cases unless they hedge more of their loans, particularly high yield loans for which risk weightings will increase. Attitudes of CLO managers and hedge funds The attitude of CLO managers and hedge fund managers themselves in working with synthetic structures to improve efficiency and flexibility may also prove to be a significant factor in expansion of the LCDS market. Although CLO managers have taken to include in their CLOs synthetic buckets for unfunded CDS exposure, such buckets still seem to be unused or under-used. Some of the major advantages of LCDS to CLO managers is the quicker access to a large pool of syndicated loan exposures which will speed up the construction of CLOs through shorter or no warehousing periods and increase diversification of synthetic CLOs compared to cash CLOs. LCDS also provides a route into markets with regulatory restrictions and banking monopoly laws for unregulated hedge funds and managers. The absence of the need to get borrower consents and not having to deal with withholding tax requirements on the underlying asset should also speed up access for CLO managers. CLO managers will, however, have to deal with the lack of information they receive relative to a holder of the underlying cash instrument. As we shall see later (see Syndicated Secured Dispute Event ), public information on syndicated secured loans is very thin on the ground in the European markets. Most information is private and only available to syndicate members and other indirect investors in such loans. Market participants investing in such loans synthetically will not have access to such information. In spite of the limits to information available in the syndicated loan market, many CLO managers are believed to be looking to take 9

11 advantage of the efficiency and flexibility the market will provide. The greatest restraint currently is a lack of liquidity. Many CLO managers may remain on the sidelines until we see the development of a more liquid market. There has been an explosive growth in hedge fund linked structured products but the move of hedge funds into structured credit products has been even greater. In the US, hedge funds now control approximately 30% or US$210 billion of high yield trading volume, 26% or US$234 billion leveraged trading volume, 30% or US$2.5 trillion of credit derivative trading and an estimated 80% of all distressed debt trading. The current picture in Europe is very different with banks still making up more than half of the market in syndicated secured loans. This seems to be changing though. Hedge funds are big purchasers of equity, other subordinated tranches of CLOs and asset-backed securities and are very active in credit derivative markets as buyers and sellers of protection. Given the volumes, they are increasingly able to influence not only pricing but also the structure of credit products, and are becoming a major force in the capital markets. 10

12 The Documentation for Loan-Only Credit Default Swaps On 8 June 2006, ISDA published, for use in connection with US LCDS, the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement (LCDS Supplement) which incorporates the Credit Derivatives Definitions. In addition, ISDA published a template confirmation for use with the LCDS Supplement (LCDS Confi rmation). The LCDS Confirmation will, in the case of US LCDS be used to document particular transactions and any amendments to the ISDA Master and the LCDS Supplement. Documentation for European LCDS is still in draft form. The last discussion draft of the General Terms Confirmation for Credit Derivative Transactions on Syndicated secured loans (Syndicated Secured Loan Terms), annexing the Loan Transaction Supplement (Supplement) was circulated by ISDA on 2 May A revised draft is expected to be circulated very shortly. In the absence of a European industry-wide standard, some European market participants are using documentation such as the trade confirmation developed by Morgan Stanley for use with European syndicated secured loans. The more salient features of both sets of LCDS documentation are set out below. The discussion of the European LCDS is based on the currently available ISDA draft of 2 May Callability/Cancellability Callability is a feature that is common for syndicated secured loans, particularly in Europe where, with the exception of the junior or second lien loans, generally no hard call protection applies. Even in the case of junior or second lien loans call protection is limited to an initial lock-up period of one year or so and/or pre-payment penalties for the first few years. Callability refers to the ability of a Reference Entity to pre-pay or refinance a loan in accordance with its terms prior to the final maturity of such loan. It enables the Reference Entity to get out of a loan in times of falling interest rates or if the Reference Entity has improved its financial position and is therefore able to obtain a better deal on spreads by reducing the premium over e.g. LIBOR or EURIBOR compared to the existing spread. European LCDS terminate or cancel upon redemption, repayment or other discharge in full of the Reference Obligation. This achieves a match between the loan exposure and the hedge of the associated credit risk, at least for syndicated secured loans or tranches of such loans which have bullet repayment. If a loan is amortising, this has no effect per se on the LCDS (unless standard terms are amended) since the Notional Amount of the LCDS is fixed on inception of the contract. US LCDS do not terminate upon redemption, repayment or other discharge but are subject to substitution in such circumstances. The substitution process (see Substitution below) built into US LCDS ensures that these contracts are not so cancelled. They can however be called (in whole only) prior to the Scheduled Termination Date through optional termination (Optional Early Termination Date) at the election of either party on or after a 30 Business Day period after the effective date 11

13 of a search notice (Search Notice) delivered by the Calculation Agent provided one of the following conditions have been satisfied: no substitute Reference Obligation is identified as at the Optional Early Termination Date; or the identification of a Substitute Reference Obligation has not, by the Optional Early Termination Date, become binding on the parties as to the Syndicated Secured characteristic because aspects of the Secured Syndicated Secured Dispute have been completed by such date. Whilst the US approach is more desirable for a trading protection seller, given that the premia on the LCDS continue for the duration of Reference Obligation to the original maturity date and because the protection seller keeps any upside at times of declining credit spreads, it does not allow for the matching of exposure and risk. It is to be seen whether the European markets adopt the US-style substitution mechanism and opt for a non-cancellable LCDS. If it does, one of the issues that will need to be resolved is how the dealer poll (see Syndicated Secured Dispute Event below) in connection with substitution (see Substitution below) under the US LCDS would work in the European market. This is intrinsically linked to the issue of private versus public information which market participants have in syndicated secured loans. Whilst in the US basic information (which is sufficient for investors in senior tranches but may not be sufficient for investors in the lower tranches) on the structure of syndicated secured loans and their tranches is publicly available on information services such as Loan Connector, the European loan market is much more private with respect to information. Information is only available to lenders of record and, subject to confidentiality agreements, prospective investors who are proposing to take on direct or indirect rights in the loan in the secondary market. Although the revised draft of the European LCDS is due for circulation shortly (and will include Cancellability), the debate on Cancellability is far from over. Restructuring This Credit Event, in the form of Modified Modified (as compared to the US where bond CDS use the form of Modified Restructuring), is adjusted for European LCDS by the addition of the following wording: or (vi) any security, guarantee or other collateral relating to one or more Reference Obligations is released or discharged and as a result thereof any security, guarantee or other collateral relating to one or more Reference Obligations (taken as a whole) is materially diminished (including, without limitation, a waiver of any mandatory prepayment provisions following a disposal of assets), as determined by the Calculation Agent in consultation with the parties. The rationale for the addition of the above language is to reduce moral hazard. The inclusion of Restructuring in European LCDS is, as we have seen, one of the concessions granted to the end-users for which this product has been created. Restructurings are common in the leverage loan market and whilst they may not always adversely affect the holder of a syndicated secured loan (e.g. increase in the spread in return for an extended repayment schedule) they certainly have a fairly high level of uncertainty attached and lenders wish to cover such risk through credit protection. The inclusion is, for the same reason, not particularly desirable for the protection seller since Restructuring is fraught with subjective interpretation and moral hazard (why should 12

14 a protection buyer cooperate in a restructuring that would adversely affect its rights when it has protection against such event?) and, in addition, is more likely to be easily triggered in the leverage loan market due to the above-referenced tendency to restructure loans frequently. Following the occurrence of a Credit Event and the satisfaction of the Conditions to Settlement) the buyer of protection can deliver any Deliverable Obligation stipulated in the LCDS whose maturity is not longer than the maximum of that implied under the Restructuring and the longest available tranche prior to the Restructuring. In the case of US LCDS, no Restructuring Credit Event applies even though it applies for US bond CDS. Whilst this is likely to lead to wider spreads on European LCDS compared to US LCDS (to compensate the protection seller for the additional risk), the inclusion makes the European LCDS more valuable to the protection buyer since it enables it to efficiently and effectively reduce regulatory capital usage provided the conditions of Basel II relating thereto are satisfied. Basel II introduces higher-risk categories, such as claims on corporate borrowers rated below BB-, which will be weighted at 150 per cent. This may include syndicated secured loans. Besides a multitude of other conditions, full regulatory capital relief under Basel II is only applicable if Restructuring is included in the derivative instrument. If it is not, then, provided the other relevant conditions of Basel II with respect the derivative instruments are satisfied, only partial recognition of the credit derivative will be allowed. If the Notional Amount of the CDS is less than or equal to the notional amount of the Reference Obligation, 60 per cent. of the amount of the hedge can be recognised as covered. If the Notional Amount of the CDS is larger than that of the Reference Obligation, then the amount of the eligible hedge is capped at 60 per cent. of the Notional Amount of the Reference Obligation. Reference Obligation For European LCDS the Reference Obligation is all tranche or facility of a syndicated loan of the Reference Entity in existence at the trade date (Trade Date) of the LCDS or as otherwise stipulated in the Supplement. This commonly means the first-lien of a syndicated secured loan but can also be the second-lien or third-lien of a syndicated secured loan. In addition, the Reference Obligation can be comprised of any new tranche (New Tranche) of the Reference Entity which is made available after the Trade Date in accordance with the applicable credit agreement whereby such New Tranche has to rank at least pari passu with the Reference Obligation(s) exiting on the Trade Date (Existing Tranches) and if such Existing Tranches are guaranteed, secured or otherwise collateralised, the New Tranche must benefit from an equal or better ranking guarantee, security or collateral as the Existing Tranches. Finally, a Reference Obligation can be a credit facility with an undrawn commitment which has not been permanently reduced or cancelled. In contrast, the Reference Obligation for a US LCDS is a loan or tranche of a Reference Entity (a) specifically specified as Reference Obligation or (b) specified by stipulating Secured List, in which case it is a loan with a Designated Priority specified, with respect to any day, in the Relevant Secured List (Relevant Secured List). The Relevant Secured List is published by Markit Group Lim- 13

15 ited (or its successor) and available from its website. It is worth noting that the Reference Obligation specified under (a) has to be, unless specifically excluded, a Loan (as defined under the Credit Derivatives Definitions) of the Reference Entity with the Designated Priority on any given day set out in the Relevant Secured List (if any on such day). In summary, the US LCDS is more restrictive in the choice of Reference Obligation because of the requirement of Designated Priority which does not apply to European LCDS where the Reference Obligation can be the entire syndicated loan or a specific tranche thereof. Deliverable Obligation The Deliverable Obligation for European LCDS is the Reference Obligation and any senior obligation which is secured by a security interest over the same assets as secure one or more Reference Obligations and benefits from the same or equivalent guarantees or other collateral as one or more Reference Obligations and in all material respects, ranks senior to the Reference Obligation, as determined by the Calculation Agent (Senior Obligation). This means that the protection buyer can, to satisfy its delivery obligation under Physical Settlement, deliver an obligation which is a higher ranking tranche of the Reference Obligation. Whilst this is a more expensive option, it provides flexibility for protection buyers with a synthetic long position in circumstances where it can not or not fully source the required amount of the Reference Obligation but it holds or can obtain a more senior tranche of the Reference Obligation. A Senior Obligation includes undrawn facilities which if drawn would be a Borrowed Money (as defined in the Credit Derivatives Definitions) obligation of the Reference Entity. A Deliverable Obligation can have funded and unfunded facilities provided however that (a) Delivery of Undrawn Commitments is not excluded in the Supplement and (b) the total commitment under the Deliverable Obligation (i.e. unfunded and funded amount) must be specified in the NOPS even though it is acknowledged that such amounts may change prior to delivery. The Deliverable Obligation for a US LCDS is Loan (as defined in the Credit Derivatives Definitions), i.e. any obligation that satisfies the Deliverable Obligation Characteristics which include, but are not limited to, Syndicated Secured, i.e. any obligation (including a contingent obligation) arising under a syndicated loan agreement with a Designated Priority or a priority senior thereto. The Syndicated Secured characteristic disregards any collateral securing the chosen Deliverable Obligation, any subordination of such obligation to other obligations of the Reference Entity and any lien or protection in respect thereof granted or to be granted under the US bankruptcy code or similar insolvency proceedings. If the Deliverable Obligation has a priority which is higher than the Designated Priority it is eligible for deliver provided however that the factors listed in the previous sentence will equally be disregarded. In addition, the protection buyer can deliver Participation Loans which are Participations, Subparticipations or the Assignment of Participations (each as defined in LSTA Rider) pursuant to which the protection buyer can create for the protection seller certain contractual rights to payments (for European LCDS see Settlement below). Revolving facilities can also be delivered provided however that the aggregate of the outstanding principal balance (i.e. the funded and unfunded portion) of all Deliverable Obligations (including such revolving facilities) in the relevant currency equivalent (if denominated in one or more currencies) does not exceed the Physical Settlement Amount. 14

16 Although the US LCDS appears to provide more choice in the selection of the Deliverable Obligation as compared to the European LCDS, the choice under the US LCDS may in practice be relatively restrictive since the Deliverable Obligation needs to have the Designated Priority. Substitution of the Reference Entity The Reference Entity in a European LCDS is any person from time to time a borrower (or otherwise entitled to the benefit of any credit), guarantor, obligor or other surety under or in respect of the Reference Credit Agreement (as defined in the Syndicated Secured Loan Terms). The Successor provisions of Section 2.2 of the Credit Derivatives Definitions are disapplied. Whichever entity is from time to time a borrower etc. is the Reference Entity. If there is none, this would mean that the Reference Obligation has been repaid, redeemed or otherwise discharged in full and the European LCDS would terminate. For US LCDS the Reference Entity is stipulated in the LCDS Confirmation and the Successor provisions of Section 2.2 of the Credit Derivatives Definitions will apply with an amendment to the Relevant Obligation definition in Section 2.2(f) thereof which ensures that such Relevant Obligation satisfies the Syndicated Secured characteristic immediately prior to the Succession Date by reference to the Relevant Secured List or if none, the determination of the Calculation Agent (which is subject to the Syndicated Secured Dispute Resolution). Substitution of the Reference Obligation or Deliverable Obligation For European LCDS Section 2.30 of the Credit Derivatives Definitions is disapplied, i.e. there is no substitution of the Reference Obligation once it is repaid, redeemed or otherwise discharged in full. This goes hand-in-hand with the Cancellability feature of European LCDS. In contrast, US LCDS have a very elaborate substitution mechanism which seeks to ensure that the LCDS is only called as a last resort. The substitution mechanic relies on Section 2.30 of the Credit Derivatives Definitions with modification to clauses (a) and (b) thereof. If: Secured List is stipulated and the Relevant Secured List is withdrawn; or the Reference obligation stipulated in the Confirmation: - is repaid in whole or terminated with unfunded commitments having been repaid in full, in the opinion of the Calculation Agent (a) the Reference Obligation is materially reduced by any unscheduled redemption or otherwise or (b) the Qualifying Guarantee of an Underlying Obligation is no longer valid and binding and enforceable in accordance with its terms or (c) the obligation is no longer an obligation of the Reference Entity other than as a result of a Credit Event; or - in the opinion of the Calculation Agent such Reference Obligation fails to satisfy the Syndicated Secured characteristic, the Calculation Agent will, in each case, upon request by either party to the LCDS or upon the effective delivery of a Credit Event Notice, deliver a Search Notice which stipulates that the Calculation Agent has commenced its search for a substitute obligation (Substitute Reference Obligation). The Substitute Reference Obligation 15

17 has to satisfy the Syndicated Secured characteristic and be a Loan of the Reference Entity Upon completion of the search, the Calculation Agent will issue an Identification Notice which will identify the Substitute Reference Obligation. The choice of such obligation is, absent obvious or manifest error or a Syndicated Secured Dispute. Event, binding on the protection buyer and the protection seller as to the Syndicated Secured characteristic. It is worth noting that if the Reference Obligation changes following the initial publication of the Relevant Secured List or due to a change in the existing Relevant Secured List, this will not trigger substitution of such Reference Obligation. Syndicated Secured Dispute Event and Syndicated Secured Resolution European LCDS have no dispute resolution mechanism and do not need one since there is no substitution of the Reference Obligation. This contrasts with US LCDS which does have a built-in dispute mechanism for Syndicated Secured Dispute Events, i.e. a dispute with respect to the Syndicated Secured characteristic of the Reference Obligation or the Substitute Reference Obligation. Either party to the LCDS may dispute the Calculation Agent s determination that: the current Reference Obligation failed the Syndicated Secured characteristic; or the Substitute Reference Obligation satisfies the Syndicated Secured characteristic which, in either case, it can do by showing that a third party has etered into an LCDS and has commenced the dispute procedure with respect to the same current or Substitute Reference Entity, as applicable. In addition, the protection seller can dispute whether a particular Deliverable Obligation satisfies the Syndicated Secured characteristic. Again, it can do so by showing that another protection seller has a dispute with respect to the same Deliverable Obligation. Following the occurrence of a Syndicated Secured Dispute Event the Syndicated Secured Dispute Resolution operates to resolve the dispute by a dealer poll. The mechanics of the dealer poll are as follows: The Polling Agent (either the Secured List Publisher or the Calculation Agent (each as defined in the LCDS Supplement) conducts a poll. If the Polling Agent is the Secured List Publisher, a poll will be in accordance with the Secured List Publisher s polling rules unless a poll under same rules for same Loan, Reference Entity and Designated Priority was completed or commenced prior to a request by the Calculation Agent. The Poll is either (a) Affirmative (i.e. Syndicated Secured is satisfied), (b) Negative (i.e. Syndicated Secured is not satisfied) or (c) where quorum for a poll was not reached or no responses have been received by the relevant deadline Affirmative if the Calculation Agent so determines, otherwise Negative. If the Polling Agent is the Calculation Agent, it will poll Specified Dealers (listed in Annex A to the LCDS Supplement). The Poll is Affirmative if the Calculation Agent receives (a) 4 or 16

18 more responses and at least 3/4 agree that Syndicated Secured applies or (b) 2 or 3 responses and all agree that Syndicated Secured applies. Otherwise the poll is Negative unless, in the case of one or no response, the Calculation Agent decides the poll is Affirmative. If the poll is Negative, the Calculation Agent chooses another Substitute Reference Obligation in accordance with Section 2.30 (as amended) and if the poll is again Negative with respect to the next proposed Substitute Reference Obligation the process is repeated until the earlier of the Scheduled Termination Date or the Optional Early Termination Date (Section 5.2 of the LCDS Supplement) of the US LCDS. If the dispute is initiated by the protection seller with respect to a Deliverable Obligation and the poll is Negative, the protection buyer has 3 Business Days to revise the NOPS in respect of such Deliverable Obligation unless such obligation was first identified in a NOPS after the NOPS Fixing Date in which case no revision is permitted. Settlement Physical Settlement is the default settlement mechanism for European and US LCDS. This seems, at least for the European market, somewhat strange given the banking monopoly issues in the various European jurisdictions. In addition, one reason for the rise of the LCDS market is the fact that investors cannot source any or sufficient allocation of syndicated secured loans and thus resort to synthetic exposures. The latter may by far outstrip the amount of Deliverable Obligations available in the market since the Notional Amount of an LCDS may well be in excess of the actual amounts of such Reference Obligation (unless a more senior, albeit more expensive tranche of the Reference Obligation remains available for delivery). Recent bankruptcies (Delphi Corp., Dana Corp. to name but two) in the US clearly showed the difficulties Physical Settlement can have on the markets. This has precipitated alternative mechanisms to deal with Physical Settlement issues and it may well be that the terms of the European LCDS moves to Cash Settlement and/or a hybrid settlement procedure which may even be capable of selection by either party. In European LCDS, the protection seller (but not the protection buyer) can elect Cash Settlement: for all or some of the Deliverable Obligations specified in a NOPS. If no firm quotations are obtainable for all or some of the Deliverable Obligations which are subject to Cash Settlement, Physical Settlement will then again apply as an automatic fall-back for those Deliverable Obligations. The protection seller makes its Cash Settlement election within 5 business days (BD) after the date that falls 30 calendar days (CD) after the Event Determination Date (i.e. the first date on which the Credit Event Notice and if applicable the Notice of Publicly Available Information are effective); or because (a) the Deliverable Obligations specified in the NOPS are not, on the Physical Settlement Date, capable of being assigned or transferred to the protection seller or its designee, because neither is a permitted assignee, transferee or other recipient, (b) required consents to the assignment/ transfer have not been received or (c) the protection buyer has not received the Deliverable Obligations due to be delivered by it and, as a result, the protection buyer gives notice to the protection seller to elect to create participations in the relevant Deliverable Obligations. The protection seller s election of Cash Settlement has to be made within 5 BD after the date on which the protection buyer s notification with respect to the creation of participation becomes effective and will apply to those Deliverable Obligations stipulated by the protection seller in its notice. 17

19 Cash Settlement (without Physical Settlement fall-back option) CD 5 BD 5 BD 5 BD Cash Settlement with respect to relevant obligations If Physical Settlement and Deliverable Obligations (not subject to Participations or Cash Settlement) have not been delivered: Deemed Termination Date with respect to such Deliverable Obligations Physical Settlement Date with respect to relevant obligations OR OR Protection buyer does not create participations : 5th BD after Physical Settlement Date is deemed to be Termination Date with respect to relevant obligations NOPS OR Participations (with elevation rights) with respect to relevant obligations Cash Settlement with respect to relevant Deliverable Obligations Event Determination Date Cash Settlement election to be delivered by protection seller to protection buyer with respect to relevant obligations no later than 5th BD after the date on which the protection buyer s notification with respect to participation becomes effective Participation notice with respect to relevant obligations to be delivered by protection buyer no later than 5th BD after Physical Settlement Date Cash Settlement election notice with respect to relevant obligations to be delivered by protection seller no later than 5th BD after NOPS

20 The US LCDS documentation is for use in conjunction with the Physical Settlement Terms rider (the LSTA Rider) published by the Loan Syndication and Trading Association (LSTA). This LSTA Rider provides procedures intended to harmonise the standards for physical settlement under an LCDS with existing procedures in the secondary loan market developed by the LSTA and modified to fit the US LCDS market. A key term of the LSTA Rider is the market standard indemnity which allows the documentation relating to Physical Settlement under an LCDS to accurately mirror, on an on-going basis, evolving credit-specific documentation practices in the secondary loan market. Pursuant to the market standard indemnity, the protection buyer promises to indemnify the protection seller for damages actually suffered as a result of an inconsistency between the documents used to transfer the secured loan and the documentation used in standard market practice applicable to the secured loan at the time of transfer. This promotes and facilitates fast and efficient physical settlement of a US LCDS following a Credit Event. There is currently discussion in Europe as to whether a similar settlement mechanic should also be hardwired into the European LCDS. The terms of the LSTA Rider stipulates physical settlement by: assignment unless: - assignment has not occurred on or before the thirteenth Business Day following the Proposed Assignment Settlement Date because third party conditions precedent to such assignment have not been fulfilled or waived on or before such date. This failure will lead to a settlement fall-back to participations; - the protection seller does not execute and deliver to the protection buyer the require documentation and does not pay the relevant purchase price as prescribed in the LSTA Rider. Such failure will constitute an Additional Termination Event under the LCDS. participation unless: - the protection seller elects Cash Settlement by notice to the protection buyer on or before the fifth Business Day following the Proposed Fall-Back Participation Settlement Date; - participation fails because the protection seller does not execute and deliver to the protection buyer the required documentation and does not pay the required purchase price, or it has, but any third party condition precedent has not been fulfilled or waived, in each case on or before the fifteenth Business Day after the Proposed Fall-Back Participation Settlement Date. Such failure will constitute an Additional Termination Event under the LCDS unless the protection seller has elected a Cash Settlement; or - the protection seller has executed and delivered all relevant documentation on or before the 5th Business Day following the Proposed Fall-Back Participation Settlement Date and a third party condition precedent has not been fulfilled or waived on or before the fifteent Business Day following the Proposed Fall-Back Participation Settlement Date. This will trigger partial Cash Settlement in accordance with Section 9.8 of the Credit Derivatives Definitions as amended by the LSTA Rider. In addition, the LSTA Rider enables the protection seller and the protection buyer to mutually elect alternative settlement structures or other settlement arrangements which reflect the economics of 19

21 the trade. The LSTA Rider also deals specifically with the situation where the protection buyer is a lender under a Deliverable Obligation or holds a participation or subparticipation therein. In terms of timing, for both, the European and US LCDS, the NOPS has to be delivered within 30 calendar days (CD) of the Event Determination Date. Deliverable Obligations have to be delivered by the protection buyer to the protection seller within 30 BD of the day that is 30 CD after the Event Determination Date (in the case of European LCDS) and within 30 BD of the satisfaction of the Conditions to Settlement (in the case of US LCDS). Outlook The two sections above highlight the different motivations of the participants in this fast developing credit market and some of the similarities and differences that apply with respect to how the US market and the European markets are dealing with documentational issues that reflect those motivations. Whilst there are still obstacles and unresolved issues such as the discussion of private versus public information, cancellability and the inclusion of Restructuring as Credit Event, these obstacles are unlikely to constitute a bar to the development of this market. LCDS fill the gap satisfying more or less the needs of end-users who require a hedging tool and investors who see LCDS as a trading product. LCDS can be employed for (1) capital structure arbitrage (the relative value of senior loans versus high yield bonds or second lien or mezzanine loans); (2) credit risk management; (3) regulatory capital relief; (4) provision of credit exposure to bank loans from obligors located in jurisdictions having strict bank monopoly laws; and (5) circumvention of possible adverse tax consequences arising from a direct investment in a syndicated secured loan. Finding an agreed documentational approach is not far away even if it involves an agreement to differ on certain specific issues. It is simply a matter of understanding what those issues are and amending the documents appropriately. 20

22 Loan-Only Credit Default Swaps And Basis Risk Basis Risk - General This section looks at Basis risk which arises from structural differences between holding a position in a syndicated secured loan and holding a synthetic position in the same syndicated secured loan through a Loan-Only Credit Default Swap. Basis risk arises from the potential difference between the return on the LCDS referencing a particular borrower (the Reference Entity ) and the return on a syndicated secured loan (the Reference Obligation ) granted to such Reference Entity as a result of factors affecting each of the instruments differently. Basis risk is only one of several aspects that an investor will need to take into account to make a meaningful investment decision between the two instruments when looking to hedge risk or identify investment opportunities. Other factors include, for example, the fact that derivative instruments used to obtain a synthetic position may have no initial funding costs. Basis risk arises due to the factors that affect the return on the syndicated secured loan and the return on the derivative instrument referencing the loan not being constant and thereby allowing variances between the return on the holding of the syndicated secured loan and the derivative to increase or decrease over time. This prevents the derivative instrument from acting as a complete hedge to the underlying reference loan. This may or may not be important depending on the motivation of the parties involved in the trade. By way of example, some factor relevant to Basis risk are set out below: If the cash instrument is more liquid than the derivative instrument the latter would tend to have a higher spread and may be more difficult to transfer than the cash instrument as a result of the lesser liquidity; The investor who is long the cash instrument holds an interest with certain payment characteristics whereas the protection buyer under the derivative instrument may have a cheapest-to-deliver option pursuant to which it can deliver a cheaper obligation than the Reference Obligation provided such obligation is pari passu with the Reference Obligation; The investor who is long the cash instrument is subject to default on that cash instrument if any event of default occurs whereas the protection seller under the derivative instrument is not liable to pay for default other than in respect of a specified Credit Event, typically Failure to Pay, Bankruptcy and, for European LCDS, Restructuring ; and The investor who is long the cash instrument is exposed to the credit risk of the Reference Entity whereas the protection buyer under the derivative instrument is exposed to the credit risk of the Reference Entity and is, in addition, exposed to the credit risk of the protection seller. Market participants motivation for using a CDS will shape its terms, to the extent this is possible in light of standard documentation in this market, and thus affect pricing of such derivative instruments. Motivation depends on whether the entity is a buyer or seller of protection looking to manage individual loan or portfolio credit risk (and, related thereto, regulatory capital) or whether the entity is a dealer in a dealer market viewing CDS as a separate trading instrument. 21