A CREDITFLUX PRIMER. Credit derivative and structure credit. Essentials. Published in association with

Transcription

1 A CREDITFLUX PRIMER Credit derivative and structure credit Essentials Published in association with

2 A CREDITFLUX PRIMER Credit derivative and stuctured credit Essentials Written and edited by Michael Peterson in collaboration with Terri Duhon and Anu Munshi of B&B Structured Finance Limited, with contributions by Euan Hagger and Dan Alderson Design by Julian Knott Published by Creditflux Limited 63 Clerkenwell Road London EC1M 5NP United Kingdom ISBN: Creditflux Limited, July 2006

3 About the authors Michael Peterson Michael Peterson has been reporting on the structured credit and credit derivative markets since the late 1990s, first as a freelance journalist and, since 2001, as editor of Creditflux, a subscriptiononly print and web publication. Creditflux provides unrivalled news and analysis of the global market for credit derivatives and structured credit, and is widely regarded as the industry s leading publication. Terri Duhon Terri Duhon has 12 years of experience in the derivatives market, starting as an interest rate derivatives trader at JP Morgan in In 1998, Terri set up the exotic credit derivative trading book at JP Morgan and was instrumental in the Bistro product, which pioneered synthetic securitisation. In 2000, she helped to build JP Morgan s European structured finance business, later moving to ABN Amro to help build its global structured credit business. Terri founded B&B Structured Finance in Anu Munshi Anu Munshi has 7.5 years of experience in the structured credit market at JP Morgan in the US, Asia and Europe. Her roles at JP Morgan included structuring and marketing emerging market and credit derivatives, educating investors on credit derivatives, ABS and CDOs, and developing some of the recent credit derivative products such as CDS options and CMCDS. Anu joined B&B Structured Finance as partner in 2005.

4 Contents CHAPTER ONE The background CHAPTER TWO The products Single name credit default swaps Credit indices Nth-to-default baskets Collateralised debt obligations Index tranches Asset-backed credit default swaps Other credit derivatives CHAPTER THREE The practicalities Pricing and valuation Market conventions Confirmation and settlement List of illustrations Structured Credit and Credit Derivatives: Essentials 3

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6 CHAPTER ONE The background CREDIT RISK Credit risk is the risk that a borrower is unable or unwilling to make payments as they become due What is credit? Two main factors determine the value of bonds and loans. One is the prevailing rate of interest usually set by a central bank such as the US Federal Reserve or the European Central Bank. The interest paid on bonds or loans may rise or fall in line with prevailing interest rates or it may be fixed in which case the value of the asset rises and falls as interest rates change. The other factor is credit risk, the risk that the borrower is unable or unwilling to make payments as they become due. When the government of France or the United States issues bonds, the credit risk involved is minimal. What investors need to worry about is interest rates. But when companies or emerging market governments borrow, investors are exposed to both interest rate and credit risk. The credit market, as defined in this primer, is the business of trading, structuring and investing in the credit risk of large companies, emerging market countries and structured finance bonds, either through cash instruments (bonds and loans) or through credit derivatives. Structured Credit and Credit Derivatives: Essentials 5

7 CHAPTER ONE THE BACKGROUND Credit derivative outstandings $bn 2001 June 631 December June 1,600 December 2, June 2,690 December 3, June 5,440 December 8, June ,400 December ,300 Source: Isda What are credit derivatives? Credit derivatives were first traded sporadically at the end of the 1980s but it was not until the early 1990s that a real market for these products began to emerge. In the late 1990s and the first half of the next decade, credit derivatives grew rapidly to achieve a central role in the financial markets. The purpose of a credit derivative is to transfer only the credit risk of a borrower and not the associated interest rate risk. The fact that credit risk can be traded in isolation makes credit derivatives a very powerful tool. The main types of credit derivative products are single name credit default swaps, credit derivative indices, index tranches, synthetic CDOs and CPPI.(See the products, page 17). Unlike bonds and loans, which are financial contracts between a borrower and a lender, credit derivatives are contracts between any two counterparties which reference a specific borrower (the reference entity ). Very often neither counterparty is a lender to the reference entity. The reference entity is rarely involved in the trade and usually has no reason to know that the credit derivative contract exists. All credit derivatives traded to date (mid-2006) have been over-the-counter (OTC) derivatives. Unlike many equity or commodity options and futures, they are not traded on an exchange but are simply private contracts between two counterparties one of which is usually a dealer (also called a market maker). 6 Credit derivative and structured credit essentials

8 CHAPTER ONE THE BACKGROUND What is structured credit? The term structured credit has several different meanings. By one definition, it refers to a wide range of credit-derived products, including CDOs and credit derivatives. An alternative definition, and the one used in this primer, is that structured credit refers to tranched credit products. By this definition, a fully distributed cash CDO is a structured credit product but it is not a credit derivative. Single name credit default swaps are credit derivatives but not structured credit products. And single-tranche credit derivatives, index tranches and nth-to-default baskets fall within the definition of both structured credit and credit derivatives. How big is the market? Since credit derivatives are private contracts, it is difficult to calculate the size of the market with any accuracy. The task is also complicated by the different ways volumes are measured, problems of double-counting, and doubts about whether or not certain products should be considered as credit derivatives. As a result, estimates of the size of the market vary greatly. But all the various surveys on the size of the market agree that volumes have grown very rapidly since the beginning of the current century. The International Swaps and Derivatives Association (Isda), the trade association for dealers and users of over-the-counter derivatives, carries out a twice-yearly survey of the size of the market. It asks its members to calculate the total notional amount of all the derivatives they have outstanding. (In 2006, 86 firms provided information on their credit derivative positions, indicating that most big market participants are included in the survey.) According to Isda, the total face value of all outstanding credit derivatives at the end of 2005 was $17.3 trillion. That is a 27-fold increase on the $631 billion figure at the end of June 2001, when Isda first surveyed its members on their credit derivative positions (see table opposite). Even so, credit derivatives are still only a small part of the total derivatives market. According to the same Isda survey, the total of all outstanding over-the-counter derivatives Credit derivative and structured credit essentials

9 CHAPTER ONE THE BACKGROUND was $236 trillion, with interest rate derivatives taking the lion s share of that total. According to the Bank for International Settlements (BIS), the Baselbased central banks organisation, the total volume of outstanding credit derivatives at the end of 2005 stood at $13.7 trillion. These figures are based on data submitted by banks in the G10 group of largest economies to their central banks. CDO INFLUENCE Synthetic CDOs account for only a small portion of total credit derivative volumes, but they are a driving force behind the growth of the market What are the main products? Unlike Isda s survey, the BIS figures give a breakdown of the market by type of instrument. At the end of 2005, just under 73% of outstandings were for single-name contracts, with multi-name instruments (that is, baskets, index tranches and synthetic CDOs) accounting for the remainder. As this survey shows, synthetic CDOs (see page 40) are only a small part of the market in terms of volumes, but they are a big force driving the growth of the market. Dealers issue these investment vehicles to investors including banks, pension funds, insurers and individuals, and then hedge themselves by trading other credit derivatives such as single name credit default swaps, credit indices and index tranches, so increasing the amount of activity in all credit derivatives. Cashflow CDOs (see page 39) are not usually thought of as credit derivatives, but they are certainly structured credit products. And they play a similar role to synthetic CDOs of channelling investments into the broad credit market. According to figures compiled by Creditflux, there was a total of $469 billion of cashflow CDOs outstanding at the end of 2005, with $194 billion of new deals issued in 2005 alone. Who is involved? The credit derivatives business has historically been dominated by banks and investment banks. This is not surprising when you consider the major roles that banks and investment banks play in the credit business. Commercial banks are the main type of institution involved in lending money to companies using loans. Credit derivative and structured credit essentials

10 CHAPTER ONE THE BACKGROUND Synthetic CDO volumes Estimating the size of the structured credit market is complicated not only because credit derivatives are bilateral contracts, for which it is difficult to get accurate information on volumes, but because many credit derivatives are leveraged, referencing exposure greater than their own notional size. Nevertheless, the numbers available illustrate a large market that is growing fast. New volumes of what Creditflux defines as portfolio credit swaps (synthetic CDOs and other tranched portfolio credit derivatives) increased to nearly $300 billion in 2005 from $125 billion in 2004 and $196 billion in Meanwhile, investment banks (also known as securities houses) underwrite and distribute the bonds which governments, financial institutions and corporates (nonfinancial companies) issue to the broader investment community. According to figures compiled by the British Bankers Association for the global market in 2003, banks were the most important group of buyers of protection that is, counterparties using credit derivatives to offload credit risk. They were also the biggest group of protection sellers that is, counterparties using derivatives to invest in credit. (See chart on page 10.) Banks There is a common perception that banks use credit derivatives mainly to reduce their exposure to credits they do not like. While this may be true for many banks, it is by no means the whole story. All banks are regulated indirectly by the BIS (under regulations called the Basel Accord, and to be updated in the future to the Basel II Accord) to reserve a certain amount of capital against the assets they hold. This is called the bank s regulatory capital requirement and it depends on factors such as the credit risk and maturity of the assets it holds. Regulatory capital is a measure designed to preserve bank capital, since the riskier a bank s assets the more capital it has to reserve against those assets. The credit portfolio management function of a typical commercial bank looks at the profitability of the assets on its balance sheet, taking into account the regulatory cost of holding those assets. The credit portfolio manager may choose to sell an asset that does Credit derivative and structured credit essentials

11 CHAPTER ONE THE BACKGROUND Buyers of credit protection (2003) Sellers of credit protection (2003) hedge funds 16% securities houses 16% others 17% banks 51% hedge funds 15% securities houses 16% others 11% insurance companies 20% banks 38% Source: British Bankers Association not provide enough of a return over its regulatory capital charge or does not fit with its portfolio strategy. Alternatively, in many cases, the credit portfolio manager will hedge the risk using a credit derivative, which allows the bank to release regulatory capital. In addition, banks of all types make use of credit derivatives as an investment tool. Many banks have a proprietary trading desk which makes short or medium-term bets on credit in much the same way that a hedge fund does. In addition, many commercial banks invest in single name credit or in synthetic CDO tranches on a longer term basis. They may also be a dealer (see below). Many regional banks act as a dealer within a certain niche, for example, repackaging synthetic CDOs for smaller banks and investors in their own country. Dealers (market makers) Dealers or market makers provide a service allowing market participants such as banks, insurance companies, corporates and hedge funds to buy and sell credit derivatives, making money from 10 Credit derivative and structured credit essentials

12 CHAPTER ONE THE BACKGROUND the difference between the buying and selling price (known as the bid and the offer). They can be commercial banks such as Citigroup or investment banks such as Morgan Stanley. Large credit derivative dealers typically offer a wide range of credit derivative instruments and make a market on a broad choice of reference entities. In almost all cases they also trade credit derivatives for their own book, though sometimes this proprietary trading business is kept at arms length from the market-making function. Most credit derivative dealers have dealing desks in New York and London, and some also trade from Hong Kong, Singapore, Sydney or Tokyo. Liquidity is one of the biggest concerns of hedge funds. They want to know they can get out of a position when they need to. Until the launch of liquid credit derivative indices, the market was regarded as too illiquid for their purposes The biggest credit derivative dealers have historically been JP Morgan and Deutsche Bank, two large universal banks (offering both commercial banking and investment banking). In recent years, the business has become less concentrated and around a dozen firms can be thought of as full blown credit derivative dealers. The list of institutions signed up as dealers on the main credit derivative indices in Europe and in North America (see table on page 13) gives an indication of which banks are involved as credit derivative dealers in each region. Hedge funds Hedge funds, investment management vehicles designed to produce positive returns regardless of the direction of the market, are typically short-term investors. One of their biggest concerns is to ensure that they will be able to get out of or unwind a position when they need to. (This ability is known as liquidity.) Credit derivative and structured credit essentials 11

13 CHAPTER ONE THE BACKGROUND For a long time, few hedge funds traded credit derivatives, regarding the market as too illiquid for their purposes. That changed in around 2003, with the launch of the liquid credit derivative indices that later evolved into itraxx and CDX (see page 30). This meant that for the first time, hedge funds could trade in and out of credit in large sizes without losing large amounts of money on the difference between the buying and selling price (the bid-offer spread) on each trade. Since then, hedge funds have become key players in the credit derivatives market. Anecdotal evidence suggests their share of the market in terms of outstanding trades has grown substantially since 2003, when the BBA survey put this figure at 15%. In fact, because they are active buyers and sellers, hedge funds can often dominate daily trading volumes. TRANSFORMATION Some insurance companies write insurance policies which are converted into selling protection on credit derivatives Some of the biggest multi-strategy hedge funds such as Amaranth, Citadel Investment, Moore Capital and Tudor Investment are active in the credit market. Other big hedge fund players are credit specialists, typically set up by former credit derivative traders at investment banks. These include BlueMountain Capital, Cairn Capital, Cheyne Capital Management, Solent Capital and Tricadia Capital. Most credit hedge fund managers are based in London or in various locations in the United States. The funds themselves are usually domiciled offshore. Asset managers Asset managers that manage institutional money are fairly active in credit derivatives, especially those that manage CDOs. Traditional long-only funds such as mutual funds are much less involved. However, their involvement is thought to be increasing, and many funds have become members of the DTCC DerivServ settlement system for credit default swaps (see page 75) in 2005 and Insurance companies Insurance companies are involved in credit derivatives in two different ways. Life insurers and property and casualty insurers hold large investment portfolios to match their liabilities. Some have invested a small portion of these funds into credit derivatives, generally using credit-linked notes. 12 Credit derivative and structured credit essentials

14 CHAPTER ONE THE BACKGROUND Licensed index dealers itraxx Europe ABN Amro Bank of America Bank of Montreal Barclays Capital Bayerische Landesbank BBVA Bear Stearns BNP Paribas Calyon Citigroup Commerzbank Credit Suisse Deutsche Bank Dresdner Kleinwort Goldman Sachs HSBC Dow Jones CDX ABN Amro Bank of America Barclays Capital Bear Stearns BNP Paribas Citigroup Credit Suisse Deutsche Bank HypoVereinsbank ING Ixis Corporate & Investment Bank JP Morgan Lehman Brothers Merrill Lynch Morgan Stanley Natexis Banques Populaires Nomura Nordea Royal Bank of Scotland Santander Société Générale TD Securities UBS Source: International Index Company Goldman Sachs HSBC JP Morgan Lehman Brothers Merrill Lynch Morgan Stanley UBS Wachovia Source: Markit Credit derivative and structured credit essentials 13

15 CHAPTER ONE THE BACKGROUND The other way insurance companies use the credit derivatives market is by writing insurance policies. In economic terms, this is similar to selling protection on credit default swaps and these insurance policies are usually converted into credit derivative contracts through a special insurance vehicle known as a transformer. The insurance companies that are involved in this business include both specialist bond insurers known as monoline insurers and reinsurers. Pension funds Pension funds are not big players in the credit derivatives market, though some funds have invested in CDOs and their involvement is growing. Pension funds often face compliance issues in trading credit derivatives, since their investment management guidelines often prevent the use of derivatives. Retail investors Credit derivatives are wholesale financial products that can almost never be traded directly by individual investors. Not only are the minimum trade sizes too large for most investors, banks are usually prohibited from offering these products to retail customers. However funded credit derivative products such as CDOs and credit CPPI products, which more easily lend themselves to being highly rated or principal protected, are an exception. These products are commonly sold to high-net-worth individuals, and in certain countries (notably Australia, Canada and the Netherlands) have been sold to true retail customers. Corporates Despite the best efforts of many credit derivative salespeople, big corporates have not taken to using credit derivatives in the same way that they routinely hedge their currency or commodity price exposures. Interdealer brokers Interdealer brokers do not trade credit derivatives themselves. They act as agents when credit derivative dealers trade with each other. As in other derivative markets, almost all credit derivative trades between dealers are brokered by one of the small number of these specialist firms. The biggest include Creditex, Creditrade, Garban, GFI and Tullett Prebon. 14 Credit derivative and structured credit essentials

16 CHAPTER ONE THE BACKGROUND Highlights in evolution of the credit derivative market Late 1980s First cashflow CDOs issued First credit derivatives begin to be traded, often swaps on specific bonds created for tax or regulatory purposes Mid to late 1990s Issuance of large balance sheet synthetic CDOs for the purpose of achieving regulatory capital relief 1996 Isda publishes the first credit derivative definitions July September Isda publishes the second credit derivative definitions, which bring much greater standardisation and acceptance to the market Bank of America extends the maturity of a loan to Conseco, triggering a controversy which eventually leads the market to change its definition of restructuring as a credit event 2001 December December 2002 April April Default of Enron, the biggest corporate default in history by volume of debt outstanding Default of Argentina, the biggest sovereign default in history by volume of debt outstanding, triggering a controversy on the definition of repudiation/moratorium, the main credit event for sovereigns Morgan Stanley launches Synthetic Tracers, which becomes the market standard index for North American investment grade credit Dealers launch the reference entity database (Red) in response to high profile cases in which counterparties had disagreed over which was the intended reference entity in a credit default swap. The project is later taken over by data company Markit. continued Credit derivative and structured credit essentials 15

17 CHAPTER ONE THE BACKGROUND Highlights in evolution of the credit derivative market December 2003 March April October 2004 April 2005 April/May May June September October North American dealers begin trading credit derivatives with standard maturity and payment dates in an effort to increase liquidity. European dealers later also adopt this practice Isda publishes 2003 credit derivative definitions, which significantly revise the 1999 short-form documentation in areas such as restructuring, successor events and guarantees JP Morgan and Morgan Stanley kick-start credit index trading in Europe by merging their proprietary indices to form Trac-x North American dealers launch CDX NA IG, which takes over as the standard credit index for North American investment grade Credit derivative dealers agree to merge various indices to form a single index in each market A dramatic repricing of credit index tranches causes losses to banks and hedge funds Default of Collins & Aikman, the first credit event to be settled using an auction Isda launches standard documentation for credit default swaps on asset-backed securities The New York Fed hosts a meeting between top credit derivative dealers and regulators from around the world, who are concerned about the operational weaknesses of the credit derivatives market. Dealers agree to take steps to cut the time it takes to settle trades. Default of Delphi, thought to be the biggest default to date in terms of credit derivatives outstanding 16 Credit derivative and structured credit essentials

18 CHAPTER TWO The products BUILDING BLOCKS Almost all credit derivatives take the form of a credit default swap. The simplest type is a single-name credit default swap Single name credit default swaps Credit default swaps, also known as default swaps, credit swaps and CDS, are the basic building block of the credit derivatives market. Almost all credit derivatives take the form of a credit default swap, and most of these swaps are based on a standard legal contract known as a confirm. The simplest and most common type of credit default swap is one where there is just one reference entity. This is called a single-name credit default swap. The reference entity can be any borrower, but is most often one of a few hundred widely traded companies (corporates or financials) or a handful of governments (sovereigns). Credit default swaps can be used to transfer types of credit risk other than borrowings (such as trade debt), but these contracts are not standard and are rarely seen in practice. A single name credit default swap acts rather like an insurance contract against the default of a reference entity. The buyer of protection (known in the contract as the fixed rate payer ) makes periodic premium payments to the seller of protection (the floating rate payer ). Structured Credit and Credit Derivatives: Essentials 17

19 Example of a single name credit default swap An investor who wants to take a view on France Telecom might sell credit default swap protection. In May 2006, dealers quoted five-year credit default swap spreads on France Telecom at 37/39 basis points (bp, hundredths of a percentage point). This means the dealer quotes 37bp for a trade where the investor sells five-year protection and the dealer buys protection, and 39bp for a trade where the investor buys protection. (The difference between the two quotes is known as the bid-offer spread.) On a typical trade size of 10 million, the protection seller would receive 37,000 a year, usually in four quarterly payments. Conversely, the investor could buy protection for 39bp, paying 39,000 a year. If France Telecom defaults during the life of the trade and, following the default, the value of the company s debt falls to 40% of face value (the recovery rate ), the protection seller will compensate the protection buyer for the 6 million loss. If the reference entity defaults (that is, it undergoes one of the credit events defined in the contract) the protection buyer stops paying premiums and receives a one-off payment from the protection seller which compensates the protection buyer for the loss experienced as a result of the default. (Note, however, that a credit default swap is not an insurance contract. There are several important legal and economic differences between the two products. For example, the buyer of an insurance policy can normally only insure itself against an event that would cause it a loss that is, it must have an insurable interest in the risk whereas a buyer of credit protection does not need to own debt issued by the reference entity.) In the event of a default, the credit default swap terminates and settlement takes place with the protection seller making a payment to the protection buyer. Depending on the terms agreed up front by the counterparties, settlement can be either physical (current market standard) or cash. In either case, the settlement amount is intended to compensate the protection buyer for the loss that it would have incurred had it owned the notional amount of the reference entity s debt. 18 Credit derivative and structured credit essentials

20 Physically settled credit default swap $30,000 annual premium paid quarterly for IBM protection protection buyer (fixed rate payer) $10mm protection seller (floating rate payer) deliverable obligation (worth $4mm) Source: B&B Structured Finance Ltd Physical settlement The standard form of settlement for credit derivatives at the time of publication is physical settlement. After the protection buyer has triggered a credit event, with the delivery of a notice of physical settlement, the protection buyer delivers to the protection seller bonds or loans ( deliverable obligations ) with a notional amount identical to the notional amount of the credit default swap. The protection seller then pays the protection buyer the notional amount of the credit default swap. For example, for a standard $10 million contract on IBM, when IBM defaults, the protection buyer delivers defaulted bonds with a $10 million face value and receives $10 million from the protection seller. If the defaulted bonds are worth $4 million (40% of their face value, where 40% is called the recovery rate), the protection buyer has effectively made $6 million as a result of buying protection. The seller of protection could choose to sell the defaulted bonds, so achieving their recovery value. Credit default swap contracts define the deliverable obligations that is, which of the issuer s bonds or loans can be delivered by the protection buyer following a credit event. This pool of deliverables is usually defined as bonds or loans issued by the reference entity that are not subordinated to the reference obligation. However, certain types of debt instruments such as those denominated in Credit derivative and structured credit essentials 19

21 minor currencies, those that are not fully transferable, and those whose payment is contingent on particular circumstances are usually excluded from this pool and may not be delivered. In a standard credit default swap, the pool of deliverables includes all the entity s conventional senior debt (bonds and loans, secured and unsecured), but it excludes subordinated (junior) debt, preference shares, trade debts and obligations with certain nonstandard features. DELIVERABLES In a standard credit default swap, the pool of deliverable obligations includes all the reference entity s senior bonds and loans, but excludes subordinated debt, preference shares, trade debts and obligations with non-standard features The reference obligation is simply a specific bond or loan issued by the reference entity which is agreed to at the start of the trade in order to characterise the deliverable obligations. If the protection buyer can access more than one deliverable obligation, it has the option of delivering the cheapest one available. Thus the protection buyer owns a cheapest-to-deliver option, which is one of the main reasons that credit default swap spreads are usually wider than bond spreads for the same reference entity. Physical settlement has the advantage that it is not subject to manipulation by either party. But it has some severe drawbacks (see page 75). As a result, many credit derivatives are cash-settled. Cash settlement In a cash-settled credit default swap, no bonds or loans are delivered. Instead, the protection seller simply pays the protection buyer an amount of money calculated as the notional value of the contract minus the recovery rate. While most single name credit default swaps are physically settled, counterparties may agree to cash settle them instead. The recovery rate is based on a dealer poll, where the calculation agent obtains quotes from several firms that are active market makers in the reference obligation to determine its market value. For example, if the $10 million IBM contract were to be cash settled, the protection seller would pay the protection buyer $6 million, based on the 40% market value (recovery rate) of IBM s reference obligation. 20 Credit derivative and structured credit essentials

22 Cash settled credit default swap $30,000 annual premium paid quarterly for IBM protection protection buyer (fixed rate payer) $6mm (=$10mm - $4mm) protection seller (floating rate payer) effectively netting the following cashflows: $10mm par amount $4mm recovery Source: B&B Structured Finance Ltd Binary or digital settlement In binary or digital credit default swaps, the recovery rate is fixed. For example, if two counterparties trade a $10 million credit default swap on IBM with a 40% fixed recovery rate, the protection seller will simply pay the protection buyer $6 million in the event of a default by IBM. This approach has the advantage of simplicity, but the disadvantage that the protection buyer does know if it has bought enough protection to cover its losses. For this reason, binary credit derivatives are relatively rare. Credit default swaps compared to bonds As credit default swaps isolate and transfer credit risk, users can buy and sell protection depending on whether they want to hedge (or in some cases speculate) or take on credit risk. Since sellers of protection take on credit risk and earn a premium for this risk, they are equivalent to the buyers of bonds. And since buyers of protection hedge credit risk paying a premium for getting rid of risk this is equivalent to shorting a bond. In both cases, the party taking on credit risk loses money if the credit defaults. Credit derivative and structured credit essentials 21

23 The main difference between bond and credit default swap cashflows is timing of principal payments. The bond buyer pays the principal to buy the bond on the trade date, whereas the protection seller pays the principal (or rather, principal less the recovery rate) only when the credit defaults. Credit default swaps are therefore leveraged instruments because the protection seller does not need to put any money down to earn a premium for the risk it takes. Credit default swaps are also referred to as unfunded instruments, since the protection seller unlike the bond investor does not need to raise money (or get funding) to buy credit risk. CDS versus bond cashflows bond $100 principal bond issuer bond coupon x $100 principal recovery/deliverable obligations bond investor CDS protection buyer (fixed rate payer) premium/credit spread contingent payment protection seller (floating rate payer) effectively netting the following: par amount recovery/deliverable obligations Source: B&B Structured Finance Ltd 22 Credit derivative and structured credit essentials

24 Credit default swaps are leveraged instruments. The protection seller does not need to put down money to earn a premium for the risk it takes. By contrast, a bond investor needs to raise money to take on credit risk Credit default swap cashflows mean that the protection buyer is exposed to the credit risk of the protection seller. This counterparty risk is the risk that the protection seller cannot or will not pay the par amount, at the time when the protection buyer needs it most. By contrast, the protection seller s only counterparty risk is that the protection buyer will stop making premium payments. Single name trading strategies Single name credit default swaps can be used as part of a large range of relative value trading strategies. Among the simplest are basis trades. This strategy is designed to take advantage of the difference (the basis) between credit default swap spreads and cash bond or loan spreads for the same credit. A trader puts on a negative-basis trade when the credit default swap spread is lower than the spread over Libor on a cash asset, allowing the trader to buy the bond, buy protection on the issuer of the bond and earn a positive net spread (this surplus is referred to as positive carry). The trader either buys a floating rate asset or a fixed rate bond that has been asset-swapped into a floating rate instrument paying a spread over Libor. This trade carries no credit risk and the trader is able to earn a positive spread for taking advantage of the CDSbond basis. Because of the bid-offer spread, negative basis trades tend to be worth putting on only when the basis exceeds around 10bp. These opportunities have become increasingly rare as the trade has become well known. Other single name trading strategies include convergence trades where a trader believes that the difference between the spreads of two names will decrease. Credit derivative and structured credit essentials 23

25 For example, if Renault spreads are wider than Peugeot spreads, and a trader believes their credit risk is very similar, the trader could sell protection on Renault and buy protection on Peugeot, expressing the view that their spreads will converge and making a gain on the overall trade. Another strategy is to sell protection on one name whose spreads the trader believes will tighten, and to use the income to buy protection on another name whose spread the trader believes will widen. For names where there is a liquid market in both senior and subordinated credit default swaps (chiefly financials), traders can use single name credit default swaps to bet that the reference entity s subordinated debt will outperform its senior debt or vice versa without taking an outright view on the creditworthiness of the borrower or the direction of its spreads. The emergence of a liquid market in seven and 10-year credit derivatives, starting around 2005, has made it possible for traders to express views on spreads at different points on the credit curve (called curve trades) using single name credit default swaps. These strategies express a view not just on the likelihood of default, but on the timing of any possible default. Basis trades Basis trades involve buying a bond and buying protection or vice versa asset swap par (100) investor coupon (L+X) CDS CDS premium = Y bp dealer basis = Y - X bp Source: B&B Structured Finance Ltd 24 Credit derivative and structured credit essentials

26 Curve steepener 10Y CDS widens relative to 5Y CDS initial CDS curve company X CDS spreads 5Y CDS tightens relative to 10Y CDS or some combination of these two effects 5Y 10Y time Source: B&B Structured Finance Ltd A popular curve trade in 2005 and 2006 has been a curve steepener. A trader who believes that an issuer s long-term credit spreads are likely to widen relative to shorter-term spreads, causing the credit curve to steepen, might sell five-year protection and buy 10-year protection on the name, making money when five-year spreads tighten, ten-year spreads widen or some combination of the two effects. A curve flattener is the opposite bet that spreads at different maturities will converge. Credit default swap conventions The credit default swap creates no legal relationship between the reference entity and either of the counterparties, only between the two counterparties. Confirms are used to document the trade and confirm the terms and conditions agreed by both parties. The confirms contain a list of definitions that determine, among other things, the credit events that will trigger settlement, the obligations observed to determine whether a particular type of credit event such as failure to pay has occurred, the form of Credit derivative and structured credit essentials 25

27 settlement, and the bonds and loans that may be delivered if the contract is physically settled. The definitions and the confirm template are drawn up periodically by Isda. The most recent are the 2003 credit derivative definitions (see page 69). By convention, there is a standard set of choices from the menu for each type of credit (for example North American high yield corporate, Asian sovereign, European investment grade corporate or Japanese corporate). Prices are quoted assuming that this market standard documentation will be used. However, counterparties sometimes agree to trade on non-standard terms. STANDARDS Prices are quoted assuming that market standard documentation will be used. Counterparties somethimes agree to trade on nonstandard terms Credit events (or defaults) are precisely defined in a credit default swap. The definition of credit events can make a big difference to the value of the credit default swap. Different types of credit events are used as the market standard for different types of credits (see page 71). For example, North American high yield corporates trade with only two credit events: bankruptcy and failure to pay, while investment grade credits in North America can also be triggered by some types of debt restructuring. The notional size of a credit default swap on an investment grade credit is typically $10 million or 10 million, although US investment grade names often trade in sizes of $20 million. For high-yield names, typical trade sizes are smaller, usually $5 million or less. The quoted price of a credit default swap is the annual premium or coupon expressed as a proportion of the trade size (or notional) in basis points. This figure is commonly referred to as the spread of the credit default swap, by analogy with a bond s spread over Libor. In most credit default swaps, the premium is fixed for the life of the trade. (The main exceptions are constant maturity credit default swaps see page 60). Single-name credit default swaps can be for any term agreed at the outset by the counterparties. However, the majority of trades are for one of a few standard maturities. Originally, most credit default swaps were five-year trades. However, by early 2006, three, seven and 10-year trades had also become popular. 26 Credit derivative and structured credit essentials

28 Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contacts with each other through a credit support annex (CSA) - effectively a margining arrangement Credit derivatives can be funded or unfunded. In an unfunded trade, as described above, the protection seller makes no payments until there is a default. Alternatively, single-name credit default swaps can be funded by repackaging them as credit-linked notes. Even though single-name credit default swaps are unfunded, most counterparties generally collateralise their contracts with each other through a credit support annex (CSA), which is effectively a margining arrangement. As a protection buyer s credit exposure to its counterparty increases beyond a certain threshold, the counterparty has to post collateral to offset the protection buyer s counterparty credit risk. Most trades with hedge funds are transacted under a CSA. For example, a hedge fund might trade a $10 million single name default swap with a dealer and put up $1 million to collateralise the trade. If the market value of the trade moves against the hedge fund beyond a certain threshold, say $2.5 million, the dealer will ask it to post additional collateral to cover the increased risk. Credit-linked notes Credit-linked notes (CLNs) are typically issued by dealers or by special-purpose companies (or special-purpose vehicles, SPVs) domiciled in an offshore location. Some dealers have a medium term note (MTN) issuance programme under which they can issue notes in their name, which are linked to reference entities to which investors want to take risk. For example, an investor might want to take $10 million of exposure to Hilton Hotels in a maturity or currency for which there are no outstanding Hilton bonds. A dealer with an MTN programme could issue a $10 million note in its own name, with Hilton being the primary credit risk of the instrument. The investor would pay Credit derivative and structured credit essentials 27

29 Credit-linked deposit dealer (protection buyer) deposit issued by dealer paying L + CDS premium 100 investor (note holder) 100 L deposit Source: B&B Structured Finance Ltd the dealer $10 million on the trade date to buy the note, whose proceeds the dealer puts into its own deposit. The dealer issues a note which embeds a credit default swap in which the dealer buys $10 million of Hilton protection from the investor. The note coupon would consist of the interest earned from the deposit (typically Libor) plus the spread of the credit default swap, and would be paid to the investor quarterly. If there is no default, the credit default swap and deposit terminate on the maturity of the note, and the proceeds from the redemption of the deposit are paid back to the investor. If Hilton experiences a credit event, the deposit is unwound and its proceeds used to pay the dealer the par amount. The dealer then pays the investor the recovery amount in the case of a cash settled CLN or delivers deliverable obligations in the case of a physically settled CLN. 28 Credit derivative and structured credit essentials

30 CLN issued by an SPV dealer (protection buyer) CDS premium SPV CLN issued by SPV paying L+ CDS premium $100 investor (note holder) 100 L collateral Source: B&B Structured Finance Ltd Credit-linked notes are also often issued by SPVs. SPVs are set up by dealers to issue numerous different credit-linked notes. However, the notes are documented so that each investor s risk exposure is completely segregated. Applying the example above to an SPV-issued CLN, the dealer arranges for its Cayman Island s vehicle XYZ Finance Limited, to issue $10 million of notes. The investor buys the note from the SPV and the proceeds are invested in low-risk collateral such as triple A rated Rabobank bonds. (Sometimes, the collateral takes the form of a repo agreement with the investment bank.) XYZ Finance Limited then sells protection on a $10 million Hilton Hotels credit default swap to the dealer. The premium from the credit default swap along with the coupons from the collateral are paid to the investor quarterly. Credit derivative and structured credit essentials 29

31 If there is no default, the credit default swap terminates and the collateral redeems on maturity, and the collateral redemption proceeds are paid back to the investor. If there is a credit event, the collateral is sold and its proceeds used to pay the dealer the par amount. The dealer either pays the investor the recovery amount or delivers deliverable obligations to the investor. From a protection seller s point of view, investing in a credit-linked note is like buying a bond issued by the reference entity. The investor pays the notional amount of the trade upfront, receives a regular coupon payment and receives principal back when the bond matures. In the event of default, the investor receives the recovery rate of the reference entity s debt. Investors buy credit-linked notes for a variety of reasons. Creditlinked notes are investments customised to their maturity, currency and coupon requirements, and could match their liabilities far more closely than bonds available in the market. Some investors are not allowed to trade derivatives, so may not be able to sell protection on credit default swaps, but can buy credit-linked notes which are securities. Other investors may be able to sell protection, but prefer to buy credit-linked notes since they have cash to invest. BENCHMARKS Credit derivative indices allow investors to buy and sell a crosssection of the credit market much more efficiently than they could buy and sell individual credits Credit indices A credit derivative index is a basket of single name credit default swaps with standardised terms. Unlike other multi-name credit default swaps, such as first-to-default baskets, index swaps provide unleveraged exposure to the names in the basket. The indices act as a global set of benchmarks, allowing investors to buy and sell a cross-section of the credit market much more efficiently than they could if they were buying and selling individual credits. There are credit default swap indices in Europe, North America, Japan, Australia, non-japan Asia and emerging markets. Unlike in most equity and cash bond indices, constituents are not selected on the basis of their market size, but by specific rules set out for each index. For the main indices, constituents are chosen by liquidity, for example. They are also (for most indices) equally weighted. 30 Credit derivative and structured credit essentials

32 Credit derivative index cashflows index ref. entity 125 receives index spread on $125mm ref. entity 70 pays $1mm (par for ref. entity 70) receives recovery or deliverable obligations with $1mm face value index investor ref. entity 3 after credit event: receives index spread on $124mm ref. entity 2 ref. entity 1 Source: B&B Structured Finance Ltd A new credit derivative index is launched every six months, usually in March and September, to reflect the names in the credit derivative market that fit the rules for each index at that time. On these roll dates, a new basket of credits is created, with constituents selected by an independent index administrator based on input from dealers. Usually, only a handful of names change from one series to the next. The current series of the index is known as the on-the-run index and is usually much more liquid than the off-the-run versions. However, some off-the-run indices continue to trade actively after they have ceased to be the current version. Index trades are intended to be highly standardised to ensure liquidity. Not only do all counterparties trade the same list of names for each six month period, they also trade using a fixed spread for Credit derivative and structured credit essentials 31

33 Credit derivative index prices (bp), 20 June 2006 North America DJ CDX NA IG 45.6 DJ CDX NA HVOL 89.2 DJ CDX NA XO DJ CDX NA HY Europe itraxx Europe 34.0 itraxx Europe HiVol 61.5 itraxx Crossover Japan itraxx CJ Japan 28.9 the life of the series. If, as is usually the case, the market spread is different from the coupon, the counterparties exchange money upfront to account for this difference. Maturities are also standardised, with three, five, seven and 10-year maturities traded for the biggest indices. However, few index trades are held to maturity. In order to ensure that their positions are as liquid as possible, most counterparties roll into the new version of the index every six months. For example, a firm that bought protection on series 5 of the CDX NA IG index in January 2006, and wanted to keep a position in the on-the-run index, would have unwound this trade at the 20 March 2006 roll date and put on a new trade referencing series 6 of the index. Sources: Markit, International Index Company Indices are among the most actively traded credit derivatives because they provide a way to buy or sell diversified credit risk quickly and with low dealing costs. The main indices trade with bid-offer spreads of one-half of a basis point. These patterns of trading give credit indices their own trading dynamics. Although there is little fundamental reason why the spread of the index should not be the same as the average spread of its constituents (its theoretical value ) in practice indices often trade wider or tighter than their theoretical value. When the market price of the index is higher than its theoretical value, it is said to trade with a positive basis to theoretical. When 32 Credit derivative and structured credit essentials

34 the index price is lower than the average of the single names, the basis is said to be negative. One reason for the existence of a basis is that indices, because of their ease of execution, tend to react more quickly to changes in market sentiment than single names. And while the basis should present an opportunity for traders to put on arbitrage trades to narrow the gap, the execution cost of trading single names against the index makes this an expensive and difficult strategy (although it is one that some participants implement). One of the times the basis between the index and single names was most positive was around the time that Parmalat defaulted. A positive reflects bearish market sentiment In fact, the index basis acts as a barometer for credit markets. A positive basis typically occurs when most participants want to buy protection on the market as a macro hedge, reflecting a bearish sentiment. (One of the times that the index had its largest positive basis was around the time that Parmalat defaulted in December 2003, reflecting nervous market sentiment.) A negative basis typically occurs when most participants want to go long the market, pushing index spreads below their theoretical value due to high demand for credit risk, reflecting a bullish sentiment. Although the first tradable credit derivative index was JP Morgan s Hydi, which referenced high yield names, most credit index trading to date has been in the investment grade indices, especially North America s CDX NA IG and itraxx Europe. The low spreads and low volatility of investment grade credit since 2003 have encouraged the creation of a number of new indices (typically subsets of the main index) which consist of riskier investment grade names and those whose spreads have a tendency to move around more than the market as a whole. In both North America and Europe, HiVol inidices (comprising Credit derivative and structured credit essentials 33

35 CDX NA HY roll prompts inter-index arbitrage The North American high yield credit derivative index Dow Jones CDX NA HY touched new lows last month [October 2005] in advance of the rollover of the index. Relative value plays between the index and the North American Xover basket contributed to the spread compression, pushing the index below 360 basis points at times. Hedging long high yield index risk by buying Xover protection has proved a popular strategy, note bankers, which has driven spread compression in the high yield basket. Dealers say that relative value trading between the high yield and Xover indices has followed on naturally from the Xover s introduction, due to the overlap between the two baskets. The Xover index, which started trading on 20 September, was created to capture GMAC, Ford Motor Credit and other fallen angels such as Eastman Kodak. Nineteen of the names referenced by the CDX Xover index are also present in the outgoing high yield series. This article appeared in Creditflux 1 November 2005 high volatility credits) and Xover (pronounced crossover ) indices (including some high yield names) are now actively traded. Index trading strategies Credit derivative indices are used for a wide range of purposes, including varients of all the strategies discussed under single name trading strategies (see page 23). One of the most common applications is to provide a macro hedge. Buying protection on the credit derivative index allows users to hedge themselves against a general downturn in the credit market. Sometimes, they express a positive view on a particular credit, sector or tranche, but buy protection on the index as an overall hedge. 34 Credit derivative and structured credit essentials

36 Another important use for the index is for asset managers and CDO managers that need to put allocated funds to work quickly, before they have had a chance to select or find specific assets which they believe will outperform the market. Because of their low execution costs, credit indices are also the product of choice for hedge funds, which often want to place short term bets on the direction of the market. As a result, indices are often used in momentum trades, where traders believe they can ride the general direction of the market for a short period. Hedge funds and other relative value traders also use index swaps in curve steepening and curve flattening trades. Some hedge funds and proprietary trading desks also trade the index versus all its component single name credit default swaps to arbitrage the basis to theoretical. LEVERAGE First-to-default investors have leveraged exposure to the credits in the basket and therefore earn a leveraged return. The exact return depends largely on the correlation between the names in the basket Nth-to-default baskets A common and long established type of credit derivative consists of a small basket of reference entities usually from five to seven names. The most popular of these trades is a first-to-default basket. But second-to-default baskets, third-to-default baskets and so on are also traded though much less frequently. These types of credit derivative are therefore collectively known by the inelegant term nth-to-default baskets. In a first-to-default basket (FTD), the protection buyer makes regular premium payments to the protection seller in return for receiving a one-off payment as compensation for the first name in the basket to default. When the first name defaults, the contract settles on the defaulted reference entity for the full notional of the contract. The trade terminates and the protection seller is not liable for any further losses in the basket. In a second-to-default basket, there would be no settlement upon the first default, but once the second name defaults, the contract would settle on the defaulted reference entity for the full notional of the contract. Again, the investor is not liable for any further losses in the basket. Credit derivative and structured credit essentials 35

37 The difference between a first-to-default basket and an index referencing the same names is that if one name defaults, the index investor incurs a loss proportional to the weighting of that name in the index and the index continues. In a first-to-default trade, by contrast, a default causes the transaction to terminate and the investor suffers a loss calculated on the full basket notional. First-to-default example BMW France Telecom (32 bps) (36 bps) Both investors have exposure to the same names. But first-to-default investors can lose all their money upon one name defaulting. Thus, firstto-default investors have leveraged exposure to the credits in the basket, and they earn a leveraged return. Marriott International Reuters Group plc Sara Lee (29 bps) (26 bps) (38 bps) If an investor has $10 million to invest and is comfortable with the credit risk of five names, but finds that their spreads are too tight in the current market, the investor could sell protection on a $10 million first-todefault basket referencing those names. For example, the reference entities could be as shown in the example (left). The investor receives, say, $120,000 every year, which is 120bp on a $10 million notional, for taking exposure to the first default in the basket. This is clearly much higher than the $32,200 a year the investor would receive on an index of the same names. If there is a credit event on Reuters in the first year, the investor would settle the contract by paying $10 million to the protection buyer and receiving Reuters deliverable obligations with a $10 million face value, based on market standard physical settlement. Since first-to-default baskets are leveraged instruments, they should earn a leveraged return, but the exact return depends largely on the correlation between the names in the basket. Intuitively, in a first-to-default basket, the spread should be wider than the spread of the riskiest name in the basket. This is because the first-to-default investor is taking exposure to all the names in 36 Credit derivative and structured credit essentials

38 If correlation in the basket is one, first-to-default investor is taking no more risk than an index investor and should earn no more than the spread of the riskiest name in the basket. If correlation in the basket is zero then the first-to-default investor is taking much more risk than an index investor. the basket, and needs to be compensated for at least the riskiest name in the basket. The first-to-default basket spread should, however, not exceed the sum of all the spreads in the basket. This is because the investor should not be compensated for more than the risk of all the names in the basket. Typically, the spread offered on first-to-default baskets lies between 60% and 80% of the sum of the spreads of the names. However, a fair price needs to reflect not only the default risk of the names in the basket, but also the implicit correlation of the individual defaults. The correlation between the names in the basket is an important pricing input because it determines how much additional risk the first-to-default investor takes over an index investor. If the correlation in the basket is one, meaning that if one name defaults, all of them will default, then the first-to-default investor is taking no more risk than the index investor, since they both lose all their money at the same time, and in this extreme event, the first-to-default investor should earn no more than the spread of the riskiest name in the basket. Conversely, if the correlation in the basket is zero, meaning that if one name defaults none of the other names will necessarily default, then the first-to-default investor is taking much more risk than the index investor because the first-to-default investor can lose everything whereas the index investor loses only part of its investment. However, in practice, default correlation is difficult Credit derivative and structured credit essentials 37

39 to calculate because it is not observable, so dealers have to make certain assumptions on correlation when pricing baskets. Typically, credit derivative dealers are the buyers of protection in nth-to-default baskets, and their clients are sellers of protection since these baskets give investors a conceptually simple way to take leveraged exposure to credit, without the need to analyse dozens or hundreds of different reference names (as would be the case in a synthetic CDO). First-to-default baskets are particularly popular with investors in Asia. Cash CDO outstandings November 2005 Collateral type $bn % Asset-backed securities High yield loans High yield bonds Investment grade bonds Emerging market bonds Trust preferred securities Others Total Collateralised debt obligations Collateralised debt obligation (CDO) is one of the most unhelpful pieces of terminology in the financial markets. The term can be misleading for several reasons. First, not all CDOs are collateralised. Second, the term is most often used to refer to a transaction and not to the individual securities that are issued in that transaction (which are usually called CDO securities, notes, classes, tranches or liabilities). CDO is also used to refer to a range of financial instruments which are quite different from each other in terms of construction. CDOs are, however, a crucially important part of the financial market, since they channel investment into credit and, in return, give investors highly customised exposures to credit risk. In essence, they are a means of transforming a portfolio of assets (bonds, loans, credit default swaps, asset-backed securities and so on) into different investments (tranches), each with a different riskand-return profile. The first CDOs were known as collateralised bond obligations (CBOs) by analogy with the collateralised mortgage obligations 38 Credit derivative and structured credit essentials

40 (CMOs) used in the US mortgage-backed market. These CDOs, which appeared following the growth of the high yield bond market in the late 1980s, used high yield corporate bonds in the underlying portfolio. Cash CDOs These original CDOs were called cashflow CDOs because the interest payments and principal payments of the notes issued to investors came from the interest and principal redemptions in the underlying bond portfolio. Almost all CDOs today are cashflow in this sense. But there are also a handful of market value CDOs so called because their performance depends on the market value of the underlying asset portfolio as well as the cashflows the assets generate. Cash CDOs portfolio of credit exposures (bonds/loans ABS/CDO) sold SPV note insurance class A AAA/Aaa class B AA/Aa2 debt class C A+/A1 sourced from market/balance sheet actively managed by an asset manager or static class X not rated equity Source: B&B Structured Finance Ltd Credit derivative and structured credit essentials 39

41 While the earliest CDOs were static, meaning that the asset portfolio would not change during the life of the deal, most deals now employ a manager. The manager can help to avoid losses in the portfolio by trading out of deteriorating credits, and can take a profit when assets appreciate. The biggest cash CDO managers are generally US-based firms such as TCW, Ellington Capital Management, Highland Capital Management and Babson Capital. However, European banks such as Credit Suisse and WestLB also have big CDO management arms. Rating agencies are central to the CDO market. The economics of a CDO are heavily dependent on achieving a top rating (such as triple A) for a large proportion of the deal s liabilities. This ensures that the cost of funding the CDO tranches (that is, paying their coupons) is lower than the income from the assets in the portfolio. This generates an arbitrage between the assets and liabilities, which is why most CDOs are also refered to as arbitrage CDOs. In contrast, some CDOs are not arranged to take advantage of this arbitrage. They are carried out by banks that wish to remove assets from their balance sheets often for regulatory reasons. Such deals are often referred to as balance sheet CDOs. However, the distinction between arbitrage and balance sheet CDOs is often a hazy one in practice. Synthetic CDOs Today, the term cash CDO refers to CDOs with cash assets in the portfolio such as bonds, loans, asset-backed securities and CDO tranches. By contrast, synthetic CDOs have synthetic portfolios, that is, portfolios of credit default swaps. The first synthetic CDOs were put together by North American and European commercial banks in the late 1990s. They resembled cash CDOs in most respects, except that the issuing vehicle did not buy physical bonds and loans. Instead, it sold protection on the portfolio to the bank. Banks transacting these synthetic balance sheet CLOs typically owned the assets which were usually loans and bought protection through the deal to reduce their regulatory capital charge on the assets. The synthetic transfer of the risk using credit 40 Credit derivative and structured credit essentials

42 How a cash CDO works In a cash (as opposed to a synthetic) CDO, an investment bank sets up a vehicle to acquire a diverse portfolio of fixed income assets. The vehicle issues several classes of bonds (called tranches) which rank in sequential order of priority. This is called the capital structure of the transaction. If there are losses in the portfolio, the most junior investors (called equity investors) are the first to experience a loss. When the losses exceed the size of the equity tranche, the investors in the tranche above the equity tranche start to experience losses. When that tranche is used up, losses pass to the tranche above it. And so on. The different classes of bonds are usually rated by one or several of the major rating agencies, with the most senior liabilities enjoying a triple A rating and the second most risky bonds rated double or triple B. The equity or first loss tranche is usually unrated. Each tranche achieves its rating based on the rating agency s estimate of loss probability for that tranche, based on the expected losses in the portfolio and the level of subordination provided by the tranches beneath that tranche in the capital structure. Most cash CDOs employ features designed to divert income away from the junior liabilities and towards the senior debt if the portfolio experiences a certain level of defaults or a certain drop in income. The most important test is the overcollateralisation (OC) test, which states that the value of the assets needs to exceed the value of the outstanding liabilities by a certain ratio. In a cashflow (as opposed to a market value) CDO, the OC test is based on the par or face value of the assets, and does not take account of the market value of the portfolio. Credit derivative and structured credit essentials 41

43 Synthetic CDOs portfolio of CDS ABCDS single-tranche CDO exposures premium SPV or bank trading book sells protection note and CDS issuance class A class B class C sourced from market/balance sheet actively managed or static class X Source: B&B Structured Finance Ltd derivatives was a particularly good solution for banks given that many loans had strict confidentiality clauses and restrictions on transfer, and could not be sold into an SPV. As credit default swaps grew in volume, liquidity and transparency, and as investors and asset managers became more comfortable with the asset class, the first arbitrage synthetic CDOs were issued. The objective here was not to gain regulatory capital relief, but to take advantage of the difference between the income from a portfolio of credit default swaps and the payments on the synthetic CDO liabilities. The first set of synthetic arbitrage CDOs, which were issued in 2000 and 2001, referenced investment grade credit default swaps 42 Credit derivative and structured credit essentials

44 and were static. But with many investment grade credits being downgraded in the following years, the market shifted towards managed synthetic CDOs. From 2002 onwards, these deals were supplanted by a new breed of synthetic CDO. Rather than assembling a full capital-structure of liabilities for each deal, credit derivative dealers began to trade single synthetic CDO tranches on-demand. The first arbitrage synthetic CDOs, issued in 2000 and 2001, were static. But with many investment grade credits being downgraded in the following years, the market shifted towards managed synthetic CDOs Bespoke or single tranche CDOs, which are tailored to suit investors various requirements, are now a standard part of every large credit derivative market maker s range of products, and they are accounted for and risk-managed as part of the bank s exotic credit derivative or correlation trading book. By contrast with single-tranche CDOs, deals in which most tranches of the capital structure are sold to investors are often referred to as fully distributed CDOs. RISK TRANSFER Dealers are usually the buyers of protection on single tranche CDOs. They hedge themselves by selling protection on single name or index credit default swaps Dealers are usually the buyers of protection on single tranches. They hedge themselves by selling protection on single name credit default swaps or credit indices in a certain ratio (called the delta) based on the sensitivity of the tranche to the single name or index spreads. Since single tranche CDOs are similar to nth-to-default baskets in that they offer leveraged exposure to a portfolio of credits, they are also priced using correlation assumptions. As a result, dealers who buy single tranche protection from investors and hedge themselves by selling protection on unleveraged portfolios are left with exposure to credit correlation, which they often hedge using index tranches (see page 48). Credit derivative and structured credit essentials 43

45 How a single tranche synthetic CDO works A single tranche CDO is one that uses credit defaults swaps in its portfolio of assets and issues only one tranche tailored for a single investor instead of issuing the entire capital structure to a variety of investors. The single tranche is in the form of a credit default swap. It may also be offered in note format by creating a credit-linked note referenced to the tranche swap. Bespoke single tranches are almost always cash-settled. When there is a default in the portfolio, the calculation agent (usually the protection buyer) calculates the recovery rate for the credit and determines the loss as a percentage of the portfolio. However, the protection seller only needs to make a payment once losses exceed the attachment point. Once losses reach the detachment point, the protection seller s investment is wiped out and the protection buyer no longer enjoys any protection on the portfolio. For example, an insurance company might invest in a 20 million 5% to 6% tranche of a portfolio of 100 equal-weighted investment grade credits with a dealer as the buyer of protection. The dealer pays a premium of 50bp a year to the insurance company, and the first few defaults in the portfolio do not affect the investment. After the 10 th default (based on 50% recovery rates for the various defaults), losses in the portfolio will hit the 5% tranche attachment point. If, for example, the 11 th default brings losses in the portfolio to 5.4%, the insurance company s investment will be written down to 12 million and the 50bp protection payments will made on the reduced 12 million notional. Most single tranches are rated though, unlike cashflow CDOs, the rating is usually given by only one rating agency and the deal in this example could expect to achieve a double A or triple A rating, depending on the exact composition of the portfolio. This high rating implies that it is unlikely for the deal to suffer any loss. 44 Credit derivative and structured credit essentials

46 Single tranche CDO cashflows reference portfolio exposure 1 dealer delta hedges his exposure by selling protection exposure 2 exposure 3 exposure 4 dealer dealer buys protection on a tranche tranche X (detachment/ exhaustion point) 10% 7% (attachment point) virtual subordination exposure M Source: B&B Structured Finance Ltd Most single tranche CDOs use reference portfolios comprised of investment grade credits. Some portfolios also contain a small number of high yield names or sovereign credits. Synthetic CDOs linked to credit default swaps on asset-backed securities are also traded both in single tranche and fully distributed form, although they remain much less common than CDOs on single name corporates and financials. Most synthetic CDOs whether single tranche or fully distributed are cash-settled. The calculation agent (almost always the dealer) determines the tranche loss amount based on the recovery rate. Credit derivative and structured credit essentials 45

47 Synthetic innovations The synthetic CDO market has seen frequent waves of innovation as credit derivative dealers try to take advantage of new market conditions, and seek to achieve top ratings with the least possible subordination so that a structure can pay an attractive return for its rating. Two of the most popular products have been synthetic CDOssquared and leveraged super senior tranches. The first of these became extremely popular around 2003, but faded away following the sharp change in correlation pricing that took place in May Following the correlation repricing, leveraged super seniors surged in popularity, but volumes abated by the end of 2005 as market prices adjusted to the increase in super senior activity. A synthetic CDO-squared, usually written CDO^2, is a synthetic CDO in which the reference assets are themselves single tranche CDOs. This results in a two-tier structure. Once losses attach in the bottom tier of inner CDOs this causes losses to the top tier master CDO. A CDO squared increases the leverage of the investment, paying a higher return than synthetic CDOs on single name CDS, but also increasing the speed with which losses will eat through the tranche. (This risk is known as cliff risk.) A super senior tranche is one with a high attachment point (the percentage of subordination beneath the tranche) and very low expected losses. A leveraged super senior investor has exposure to the entire super senior tranche, but its investment notional is only a small proportion of the notional of the super senior tranche. Since they have leveraged exposure to the super senior tranche, investors receive a leveraged return. However, if the market value of the super senior tranche decreases for example, because losses start to occur on the underlying portfolio the dealer has the right to ask the investor to increase the size of its notional investment. If the protection seller is unable or unwilling to put up more funds, the trade is unwound, causing a mark-to-market loss to the investor even though actual portfolio losses may be far from reaching the attachment point of the tranche. Leveraged super senior tranches allow dealers to hedge the most senior part of the capital structure of synthetic CDOs, for 46 Credit derivative and structured credit essentials

48 A CDO-squared increases the leverage of a synthetic CDO. It pays a higher return than a CDO of single name credit default swaps, but increases the cliff risk, the speed with which losses will eat through the tranche which there has historically been little demand, while offering leveraged returns that attract typical CDO investors. Like all single tranches, super senior trades are sensitive to portfolio correlation assumptions, which is why a shift in correlation can significantly change the price of leveraged super senior deals. Credit CPPI In 2005, a new product began to appear in the structured credit market, borrowing a structure originally applied to equities and funds of funds. Usually referred to as credit CPPI, these deals offer investors a principal protected investment where the return is at risk to a leveraged portfolio of credit. However, unlike traditional forms of principal protection, the credit exposure in the CPPI increases as the portfolio performs well, and decreases as the portfolio underperforms. If the portfolio performs very poorly, the credit exposure to the portfolio is completely reduced and all cash available is invested in highly rated credit so as to guarantee the investor principal at maturity, Credit CPPI trades can be static or managed and can consist of a portfolio of single names, a credit index, index tranches (see page 48), or some combination of these different investments. With the credit markets experiencing tight spreads for an extended period of time, and the economics on CDOs looking less attractive, managers are increasingly looking to manage credit CPPI transactions at the time of publication. These deals give managers the ability to go long and short credit opportunistically without the rating agency constraints of CDOs. Credit derivative and structured credit essentials 47

49 Credit CPPI cashflows synthetic portfolio notional = multiplier * reserve premium dealer $10mm investment investor premium $10mm deposit (premium and deposit return accrue) reserve = deposit value - zero coupon bond value investment = $10mm zero = $7mm multiplier = 10 reserve = $10mm - $7mm = $3mm synthetic portfolio notional = 5*$3mm = $15mm Index tranches Source: B&B Structured Finance Ltd Index tranches are highly standardised single tranche CDOs with a credit index (usually itraxx Europe or CDX NA IG) as their reference portfolio. Unlike bespoke single tranches, index tranches have standardised documentation and use standard attachment and detachment points. Index tranches are quoted on all the maturities of the indices, which are three, five, seven and 10 years. Dealers agreed to trade tranches on these standardised terms in 2003 in an effort to create a liquid product which they could use to hedge their bespoke single tranche CDO business, and which 48 Credit derivative and structured credit essentials

50 Index tranche prices CDX NA IG series 6, five-year quotes, 16 May Full index level 38bp bid (bp) offer (bp) delta 0-3% % would reflect the market s view on credit correlation at any given time. However it wasn t until late 2004 and early 2005 that interest in these products gained momentum. There have also been various attempts to extend tranche trading to other indices, such as those in Asia and emerging markets. However, with the exception of CDX NA HY, tranche trading in indices has so far been limited. 7-10% 10-15% 15-30% Index tranches are typically deltahedged using the underyling index. Delta-hedging tranches is very Source: Deutsche Bank similar in theory to delta-hedging options. This means, for example, that if a dealer sells $10 million of protection on a 0-3% tranche of CDX NA IG it will also buy protection on the regular index in a ratio or delta based on the sensitivity of the tranche to a 1bp move in the index spread. The delta hedge is calculated to leave the dealer with no exposure to small moves in index spreads. If the delta is 20, for example, the dealer will buy $200 million of protection on CDX NA IG. Note that dealers are still left with exposure to correlation and to large spread moves in the underlying single name credit default swaps. By convention, index tranches and their index hedges are traded simultaneously in a process known as delta exchange. Although dealers proprietary correlation models will produce slightly different calculations of what the delta should be, the delta that is exchanged for each tranche is agreed periodically by a poll of dealers carried out by an interdealer broker. The main participants in the index tranche market are dealers which often trade with each other and a small number of specialist hedge funds. In the early days of the market, much of the Credit derivative and structured credit essentials 49

51 What is implied correlation? Default correlation is an important parameter in the pricing of all leveraged portfolio credit products. Historically, dealers would input single name CDS spreads plus a default correlation assumption into their model to price a single tranche. Today, due to the liquidity and standardisation of index tranches, dealers no longer have to calculate the price of the tranche as it already exists in the market. They can back-out from their models the market implied correlation. Correlation is the parameter which explains why the spread of a single tranche can move even when the average spread of its reference portfolio remains unchanged. Like all derivatives, the price of bespoke and index tranches changes in response to supply and demand. When demand for a certain type of tranche makes the spread tighten more than would be expected given the pattern of the underlying spreads, the market is said to be changing its view of correlation. trading flow consisted of dealers buying protection on the equity (0-3% tranche) and selling protection on the junior mezzanine (3-6% or 3-7% tranche) with hedge funds as their counterparties. This was known as the mezz-equity trade. The driver of this trade was the fact that the majority of investors wanted to invest in or sell protection on bespoke mezzanine tranches, leaving dealers implicitly long the equity and supersenior tranches. In other words, dealers were exposed to a move in correlation assumptions. In an effort to reverse their correlation position, dealers sought to buy equity tranche protection, and sell mezzanine tranche protection, offering attractive levels for these positions. Hedge funds took the other side of the trade, looking to take advantage of the potential mispricing that a skewed demand created. Dealers were only too happy to offset the correlation exposure built up in their correlation trading books. However, following the downgrades of Ford and General Motors in April and May 2005, and the subsequent losses experienced by some dealers and hedge funds as a result of this trade, the index tranche market has seen a broader range of trading strategies and an increase in the number of participants (despite the well publicised exit of a handful of hedge funds such as GLG and Silverback Asset Management). 50 Credit derivative and structured credit essentials

52 Among the most popular strategies are trading tranches against individual names, trading tranches of the different series of indices against each other and, as the range of quoted maturities has increased, trading five, seven and 10-year tranches against each other. SUB-PRIME Most trading in ABCDS has been concentrated in US sub-prime mortgage securitisations which consist of mortgages to less creditworthy borrowers. Asset-backed credit default swaps One of the most important developments in the credit derivatives market in 2005 and 2006 has been the growth of credit default swaps referenced to asset-backed securities (ABCDS). Assetbacked securities (ABS) are the bonds that are issued when a bank securitises assets such as mortgage loans, car loans and a host of other, retail-oriented asset types. Asset-backed securities are very similar to CDOs in that they sell a portfolio of assets into an SPV and issue a series of securities (or tranches) which rank sequentially in order of priority. When the underlying portfolio of assets is related to mortgages, the market also uses the term mortgage-backed securities (MBS). But, the generic name for the whole market is ABS. CDOs and ABS are considered the two largest subsets of the broader securitisation market. The first credit default swaps referencing individual asset-backed securities were traded around However, as far back as 1999 some synthetic CDOs had included asset-backed securities in their reference portfolios. Although there are many different types of securitisations, most trading in ABCDS (also known as synthetic ABS) has been concentrated in one sector of the market US sub-prime mortgage (or home equity) securitisations. These are securitisations of mortgages to less creditworthy borrowers or second loans secured on a single property. The original impetus for the growth of the market came from investment banks that act as securitisation underwriters. They were concerned about the amount of risk they were holding on their balance sheets through this business particularly given concerns about a possible downturn in the US housing market and wanted Credit derivative and structured credit essentials 51

53 Credit default swap on ABS ABCDS premium (fixed payment) protection buyer payments in case of principal writedown, prinicpal shortfall or interest shortfall (floating payment) payments in case of reimbursements of principal writedown, principal shortfall or interest shortfall (additional fixed payment) protection seller Source: B&B Structured Finance Ltd to use the market to hedge their pipeline of upcoming deals by buying ABCDS protection. On the other side of the market, managers of CDOs of ABS were the main sellers of protection. In 2003 CDOs of ABS were becoming very popular. The trend was generally to issue cash CDOs of ABS on mezzanine tranches of ABS and synthetic CDOs of ABS on senior tranches of ABS, generating greater demand to sell ABCDS protection on senior tranches of ABS. Since the early days, the range of trading strategies using ABS credit default swaps has expanded. CDOs have remained among the biggest sellers of protection. However, hedge funds and other active traders have taken advantage of the fact that the instrument allows them to take a short position in asset-backed securities for the first time. How an ABS credit default swap works An ABS is a transaction in which the financial institution that originated a portfolio of, say, car loans borrows money using the car loans as collateral. The financial institution sells the portfolio of car loans to a special purpose vehicle, which pays for the assets by issuing tranches of sequentially ranking debt the asset backed 52 Credit derivative and structured credit essentials

54 Credit default swaps on ABS reference a particular class of notes from a particular ABS issuer. This is because the different tranches of the securitisation have very different probabilities of experiencing a loss securities. However, similar to balance sheet CDOs, the originating financial institution generally retains the equity (first loss) tranche. These ABS tranches are always rated, as most investors require a rating, and most deals comprise a cascade of liabilities rated from triple A down to double or triple B. Unlike credit default swaps on corporates or financials which reference the issuer or reference entity, credit default swaps on ABS reference a particular class of notes from a particular ABS issuer. This is because the issuer of ABS the special purpose vehicle is bankruptcy remote. More importantly, all the different tranches of the securitisation have very different probabilities of experiencing a loss. Asset-backed securities also have other characteristics that need to be taken into account in the credit derivative documentation. For example, asset-backed securities generally amortise the principal over time rather than making a bullet payment at maturity. This feature can leave a protection buyer holding a contract on a bond that no longer exists. Also, some asset-backed securities, unlike most corporate bonds, are permitted to miss interest payments if there are insufficient funds to make the payment this is generally called interest shortfall. In addition, asset-backed securities can be written down (have their face value reduced) if they are affected by losses in the portfolio. This is referred to as a loss allocation or a principal writedown. But in many cases the principal can be written back up again if the performance of the underlying portfolio subsequently improves. These characteristics and others mean that an ABCDS contract needs to have a unique set of definitions for credit events, a unique Credit derivative and structured credit essentials 53

55 Dealers launch synthetic ABS Index The first of a series of planned CDS of ABS indices began trading on 19 January [2006]. The US index ABX HE, intended as a benchmark by its creators, represents a standardised basket of home equity ABS reference obligations. A new series of ABX HE will roll approximately every six months. It will be created from qualifying deals of 20 of the largest sub-prime home equity ABS shelf programmes from the six-month period preceding the roll and will comprise five separate sub-indices based upon the rating of reference obligations: triple A, double A, single A, mid triple B and weak triple B. The size of principal amounts of these reference obligations typically range from $7 million to $220 million. The minimum size of each deal s total capital structure must be above $500 million and each tranche referenced must have a weighted average life of between four and six years (except for the triple A tranche, which must be greater than five years). This article appeared in Creditflux 1 February settlement process and also needs to take into account principal amortisation among other things. Given the differences between ABS on different asset classes, it is unlikely there will ever be one standard contract for all ABS credit default swaps. However, by early 2006 identifiable standards were beginning to emerge for different types of ABCDS, such as those on US ABS, European ABS and US CMBS. The contract to date that has received the most attention is the one primarily used for US home equities, called pay-as-you-go or PAUG/PAYG. Unlike with a corporate credit default swap where the protection seller only ever makes a single payment, following a single credit event in a pay-as-you-go ABCDS, the protection seller compensates the protection buyer for losses on principal as 54 Credit derivative and structured credit essentials

56 they are allocated to the reference ABS, as well as interest shortfalls. However, if principal or interest is reimbursed, the protection buyer has to pay this amount back to the protection seller, and in the case of interest reimbursements, generally with interest as well. Payments can be exchanged between the two counterparties in this way throughout the life of the trade. However, anytime there is a principal writedown, the protection buyer can choose to physically settle the credit default swap by delivering the ABS to the protection seller and receiving par in return. COUNTERPARTIES Another big difference from a corporate credit default swap is that the protection seller needs to worry about the counterparty risk of the protection buyer. This potential two-way exchange of payments throughout the life of the trade means that the protection seller needs to worry about the counterparty risk of the protection buyer. This is another big difference from a corporate credit default swap, where generally only the protection buyer is worried about the risk that the counterparty will default. (The protection seller s only risk to the protection buyer is the relatively small amount of premium.) ABS credit default swaps also differ from corporate contracts in that protection payments are usually made monthly rather than quarterly. In addition, the maturity of the ABS contract is usually the same as the term of the bond, which means that ABS credit default swaps can have very long maturities, of as much as 80 years. ABS indices In 2005 and 2006, the most recent additions to the growing family of credit derivative indices were the ABX HE and CMBX indices (see page opposite). These indices comprise recently issued residential and commercial mortgage backed securities respectively. They are similar in concept to the earlier corporate credit derivative indices, but trades are documented using a somewhat modified version of the pay-as-you-go confirm, published by Isda in One important difference between ABX HE and itraxx is that all the ABX HE sub- indices reference the same list of 20 ABS issuers (or in fact SPVs). Then, each sub-index references the security from each issue for a particular rating category such as triple A. This is because the different classes of bonds each have distinct characteristics. A further difference from the corporate indices is that the composition of the asset-backed indices should see a complete Credit derivative and structured credit essentials 55

57 There have long been discussions about the creation of exchange-traded credit futures contracts, but at the time of publication no derivatives exchange appears to be close to launching such a contract. Credit derivatives remain entirely over-the-counter change at each six-monthly roll. The composition of the index is designed to reflect the most recent crop of new securitisations, reflecting the origins of the asset-backed credit default swaps market as a means for securitisation arrangers to hedge their pipeline of forthcoming deals. The ABS indices are expected to generate more interest in the ABCDS market in the same way that the itraxx and CDX did in single name CDS market. More players are comfortable taking a broad market view via an index rather than betting on single name ABS. In addition, the index also allows traders to put on relative value trades between different parts of the ABS capital structure trading triple A risk versus triple B risk, for example or between broad asset classes trading ABX against CMBX, for example. Other credit derivatives Besides single name credit default swaps, baskets, indices and index tranches, a large number of other credit derivatives have been created. Many of these instruments have been talked about since the early days of the credit derivatives market but infrequently if ever traded. For example, there have long been discussions about the creation of exchange-traded credit futures contracts, but at the time of publication no derivatives exchange appears to be close to launching such a contract, and the credit derivatives market remains entirely over-the-counter. The following section highlights some additional credit derivative products that exist, even if they remain small parts of the market. In addition to these products, large numbers of credit derivatives are traded with non-standard terms to meet the demands of particular 56 Credit derivative and structured credit essentials

58 counterparties. Examples of these more exotic credit derivatives include callable credit default swaps, where the protection buyer has the right to cancel the contract in certain circumstances; fixed recovery credit or digital credit default swaps, where the recovery rate is fixed at the outset; and hybrids, trades that combine credit with other risks such as interest rates, commodity prices or inflation. Credit swaptions Credit swaptions, that is, options on credit default swaps, have been traded on a fairly regular basis since shortly after the creation of the standard credit derivative indices. Credit swaptions allow traders to take a view on the volatility as well as the direction of credit spreads. SWAPTION TYPES Receiver swaptions: the right to sell protection Payer swaptions: the right to buy protection Though widely regarded as a natural part of the credit derivatives toolkit, credit options have never achieved the same volumes as other second-generation credit derivatives such as index tranches. One reason for the underdeveloped state of this market is that the rolling nature of the indices makes it difficult for dealers to make a market in swaptions dated longer than nine months. This is because the liquidity of an index dries up shortly after a new series is issued. Liquidity of the underlying instrument is essential for options because dealers need to delta-hedge their options with the underlying instruments regularly to reduce the risk in their trading books. Swaptions on single name credit default swaps have seen less trading than index swaptions, given the greater liquidity of indices compared to single name credit default swaps. Two types of credit swaptions are traded equivalent to the call and put options traded on cash instruments. Receiver swaptions give the option buyer the right to receive premium, that is, to sell protection, on a certain date at a certain price (called the strike ). Payer swaptions give the option holder the right to pay premium, that is, to buy protection, on a certain date at a certain price. This terminology is the same as that used in the interest rate swap option market where the premium on the credit default swap is the equivalent to the fixed leg of the interest rate swap. Credit derivative and structured credit essentials 57

59 While other asset classes see various different types of options traded, such as American, European, Bermudian and Asian options, the credit swaption market primarily trades in the form of European options. This means the option buyer can exercise its option to enter into a credit default swap with the option seller only on the maturity date of the option (called the option expiry date). The most liquid swaptions are those with strikes that are at-themoney, that is, where the exercise price is the same as the forward price of the credit default swap at the expiry date on the day of the trade. A big difference between credit swaptions and options in other markets is that single name credit swaptions trade with a knockout feature. (This feature does not apply to index swaptions.) This simply means that if there is a credit event on the underlying credit, the option contract terminates worthless. In other words, the buyer of a payer swaption is not protected against credit events prior to exercise. The knock-out feature means that dealers are often unwilling to price swaptions on credits with high spreads. A payer on a credit that is near to default would typically have one of two opposite outcomes the name survives and the option is worth a great deal or the credit defaults and the option knocks out and becomes worthless. This makes it hard to value and hedge swaptions. Recovery swaps Recovery swaps are a type of credit derivative that has seen sporadic bouts of trading since the instrument was first introduced in The product allows users to express views on recovery rates upon default. In a recovery swap two counterparties agree, in effect, to swap recovery rates following a credit event. In the case of a physically settled recovery swap the recovery buyer agrees to buy defaulted bonds from the recovery seller at the strike rate say, 40%. The recovery buyer is fixing the price at which it buys the defaulted bonds and is therefore long recovery rates, because it will benefit if the actual recovery rate is higher than the strike rate. The recovery 58 Credit derivative and structured credit essentials

60 Jump-to-default hedging spurs recovery-swap surge Dealers say that volumes of recovery swaps are continuing well above average, after surging in the weeks prior to Delphi s default in October. Says one trader: Overall activity has picked up. Last month [November] we traded as many recovery swaps as in the two preceding months together. According to trading desks, most activity has centred on troubled US automakers GM and Ford and their financial arms, as well as distressed energy giant Calpine. One New York desk was quoting recovery on GM in December as 37/40, while GMAC was quoted at 55/60, Ford 55/60 and Ford Motor Credit 57/62. Despite today s increased level of recovery swap trading, the market remains largely undeveloped. For instance, standard Isda documentation is still to be developed for the product. This article appeared in Creditflux 1 January 2006 seller wants the real recovery rate to be lower than 40% and is therefore short recovery rates. No premium changes hands during the life of the trade, and recovery swaps are quoted in terms of the strike price. A dealer might quote recovery swaps in Ford (see article above) at 55/60. This means it is prepared to sell a recovery swap at 60% and buy at 55%. This method of trading a recovery swap, which is sometimes called a recovery lock, takes a conventional credit default swap but with the premium set at zero and the reference price set at the strike rate (rather than 100%). Credit derivative and structured credit essentials 59

61 Recovery swaps tend to be traded when a company is nearing default and trading tends to be driven by dealers need to hedge their books Alternatively, though less commonly, recovery swap can be traded as two back-to-back credit default swaps, one with a fixed recovery rate and the other using normal a floating recovery. If the fixed recovery rate is the current market assumption of recovery rates on the name, then there is no exchange of credit default swap premium in the recovery swap. If, however, the fixed recovery rate is different from the current market recovery assumption, there is an exchange of premium equal to the difference between the premium on the fixed recovery swap and the premium on the market standard credit default swap. Recovery swaps tend to be traded when a company is nearing default and trading tends to be driven by dealers need to hedge their books. Most recovery trades in this situation take the form of the recovery lock, since market participants look to isolate and trade the recovery of a credit without paying any credit default swap premium. Credit derivative market makers need to make assumptions about the recovery rates of the different credits they trade for example, when offering an unwind. For investment grade credits, most banks use an assumption of 40%. If these assumptions turn out to be wrong, the dealer could gain or lose money in the event of a default. Constant maturity credit default swaps Constant maturity credit default swaps (or CMCDS) are credit default swaps in which the protection payments, rather than being for a fixed amount every quarter for the life of the trade, float up and down in line with prevailing credit spreads. For example, in a five year CMCDS referencing Ford, the payments would be calculated each quarter as a proportion of the then current five-year credit default swap spread on Ford (called the reference rate). This percentage is known as the participation rate. 60 Credit derivative and structured credit essentials

62 The lower the participation rate, the higher the market s views of forward spreads. A forward is a contract which comes into force some time in the future, so a two year-into-five year forward credit default swap is a five-year contract starting two years from now. Forward spreads can be implied from the rates for credit default swaps of different maturities today. One simple way to think about it is that the difference between a 10-year credit default swap and a three-year credit default swap must be the same as the risk of default over seven years starting in three years time. The steeper the credit curve (the graph of credit spreads plotted at different maturities), the steeper the forward curve, and the lower the participation rates offered on CMCDS. Since the CMCDS was first introduced around late 2003, participation rates have typically been low, implying steep credit curves. This has reduced protection sellers appetite for the product, since they are often unwilling to take on default risk for such low returns. Constant maturity credit default swap premium (reset quarterly) protection buyer contingent payment protection seller buyer pays the 5 year CDS premium, reset quarterly contingent payment is the same as in a standard CDS same concept as CMS or CMT trades 5Y CDS observed at regular intervals is called reference rate CMCDS premium is quoted as a percentage or participation rate of reference rate Source: B&B Structured Finance Ltd Credit derivative and structured credit essentials 61

63 Loan-only credit default swaps have generated a lot of interest in 2006, because they have the potential to change the traditionally long-only loan market into one where participants can short risk or take on risk synthetically Also, when CMCDS were first introduced, many market participants thought that a CMCDS would reduce mark-to-market volatility in the same way that a floating rate bond has less mark-to-market volatility than a fixed rate bond. However, while the reference rate floats with prevailing credit spreads (similar to Libor), the participation rate is fixed and therefore the market value of the product changes as the shape of the credit curve changes. As a result, volumes have been lower than many of the product s promoters had hoped. Most activity has centred on single names, with a few synthetic CDOs also structured using floating spread coupons. LOAN-ONLY CDS A loan-referenced credit default swap can be triggered by a default on any borrowed money debt obligation. But only senior loans can delivered into the contract. This means it should have a similar probability of default as a conventional CDS but higher recoveries Loan-only credit default swaps Secured loan-only credit default swaps (LCDS) are credit default swaps where settlement is linked to the syndicated secured loans of a company, rather than all of its senior debt. The product has generated a lot of interest in 2006, because it has the potential to change the traditionally long-only loan market into one where participants can short risk or take on risk synthetically. Volumes can be expected to grow as market standard documentation comes into practice and as investors see the benefits of the product. These contracts may appeal to protection sellers who cannot find a cash loan to buy or who have a high cost of funding. The appeal for protection buyers is that they are able to short loans. The reference obligation of an LCDS is one of the reference entity s senior, secured loans. Issuers of secured loans are usually high yield rather than investment grade companies. Typical credit events are 62 Credit derivative and structured credit essentials

64 bankruptcy and failure to pay, and US high yield corporates exclude restructuring as a credit event. Loan-only credit default swaps settle physically like standard credit default swaps, with the buyer of protection delivering a senior secured loan (such as a term loan, revolving loan or multicurrency loan) to the seller of protection. A credit event can be triggered by a default on any debt obligation (that falls within the category of borrowed money), but only obligations that are not subordinated to the reference obligations (typically loans) can be delivered into the contract. This means that a loan-only credit default swap has a similar probably of default as a conventional CDS, but recoveries would normally be higher. As a result, CDS loan spreads are generally lower than bond and conventional credit default swap spreads for the same issuer. RECOVERY VIEWS The emergence of loan-only and preferred credit default swaps may evenutally generate interest in investors taking a view on recovery rates on different levels of debt for the same reference entity LCDS spreads have so far also been lower than cash loan spreads on the same names. This partly reflects the premium that cash loans receive to compensate the lender for the issuer s option to refinance the loan at lower spreads. (Loan credit default swaps generally remain outstanding if the loan is refinanced.) The basis also reflects the fact that the LCDS maturity is fixed for, say, five years, while a cash loan can be amended or extended in some cases. Another part of the appeal of these instruments is that their spreads should move in line with loans rather than following bond spreads, which means they can be used for strategies such as going short loans, and trading the basis between the underlying cash loan and LCDS, as well as allowing capital structure investors to express views on secured loans in relation to other securities such as bonds and stock. Preferred credit default swaps Preferred credit default swaps (PCDS) represent another tweaking of standard single name credit default swaps with the aim of extending trading to a new asset class. In this case, the assets in question are preference shares and other preferred securities. These instruments fall between debt and equity in the corporate capital structure, and banks in particular make extensive use of Credit derivative and structured credit essentials 63

65 them for financing. Although they are generally regarded as fixed income products, they do not fall within the definition of borrowed money. As a result, they are not eligible to trigger default in a standard credit default swap contract. The two major changes to the standard CDS contract for a PCDS are the addition of preferred stock as a deliverable obligation and an additional credit event deferral of the payment of preferred stock dividends. The emergence of loan-only and preferred credit default swaps may eventually generate interest in investors taking a view on recovery rates on different levels of debt for the same reference entity. This trading strategy is called capital structure arbitrage. Loan-only CDS represents senior secured debt, whereas market standard single name CDS references senior unsecured and preferred CDS represents very subordinated debt. 64 Credit derivative and structured credit essentials

66 CHAPTER THREE The practicalities HOW MUCH? Supply and demand determine the price of any derivative. The purpose of quantitative research is to make sense of price relationships between different products Pricing and valuation What determines the price of a credit derivative? There is a simple and obvious answer to this fundamental question: supply and demand. The main purpose of the realms of quantitative research and complicated mathematical calculations that surround any derivatives market is not to determine the price of these products. Its role is to make sense of the sometimes bewildering relationship between the price of different products and what the market believes the key assumptions are behind that price. Of course, when firms agree to trade an innovative new kind of credit derivative one with a different sort of pay-off structure, new features or unusual terms quantitative research should help to educate the guesswork involved in pricing such a novelty. Once a credit derivative has been traded at the market price the instrument needs to be valued periodically. Most banks, hedge funds and some insurance companies have to mark their positions to market. More fundamentally, companies need to value their positions to know whether they are sitting on a profit or a loss. Credit derivative and structured credit essentials 65

67 CHAPTER THREE THE PRACTICALITIES Back-of-envelope pricing formula Present value of spread = expected loss Expected loss = probability of default * (1 recovery rate) Default probability = present value of spread/(1 recovery rate) The best kind of valuation to use when valuing a position is a market valuation: how much would someone pay or charge to take on this risk today. For most standardised single name credit default swaps, indices, and index tranches, current market prices for standard maturities are available from third party sources, most notably the data provider Markit. However, a market price for a standard maturity is not the same as a valuation for a trade done one year ago which now has four years to maturity. At the same time, some credit derivative trades are highly tailored and do not have prices from more than one dealer. So, just like in any over-the-counter derivative market, valuation often relies more on the theoretical than on actual market prices although many inputs to the theoretical valuation are actual market levels. Once a current price (theoretical or market) is determined, credit derivatives, like any financial contract, can be valued by discounting their future cashflows to the present day. The profit or loss is essentially the net present value of the difference between the contractual spread on the credit default swap and the current spread for a contract with the same maturity (an offsetting credit default swap). Since the discount rate used for calculating net present value depends on the reference entity s default risk, the higher the risk of default, the greater the probability that the two offsetting credit 66 Credit derivative and structured credit essentials

68 CHAPTER THREE THE PRACTICALITIES There is no market standard for when a credit starts to trade upfront and there is no market standard for whether the spread is fully or partially paid upfront. Just before it defaulted, Dana was quoted at 35/37.5 point up front: sell $10 million of protection and receive an initial payment of $3.5 million default swaps will terminate, reducing the present value of the future cashflows. Therefore, any credit derivative valuation requires current prices to determine default rates. Many products similarly require inputs for credit correlation, recovery rates and volatility. Upfront amounts Credit default swap payments are usually made quarterly in arrears. So the higher the probability of default, the more the seller of protection needs to worry about a credit event taking place before any income has been received from the swap. Therefore, credit default swaps on single names and tranches with spreads higher than about 500 basis points tend to trade on a points-upfront basis. In other words, the spread or a portion of the spread is present-valued and paid upfront. If only a portion of the spread is paid upfront, there is still a running spread to pay. There is no market standard for when a credit starts trading upfront and there is no market standard for whether the spread is fully or partially paid upfront. For example, in February 2006, just before it defaulted, Dana was quoted at 35/37.5 points up front. This meant a trader could sell $10 million of protection and receive an initial payment of $3.5 million. Another example of upfront amounts is in equity tranche trades. The market standard for the 0-3% itraxx and CDX IG tranches is to pay a portion of the spread upfront and 500bp running. As the 500bp running is constant, prices for the equity tranche are quoted based on the upfront amount. Again, this is due to the Credit derivative and structured credit essentials 67

69 CHAPTER THREE THE PRACTICALITIES For dealers, standardisation is a double-edged sword. Greater standardisation encourages new entrants and boosts volumes. But it also stimulates competition and drives down margins. Product innovation is always affected by these two opposite forces high probability of experiencing a loss on the equity tranche. (As losses occur, the 500bp payment remains the same but it is now calculated on the reduced notional.) Index swaps also trade with exchanges of upfront amounts. This is because the standardisation of the index contract extends to the contractual spread, which is fixed at the launch date for each series. So, if the contractual spread is fixed at 30bp but the market value is now 40bp, the seller of protection will receive only 30bp under the contract. The seller needs to be compensated for the 10bp difference between the contract and the market by receiving the present value of 10bp running. Market conventions Like all new financial markets, credit derivatives were first traded using customised, ad hoc contracts, as different counterparties came up with different ideas of how to construct trades. But over time, the conventions of the market have become more standardised. Partly this standardisation reflects the exchange of ideas and the momentum behind successful structures. For example, the market quickly converged around the idea of trading five-year contracts as the somewhat arbitrary standard maturity (although since 2003 there has been a move away from five year contracts towards seven and 10-year trades). But market participants have also consciously pushed for standardisation. Any firm that has traded a contract would like to see an active market develop in contracts using the same terms, so that the position can be sold in future if necessary. 68 Credit derivative and structured credit essentials

70 CHAPTER THREE THE PRACTICALITIES For credit derivative dealers, standardisation is a double-edged sword. Greater standardisation gives new entrants to the market confidence that they will be able to find liquidity and this drives up volumes and helps ensure the permanence of the market. On the other hand, standardisation creates competition among dealers and drives down margins. Product innovation in the credit derivatives market is always affected by these two opposite forces: the need to achieve standardisation and broad acceptance at one pole and the desire to create successful proprietary structures and enhance margins at the other. DEBATES The exact definition of seemily trivial terms such as guarantor and successor can make a big difference to a trade and generate bitter disagreement Documentation standards Most discussions about market practice in the credit derivatives market take place through Isda, the OTC derivatives industry association. The chief milestones in the development of a standard market were the publication of the second standard credit derivative definitions in 1999 and the publication of the 2003 definitions, which updated this template. The history of the credit derivatives market has been punctuated by frequent and often bitter debates over documentation. The exact definition of such seemingly trivial terms as guarantor and successor (to a reference entity) can make a big difference to the financial outcome of a trade, and market participants have often fought hard to turn the conventions of the market to their advantage. Isda s role is to draft templates and sets of definitions that traders can use in response to the emergence of new products. However, the association s general approach is to include multiple options in the contracts so that counterparties can select the elements that are applicable to their trade. This means that the publication of a template does not in itself solve the problem of what is the standard way to trade a particular type of credit derivative. This has recently been seen in the debate over ABCDS documentation. Isda has published a standard template but at the time of publication, it has not been fully adopted by all market participants and in the case of the ABCDS index is used only partially. Credit derivative and structured credit essentials 69

71 CHAPTER THREE THE PRACTICALITIES Some of the fiercest market standard debates have been over which credit events to use for particular types of credit. (The market has long since given up any attempt to use the same credit events for all credit derivatives globally.) In particular, different market participants have disagreed over how to define restructuring as a credit event, and whether such an event should count as a credit event at all in terms of documentation. The choice of credit events crystallised with the publication of the 2003 credit derivative definitions. In particular, the market settled on a confusing set of conventions for the treatment of debt restructuring as a credit event. MORAL HAZARD Protection sellers pushed for a rethink of restructuring as a credit event following a loan restructuring by Conseco in 2000 Protection sellers had pushed for a rethink of the restructuring definition following a loan restructuring by US financial company Conseco in They realised that a corporate debt restructuring could leave longer-dated bonds trading much more cheaply than shorter-term liabilities. Protection buyers could then trigger a credit event and deliver these cheaper long-dated bonds to the protection seller in exchange for payment of par. JP Morgan has calculated that protection sellers lost a total of $60 million in this way following the Conseco restructuring. The Xerox restructuring in 2002 was a similar high profile restructuring case. Investors in credit derivatives feared that banks who had lent money to companies in trouble would start routinely engineering credit events and then delivering the long-dated debt to achieve a profit on the credit derivative contracts they had put on to hedge their loans. In response, a new version of the restructuring credit event was drawn up ( modified restructuring ) which, among other things, limited the maturity of debt that could be delivered following a restructuring. Although this version gained acceptance in the North American investment grade market, European traders rejected this language, fearing that European-style loans would not be deliverable following a restructuring. The European market therefore drafted its own version of restructuring ( modified modified restructuring ). Meanwhile, North American high yield credit default swap traders abandoned 70 Credit derivative and structured credit essentials

72 CHAPTER THREE THE PRACTICALITIES Credit events by market Credit event Failure to pay Bankruptcy Restructuring (old R) Modified restructuring (mod R) Modified modified restructuring (mod mod R) Repudiation/moratorium Loss event/writedown Where used Almost all credit derivatives All corporate/financial credit derivatives, European asset-backed securities Sovereigns, Asian corporates North American investment grade corporates/ financials, Australian corporates/financials European corporates/financials Sovereigns Asset-backed securities Distressed ratings downgrade Some asset-backed securities Obligation acceleration Some emerging market sovereigns and corporates/financials restructuring as a credit event altogether, and Asian and emerging market traders stuck with the original 1999 version. To add to the confusion, when credit derivative indices were created it was decided that the North American investment grade index should, like North American high yield names, be documented without restructuring. (The European indices are documented the same as their single name constituents.) For a period after the release of the 2003 definitions, docs fell off the agenda for debate. They were no longer discussed for most corporate and financial single name credit default swaps. The Credit derivative and structured credit essentials 1

73 CHAPTER THREE THE PRACTICALITIES Dealers act to end reference entity confusion Credit derivative dealers have embarked on an initiative to list and codify reference entities and reference obligations. The project, dubbed RED (reference entity database), has been prompted by disputes in which counterparties have disagreed about which reference entity is the subject of a trade. Credit events such as Armstrong and Railtrack, in which there was some confusion about the exact reference entity involved, have opened people s eyes to the fact that you could be running significant basis risk without knowing it, says Mark Price, chief administrative officer in Deutsche Bank s integrated credit trading division. Each dealer has agreed to trawl through its books in order to come up with a list of the most commonly traded combinations of reference entity and reference obligation. The three lists will then be pooled to create a comprehensive database of reference entities and obligations. Law firm Allen & Overy has already begun the task of checking - or scrubbing - each entry to ensure that the relationship between obligation and entity remains up to date. We are looking for anything that suggests that the issuer as noted on the reference obligation prospectus has changed, says Allen & Overy partner Tom Jones. That involves checking filings on hundreds of different reference entities in over a dozen jurisdictions. This article appeared in Creditflux, 1 April 2002 quoted price reflected market standard documentation and an investor who did not want the market standard needed to specify this and could expect less liquidity and a wider bid-offer spread. However, by 2006 documentation had once again become a hot topic, as investors became aware of the impact that some aspects of documentation notably successor and settlement could 72 Credit derivative and structured credit essentials

74 CHAPTER THREE THE PRACTICALITIES have on spreads. There has been no return to the days of routinely discussing documentation before each trade. But there is pressure for a rethink of some key aspects of documentation even though there is no agreement on what the solutions could be. Names and dates Documentation is not the only aspect of the credit derivative market that market participants have tried to standardise. One of the most important developments in the emergence of a more standardised product has been the introduction of standard maturity and payment dates. STANDARD DATES From late 2002 the market began to standardise maturity and payment dates to the 20th of March, June, September and December. From late 2002, the market began to standardise credit default swap contracts so that they would all mature on one of four days each year 20 March, 20 June, 20 September and 20 December. So, for example, a five-year contract traded any time between 21 September 2005 and 20 December 2005 would have a termination date of 20 December Premiums for credit default swaps are usually paid quarterly on these same dates, which are often called IMM dates by analogy with the International Monetary Market date used in the euromoney market. (However, it should be noted that the true IMM dates are the third Wednesday of March, June, September and December.) Another initiative designed to standardise credit derivative contracts is the Red database of reference entities and reference obligations (see opposite). This was created in 2002 by a group of credit derivative dealers and was later acquired by data provider Markit. Confirmation and settlement As credit derivative volumes have grown, record-keeping and settlement issues have become ever more pressing. Settlement is the process of turning two traders spoken or electronically messaged trade agreements into legal documents checked and signed by both parties. In the early days of the credit derivatives market, settlement could take weeks or even months due to negotiation over specific wording in the confirmation. Credit derivative and structured credit essentials 3

75 CHAPTER THREE THE PRACTICALITIES Hedge funds fall into line on novations protocol Fund managers are falling into line behind Isda s bitterly contested novations protocol, with dealers saying they do not expect any significant hold-outs from buy-side firms. The number of investment management firms signing up to the protocol which spells out how dealers and hedge funds should go about making an assignment accelerated in advance of a deadline on 24 October Signings by mid-month included major names in credit investment management such as BlueMountain Capital, CQS Capital, GoldenTree, Oak Hill and Solent Capital. Hedge funds such as Caxton, Tudor, Amaranth and Moore Capital were among the major scalps that dealers were still looking to collect. Banks say that negotiations with buy-side firms were continuing in the runup to the deadline. There have been a lot of conversations, says a credit derivatives trader at a US bank. It does not benefit anyone to make this a game of chicken. This article appeared in Creditflux 1 November 2005 Clearing the backlog Today much of the delay is due to inconsistencies on reference entity spelling, mismatches of reference obligations or simple overload. But, under pressure from regulators worried about industry-wide operational risk, credit derivative dealers have reduced average settlement times to no more than a few days. However, the market is still a long way from the ultimate goal of instant or T+0 settlement. Hedge funds move into the credit derivatives market in recent years has exacerbated settlement problems. This is not 74 Credit derivative and structured credit essentials

76 CHAPTER THREE THE PRACTICALITIES Hedge funds commonly use novations to unwind trades in order to get the best price available in the market. In the past novations were mainly carried out by spoken communication, and dealers complain this has played havoc with their ability to process confirmations quickly necessarily because hedge funds are less efficient at carrying out confirmation tasks than other counterparties though some of them undoubtedly do have poor back office procedures. The big issue is that hedge funds are high-volume traders, putting on and then reversing positions often within the same day. This has added greatly to the volume of new confirmations being written. A related issue is that hedge funds make frequent use of novations (also called assignments). A novation is the process of transferring an outstanding contract from one dealer to another. It is commonly used by hedge funds that unwind trades in order to get the best price available in the market. In the past, novations have mainly been carried out by spoken communication, and dealers complain that this has played havoc with their record keeping and ability to process confirmations quickly. As a result, derivative market participants agreed a new system for novations in late 2005 (see article opposite). A key development in the emergence of a more robust settlement system for the credit derivatives market is the DerivServ trade confirmation system created by the US-based Depository Trust & Clearing Corporation (DTCC) in 2003 and which quickly became an industry standard. Problems with physical settlement Following a credit event, the seller of protection under a credit default swap needs to pay the protection buyer an amount reflecting the extent of losses lenders to that credit have suffered. This process is known as credit event settlement. Credit derivative and structured credit essentials 5

77 CHAPTER THREE THE PRACTICALITIES Dealers settle Delphi default The auction to settle index and index tranche trades referencing Delphi has been given a clean bill of health by buy-side firms that signed up to the fixing. The 15-minute cash settlement auction, which took place on 4 November 2005, resulted in a price of It was quite efficient and an orderly process, says a trader at a credit hedge fund. The auction came out lower than some had anticipated, as speculative cash bond buyers were hoping to squeeze the bonds higher. There was massive pressure from dealers to get everyone signed up and it looks like most who had positions did. Delphi s bonds traded as high as 71 cents in the dollar in the lead-up to the auction. In all, 577 parties signed up to the Isda protocol supporting the auction, which was administered by Markit and electronic broker Creditex. This article appeared in Creditflux 1 December 2005 At the time of publication, physical is the most common form of settlement for single name credit default swaps. However, as the credit derivative market has grown, several big problems with physical settlement have emerged. One is the practical issue of acquiring and delivering bonds for each contract a counterparty has outstanding on a defaulted name. For active counterparties in the credit derivatives market, the administrative burden of physically settling hundreds or even thousands of individual contracts can be very large. Another problem is that some protection sellers are not permitted to buy distressed bonds and so are not able to settle credit default swaps physically. 76 Credit derivative and structured credit essentials

78 CHAPTER THREE THE PRACTICALITIES Several big problems with physical settlement have emerged. First, active market participants face practical difficulties acquiring and delivering bonds for each contract. Second, some protection sellers are not permitted to take delivery of distressed bonds. Third, the process of settling credit derivatives can itself distort the price of the defaulted obligations A third problem is that the very process of settling credit derivatives tends to distort the price of a recently defaulted debt obligation. Traders who have bought protection need to go into the market and acquire obligations to deliver to their counterparties. And this causes the value of the defaulted debt to rise. The extent of this technical squeeze depends largely on the ratio of credit default swap contracts outstanding to deliverable obligations for the defaulted reference entity. In an extreme case, where there are many more credit derivative contracts than physical debt obligations, the price of the defaulted bonds and loans could theoretically be pushed up to par. This would make credit default swap protection worthless. Short squeezes have occurred since the earliest days of the credit derivatives market, for example, after Russia s default in However, as the ratio of credit derivatives to cash credit instruments has grown, the tendency for defaulted bonds and loans to be squeezed has increased. Following the bankruptcy by Delphi in October 2005, the short squeeze is said to have increased the value of the US car parts maker s bonds by between 10 and 15 percentage points. Dealers were nervous that an artificially high settlement on Delphi one of the most widely referenced names in the credit derivatives market would undermine confidence in the product altogether. Some large market participants privately expressed the view that if Credit derivative and structured credit essentials

79 CHAPTER THREE THE PRACTICALITIES Delphi settled around 70 cents in the dollar, it would spell the end of the credit derivatives market. As a result of these problems, and inspired by the success of cash settlement for index credit derivatives, there is a move to create a system of cash settlement for single name credit default swaps. Talks on this issues were continuing at the time of publication. 78 Credit derivative and structured credit essentials

80 CHAPTER THREE THE PRACTICALITIES Select credit events since 2001 Date Borrower Sector Event 1-Mar-06 Dana automotive misses coupon 20-Dec-05 Calpine energy files for chapter 11 bankruptcy 8-Oct-05 Delphi automotive files for chapter 11 bankruptcy 14-Sep-05 Delta Air Lines transport files for chapter 11 bankruptcy 10-Sep-05 Northwest transport misses equipment trust Airlines certificate payments 17-May-05 Collins & Aikman automotive files for chapter 11 bankruptcy 22-Feb-05 Winn-Dixie retail files for chapter 11 bankruptcy 2-Feb-05 Tower automotive files for chapter 11 bankruptcy Automotive 24-Dec-03 Parmalat food placed in extraordinary administration 17-Dec-03 Solutia chemicals files for chapter 11 bankruptcy 14-Jul-03 Mirant energy files for chapter 11 bankruptcy 1-Apr-03 HealthSouth healthcare misses coupon and principal payment 28-Mar-03 Reliant Resources energy loan maturity extension 25-Mar-03 British Energy energy misses principal payment 17-Mar-03 Marconi electronics misses coupon 2-Dec-02 United Air Lines transport misses coupon 16-Sep-02 NRG Energy energy misses coupon 15-Sep-02 AT&T Canada telecoms misses coupon 15-Jul-02 Worldcom telecoms misses coupon 21-Jun-02 Xerox imaging debt restructuring 16-May-02 Teleglobe telecoms files for bankruptcy 8-May-02 NTL telecoms files for chapter 11 bankruptcy 22-Jan-02 Kmart retail files for chapter 11 bankruptcy 2-Dec-01 Enron energy files for chapter 11 bankruptcy 6-Nov-01 Republic of sovereign debt restructuring, followed by Argentina repudiation/moratorium 7-Oct-01 Railtrack transport placed in railway administration 4-Oct-01 Swissair transport files for bankruptcy Source: Creditflux Credit derivative and structured credit essentials

81 CHAPTER THREE THE PRACTICALITIES Illustrations in this primer Credit derivative outstandings Credit derivative market participants Licensed index dealers Highlights in the evolution of the credit derivatives market Physically settled credit default swap Cash settled credit default swap CDS versus bond cashflows Basis trades Curve steepener Credit-linked deposit CLN issued by an SPV Credit derivative index cashflows Credit derivative index prices (bp), 20 June First-to-default example Cash CDO outstandings, November Cash CDOs Synthetic CDOs Single tranche CDO cashflows Credit CPPI cashflows Index tranche prices Credit default swap on ABS Constant maturity credit default swap Credit events by market Selected credit events since Credit derivative and structured credit essentials