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The credit guide to credit default swaps

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The credit guide to creditdefault swaps

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Head officeRisk Waters GroupHaymarket House28–29 HaymarketLondon, SW1Y 4RXUnited KingdomTel +44 (0)20 7484 9700

Editor, CreditDavid WattsAuthorPhilip MooreContributorSaskia Scholtes Director of Editorial ServicesCelia MatherSubeditorAlex KrohnDesignerMatt HadfieldAdvertising ManagerSimon CrabbPublisherSean O’Callaghan

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Cover illustration Tan Doan

T he credit default swap market has been almost doubling annually since it began in earnest in 1996.And there are as yet no signs of a slowdown. With a number of emerging market financial crises,particularly Asia and Russia, and an unprecedented fall in corporate credit quality in both the US

and Europe, credit default swaps have been well tested in the past nine years. That is not to say there have not been any difficulties. The industry body tasked with laying down the

guidelines for derivatives – the International Swaps and Derivatives Association – has had to revise theCDS contract documentation several times since it was first published in 1998. National Power, a UKenergy producer, Railtrack, the now-defunct operator of Britain’s rail network, and Conseco, a US insur-ance company, have all thrown spanners in the works for the buyers and sellers of CDS protection. Andmost recently Six Continents, a UK retailer, is doing its best to put the brand new Isda credit derivativesdefinitions, only published in February, to the test.

Nevertheless these simple insurance contracts appear able to evolve and adapt to all that is thrown atthem – with the occasional help of a court case.

What’s more, credit default swaps have moved well beyond providing simple insurance for lenders.They are now traded in their own right and are used as building blocks for the newest and most innova-tive structures in the capital markets, including synthetic collateralised debt obligations, credit-linkednotes and first-to-default baskets.

It will be fascinating to see what the CDS market will grow to become and how else people will put itto use. But in the meantime Credit attempts to take some of the mystique out of these simple contractsand break down some of their uses.

David WattsCredit

credit The ABC of CDS 3

Editor’s letter

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6 IntroductionWhat everybody ought to know about this credit businessChanges in the regulation of the financialservices sector and the introduction of acommon currency have simultaneouslyreduced banks’ willingness to holdexposure to corporate risk and investors’ability to buy that risk. So the business oftransferring credit risk is booming.

4 credit The ABC of CDS

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14 DocumentationLaying down the ground rulesAs with any ‘watertight’ contract, holesinevitably appear. And so Isda has beenforced to continuously revisit thedocumentation guidelines on credit defaultswaps in an attempt to respond to newconcerns and the changing market.

12 CDS: the basicsWhich credits are covered by the CDS market?Part of the attraction of credit defaultswaps is that in terms of pricing andmaturity they are not dissimilar to othermethods of trading credit risk, such as loansand bonds. This has helped the marketquickly understand and adopt them.

19 CDS growthThe size of the CDS marketFrom an uncertain inception date, thecredit default swap market has blossomedto become a major asset class in thecapital markets. For this growth tocontinue and the market to reach its fullpotential, certain impediments will need tobe removed.

Contents


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24 Market indicatorsThe ability to ‘trade rumours’The credit default swap market has rapidlybecome recognised as one of the mostresponsive financial indicators, in somecases foreshadowing even the equitymarkets. From Ahold to WorldCom, theCDS market has priced concerns in longbefore other asset classes.

30 New structuresCDSs as building blocksCredit default swaps are no longer purelyused as a form of insurance for lenders oran alternative method of gaining exposure.Their commonality and tradability hasallowed people to create new andinnovative financial products.

26 Market participantsBuyers and sellers of CDSsGreater regulation on the extent to whichbanks are exposed to corporate clients hasmeant banks have eagerly adopted creditdefault swaps to transfer risk, howeverconcerns have been expressed in certainquarters about where the transferred creditrisk is going.

35 ConclusionRisks to the systemWith the credit default swap marketdeveloping at exponential rates, are thedoom-mongers justified in their concerns?

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Soon after the Second World War, Merrill Lynchsensed – quite rightly – that the US stood on

the brink of an equity revolution, and that thou-sands of small investors could be persuaded tochannel their savings into the stock market. Topush them on their way, Merrill published a 6,000-word advertisement in The New York Times onOctober 19, 1948 entitled ‘What everybody oughtto know about this stock and bond business’. Thepiece, deliberately couched in layman’s language,proved so popular that over the next three yearsMerrill printed and distributed around one millionextra copies.

Over the five decades that followed, equitiesbecame a well-understood and popular asset classat both an institutional and a retail level. Morerecently, investors’ attention has turned withincreasing focus towards the market for fixed-income securities in general, and corporate bonds(or ‘credit’ instruments) in particular. By the endof the 1990s, this movement had become sopowerful that investor education about the bondmarket was viewed as being as important as theMerrill-style education about equities had beenin the 1950s.

Credit comes of ageA number of influences have driven a shift in assetallocation from equities to bonds at an institutionaland retail level. Recently, of course, the poor per-formance of equities has played an important rolein this process, famously encouraging UK pensionfunds to make a wholesale reallocation of theirassets away from equity and into fixed income. Butlong before the bursting of the equity bubble inearly 2000, market dynamics were encouraging anincreased supply of bonds.

One of these dynamics has been a fundamentalchange in the relationship between banks and cor-

porate borrowers. The demise of relationship bank-ing in Europe over the past 15 years is attributableto a number of causes, not least the introductiontowards the end of the 1980s of the Basel Accordon bank capital adequacy. Basel I laid down theterms for an agreement among Group of 10 (G-10) central banks to apply minimum capital stan-dards to their banking industries that were to beachieved by the end of 1992.

The standards almost exclusively addressed theissue of credit exposure, identified in the late 1980sas the principal risk incurred by the global bankingsector. In the words of the Bank for InternationalSettlements (BIS), Basel I arose as a reflection ofcentral bankers’ concern that “the capital of theworld’s major banks had become dangerously lowafter persistent erosion through competition”.

The 1988 Accord required internationally activebanks in G-10 countries to hold capital equal to atleast 8% of a basket of assets measured in differentways according to their risk profile. Under theAccord, assets are classified into four separate buck-ets of 0%, 20%, 50% and 100%, with exposure tocorporates attracting the maximum risk weighting.Reducing exposure to corporate loans was there-fore a front-line strategy for banks eager to complywith the minimum capital requirements.

Closer financial and regulatory integration aris-ing from European Monetary Union (EMU)exerted other important pressures on the Europeanbanking industry, in turn further eroding the


introduction

What everybody ought to knowabout this credit businessChanges in the regulation of the financial services sector and the introduction of a commoncurrency have simultaneously reduced banks’ willingness to hold exposure to corporate riskand investors’ ability to buy that risk. So the business of transferring credit risk is booming

Long before the bursting of theequity bubble in early 2000, marketdynamics were encouraging anincreased supply of bonds

importance of relationship banking. In particular, itforced banks to concentrate much more intensivelyon the delivery of enhanced profitability and returnon equity (ROE). This was because the launch ofthe single currency meant companies across all sec-tors (financial services included) found they couldno longer depend purely on a loyal and unques-tioning base of domestic investors.

Those same investors were themselves exposedto more competitive pressures as a result of global-isation. They therefore began to compare compa-nies on a cross-border basis, and within the bankingsector they encountered very different perform-ance levels. As recently as 1996, for example, pub-licly quoted banks in the UK enjoyed an averageROE in excess of 20% (and in excess of 30% in thecase of Lloyds Bank). By contrast, the average incontinental Europe was a little over 11%, withbanks in the largest markets posting ROE levelsappreciably below this average. In Germany, thiswas 7.5% in 1996, in France it was 6.9% and in Italyit struggled to reach 3%.

Pressure on banks was exacerbated by deregula-tion and liberalisation of financial services indus-tries throughout Europe, allowing foreign banksto enter markets that had previously been pro-tected with various degrees of intensity from inter-national competition.

One net affect of this powerful combination ofinfluences was that the supply of bank loan creditto the corporate sector was either diminished, orprovided on a much more selective basis. In turn,companies began to explore alternative sources offunding – with the debt capital market soon iden-tified as one of the most appealing options. In thelate 1990s, this emerged as one of the principaldriving forces for the arrival of ‘credit’ as an assetclass in Europe.

The importance of credit protectionHand-in-hand with the emergence of credit as anasset class in Europe, however, came the recogni-tion that far from being risk-free assets, corporatebonds in particular were hostage to a range of haz-ards generally referred to as ‘event risk’.

One of the principal sources of this event riskwas the often frenzied pursuit of shareholder valuewithin the corporate sector, driven largely by theprocess of privatisation that swept through Europe

during the 1990s. The clearest examples of thiswere provided by the telecommunications and util-ity sectors. Both had previously been cocooned bystate ownership, but in the aftermath of privatisa-tion found themselves pressurised by demandinginvestors into delivering shareholder value in theform of growth, rather than a predictable if unad-venturous stream of dividend income.

Both industries responded in a number of waysto the demands of their new investors, but a com-mon feature of their strategies was expansion viaacquisition, which had at least two important ram-ifications for their credit quality. First, especially inthe case of the utilities, it encouraged them to lookoverseas for expansion opportunities, which oftenmeant stepping into riskier emerging markets. Sec-ond, as acquisitions needed to be paid for, itexerted new pressures on their balance sheets asthey raised funding in support of their growth, dra-matically increasing their indebtedness (alterna-tively known as ‘gearing’ or ‘leverage’).

In the case of the telecoms sector, an additionalfly in the ointment came in the form of theirresponse to technological progress in general, andin particular to the advent of mobile telephony andthe internet. For a large number of European tele-coms companies, that necessitated very substantialone-off investment in third generation (3G)licences for which – with the benefit of hindsight –many overpaid.

Credit ratingsAll these influences had a powerful and negativeimpact on credit ratings assigned by the three lead-ing rating agencies (Fitch, Moody’s and Standard& Poor’s), which are designed as yardsticks meas-uring the probability of default. From a global per-spective, the telecoms sector provides the mostvivid example of declining credit quality.

In 1990, 11% of all telecoms issuers rated byS&P were triple-A, with a further 33% rated double-A and 33% single-A. With an additional 15% rated astriple-B entities, this meant 92% of borrowers


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Corporate bonds are hostage toa range of hazards generallyreferred to as ‘event risk’

within the S&P telecoms universe were classified asinvestment grade. By 2001, following a decade ofprivatisation, deregulation, new entrants arriving inthe sector and the heavy investment necessitated bytechnological innovation, the picture was dramati-cally different. By then, there were no triple-A bor-rowers left in the sector, while only 2% carried adouble-A rating and 6% were rated single-A. Thelargest concentration of ratings in the telecom sec-tor was in the single-B area (45%) and a large num-ber (19%) were rated D. In other words, by 2001only 17% of borrowers in the telecoms sector werecategorised as investment grade.

In the broader credit market, however, the pur-suit of shareholder value and increased leveragetwinned with a rapidly deteriorating global macro-economic climate has led to an acceleration in theworsening of credit quality. As S&P advised at thebeginning of 2003: “In 2002, EU credit qualityplummeted to record lows. The year saw unprece-dented levels of rating activity, with a total of 191ratings actions on a rated population of 539 entitiescarrying rated long-term debt.” During the year,according to the S&P data, there were 168 down-grades of long-term debt worth close to €750 bil-lion, compared with just 23 upgrades of securitiesvalued at €56 billion.

Has ‘event risk’ receded?In some industries, it would seem that the worst isnow over in terms of event risk and credit deterio-ration, with the telecoms sector probably provid-ing the clearest example. It is highly improbable,for example, that telecoms companies as a groupwill, in the foreseeable future at least, incur ashuge a one-off capital spend as they did to finance3G licences. It is also clear that the majority ofcompanies in the telecoms sector have learnedfrom previous mistakes and are now paying muchmore attention to the demands of bondholdersthrough, for example, selling off non-core assetsand deleveraging their balance sheets. As a result,

by early 2003 a number of European telecomscompanies, such as France Télécom and KPN ofthe Netherlands, were widely regarded as improv-ing credits.

That should not, however, be taken as a signalthat event risk in the credit market is a thing of thepast. Far from it. Credit risk was identified as thebiggest concern faced by the 175 respondents to asurvey by the Centre for the Study of FinancialInnovation (CSFI). That concern was probablymost graphically expressed by the response to thesurvey given by the representative of a German Lan-desbank, who said that “asset values do not alwayscollapse in months; they can crumble over years.That is a life-threatening problem, and not just forthe banks.”

This may be an exaggeration. But if it isaccepted that the past few years have exposed themagnitude of the risks inherent in the corporatebond market, it has also become clear that the needto hedge against these risks has become paramountfor all participants within the market.

One way investors have been able to protectthemselves from credit deterioration is through theincorporation of ‘step-up coupons’ into new bondissues, which became especially popular in the new-issue market for telecoms bonds in 2000 and 2001.This is a mechanism under the terms of which theborrower agrees to pay a higher coupon toinvestors in the event of its bonds being down-graded by the leading credit rating agencies.

But step-up coupons are of little use whencompanies rush headlong towards potentialdefault, with the spreads on their bonds wideningby several hundred basis points in the process,wiping out many times any compensation thatinvestors will have received in the form of step-upson coupons.

Transferring credit riskOf the mechanisms available to market participantsto protect themselves more comprehensively fromthese risks, the credit derivatives market in generaland the market for credit default swaps in particu-lar have emerged as a favoured option, and bankersbelieve the acceptance of hedging tools such asthese will become increasingly visible across theentire financial services industry. As Goldman Sachsexpressed in a bulletin published in May 2001: “We


introduction

The principal source of the event risk in the 1990s was theoften frenzied pursuit ofshareholder value

believe sophisticated use of default swaps willincreasingly become a necessary component of asuccessful portfolio management strategy.”

Fundamental to the growing acceptance ofcredit derivatives is the transfer of risk away fromthe balance sheets of banks and towards the muchbroader capital market, which is generally recog-nised as being more skilled and disciplined in termsof assessing and pricing credit risk. That explainswhy many commentators choose to describe thecredit derivatives sector as the market for ‘creditrisk transfer’ (CRT).

The concept of CRT, of course, is by no meansnew, and gathered momentum with the develop-ment of the market for asset-backed securities –‘securitisation’ – in the US in the 1980s. Thisprocess began with banks passing the credit riskembedded in their portfolios of residential mort-gages to capital market investors. That basic for-mula has since been applied to a spectrum of otherassets capable of generating reliable cashflows –ranging from auto loans and commercial mort-gages to receivables arising from sales of cham-pagne and music rights.

Defining the credit default swapIn a nutshell, a credit default swap (CDS) is simi-lar to an everyday insurance contract. A key differ-ence between a CDS and an insurance policy isthose buying a CDS can trade in and out of theircontracts in a way that is not possible in the insur-ance market.

In other words, a CDS is a privately negotiatedbilateral contract in which one party, usually knownas the protection buyer (or ‘risk shedder’ in theparlance of the BIS), pays a fee or premium toanother, generally referred to as the protectionseller (described by the BIS as the ‘risk taker’), toprotect himself against the loss that may beincurred on his exposure to an individual loan orbond as a result of an unforeseen development.


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Of the mechanisms available tomarket participants to protectthemselves, CDSs have emergedas a favoured option

A key difference between the securitisation arenaand the market for credit risk transfer (CRT) viacredit derivatives is that the former is generallydescribed as being a ‘funded’ agreement whilethe latter is ‘unfunded’.

In a funded, or cash, securitisation, the riskof bearing a pool of assets (be they residentialor commercial mortgages, credit card or autoloan receivables) is held by investorscomfortable that the cashflows of the assets inquestion are predictable.

The transaction is known as ‘funded’ becausethe investor provides a cash payment to buy aclaim related to the underlying cashflowssupporting the transaction. Securitisations arenot, however, always packaged as fundedtransactions. In Germany in particular, unfundedor partially funded structures have beenespecially popular among issuers, principally fortax reasons.

In these structures, which are known assynthetic securitisations, assets remain on theissuer’s balance sheet, while credit risk istransferred to third parties by using credit defaultswaps. This is a helpful way for banks without anurgent funding requirement to use thesecuritisation market in order to achieveregulatory capital relief.

In an unfunded CRT transaction, credit risk istransferred from the buyer of protection (therisk shedder) to the seller (the risk taker)without a funding obligation. In this instance,the taker of credit risk only provides funding tothe buyer of protection if a pre-defined creditevent takes place.

In other words, as a report published by theBank of England explains, “credit derivativestherefore allow banks to manage credit riskseparately from funding. They are an example ofthe way modern financial markets unbundlefinancial claims into their constituent elements(credit, interest rate, funding etc), allowing themto be traded in standardised wholesale marketsand rebundled into new composite productsthat better meet the needs of investors.” ■

Securitisation versus creditrisk transfer

This development is usually known as a ‘creditevent’, indicating that the borrower (known as thereference entity) on which the CDS has been writ-ten is unable (or is rapidly likely to become unable)to pay its debts. If a credit event occurs, the seller ofprotection will make a payment to the buyer of thecontract. Usually, as it is a private arrangement, theterms of a CDS can be renegotiated between thebuyer and seller of protection in response tochanges in market fundamentals.

Also, it may be helpful to split the term ‘creditdefault swap’ into its three component parts,because in keeping with so many other instrumentsin the capital market, there are elements of mis-nomer in the terminology.

● CREDIT: In the context of the capital market,the asset class known as ‘credit’ means differentthings to different people. But in recent years, ithas often been used as a generic term to describethe non-government or non-public sector bondmarket. In the context of the derivatives market,however, the ‘C’ in CDS can, and often does,refer to issuers of securities that would not fallinto this category – such as triple-A rated govern-ments that are prolific and regular issuers in theinternational capital market.

● DEFAULT: In a sense, the use of the term‘default’ in the context of the credit derivatives

market can be misleading, since a default is notactually required for a credit default swap to betriggered. The term default is additionally mis-leading because it implies that the use of instru-ments such as credit default swaps is restricted toinstances in which banks or investors are exposedto highly risky credits. There is also a very activemarket in CDSs written on individual names orcredits in which neither the buyer nor the seller ofprotection believes there is the remotest possibil-ity of default. In that sense, ‘default’ can often bea misnomer.

● SWAP: The use of the word ‘swap’ can also bemisleading, with ‘contract’ perhaps a better wayof describing the arrangement reached by thebuyer and seller of protection. As a report pub-lished in June 2001 by Banc of America Securitiesexplains: “The product name reflects its genesiswithin traditional (ie, interest rate) swap groups,and their use of traditional swap documents toalso document credit default swaps. Nonetheless,the product’s name – credit default swap – is amisnomer… A CDS is not really a swap in theway most of the credit spread markets think ofswaps – that is, as swaps of fixed for floating cash-flows, as is the case of interest rate swaps. In thecase of credit default swaps, there is only a ‘swap’in the instance when a credit event triggers acompensating payment.” ■


introduction

Step 3

Step 1*

Borrower (step 1) (Debts R Us Inc.)

Loan/Bond$5m ‘IOU-1’ Lender (step 1) &

Buyer (step2)

CDS protection (Safe investor Inc.)

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CDS protection(Insurance Inc.)

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Step 2

Provides $5mCDS protection(Reference entity Debt R Us Inc.)

Protection triggered

* Step 1 is not strictly necessary. Money does not need to have been lent

in order to buy CDS protection. In a credit event the protection holder can

buy debt in the market to deliver under the contract.

Premium (basis points)

Cash ($5m) to Safe Investor Inc.

Interest payments

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CDS: the basics

In theory, a CDS can be written on any name, andat any part of the capital structure that has an out-

standing obligation in the loan or bond market,from triple-A rated sovereign and supranationalborrowers down to corporates and other issuersrated as low as single-C.

There is no requirement for the underlyingentity to be publicly rated, although the liquidity ofCDSs on unrated entities will generally be lowerthan on rated names.

In practice, however, with S&P and Fitchdescribing a triple-C rated company as one that is“currently vulnerable to non payment”, and where“default is a real possibility”, the pricing on a CDScontract for a distressed borrower in this rating ter-ritory would be so prohibitive as to render bilateralnegotiations between a buyer and seller of protec-tion pointless.

On occasions where credits have plunged frombeing investment grade to deeply distressed, pricesin the CDS market have generally ceased to bequoted by protection sellers. In other words, in theCDS market, deeply distressed credits becomeuninsurable, in much the same way as unacceptablyrisky situations become uninsurable in the conven-tional insurance market. A good example of thisprocess was provided in the summer of 2001, whenCDS prices on WorldCom bonds ceased to bequoted long before the company filed for bank-ruptcy (see page 25).

PremiumsPremium prices – also known as fees or defaultswap spreads – are quoted in basis points perannum of the contract’s notional value. Usually,predetermined premiums are paid by the buyer ofprotection to the seller on a quarterly basis, withthe contract terminating either at maturity or at thetime of a credit event occurring. In the case of

those distressed credits in which the CDS marketremains open, however, it has become more usualfor sellers of credit protection to demand the pay-ment of an upfront premium as opposed to thestandard running spread.

CDS size and pricing There are no predetermined limits on the size ormaturity of CDS contracts, which have ranged insize from a few million to several billions of dollars.In general, however, contracts are concentrated inthe $10 million to $20 million range with maturi-ties of between one and 10 years, although five-year maturities are the most common. Inevitably,the maturity of a CDS will depend on the creditquality of the reference entity, with longer-datedcontracts of five years and more only written on thebest-rated names.

In the early days of the CDS market in Europe,pricing of contracts, even on comparably ratedreference entities, varied significantly from oneprovider of protection to the next. As one marketparticipant was quoted as saying in a Financial Times

survey in June 1997, “pricing is a closely guardedsecret for many firms”, and as another put it,“pricing [credit derivatives] is more of an art thana science”.

In recent years, pricing levels have become com-pressed and much more standardised. That is notto say, however, that the price quoted for creditprotection will be the same among all banks orother participants in the market. There may be arange of technical rather than credit-related reasons

Which credits are covered bythe CDS market?Part of the attraction of credit default swaps is that in terms of pricing and maturity they arenot dissimilar to other methods of trading credit risk, such as loans and bonds. This has helpedthe market quickly understand and adopt them

Pricing is a closely guardedsecret for many firms and moreof an art than a science


CDS: the basics

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why some banks will quote different CDS pricesfrom their competitors. That means that for buyersof credit protection, it can often pay to ‘shoparound’ among sellers for the best price.

Broadly, however, all sellers of protection will usesimilar parameters in reaching a price for a CDS. Ananalysis published in September 2002 by DresdnerKleinwort Wasserstein (DrKW) explains that overand above a valuation of credit risk, the likelihood ofdefault, the actual loss incurred and the recoveryrate, a range of other considerations come into playwhen pricing CDSs.

“Liquidity, regulatory capital requirements aswell as the market sentiment and perceived volatilityand shape of the curve are usually priced in,”explains the report. “As a result, to price a CDS weneed to know the credit, its default probability andrecovery rates, which depend on the level of senior-ity of the debt, plus market information. The ratingagencies, and in particular Moody’s, provide a longhistory of statistical information on one-year andcumulative default probabilities, as well as recoveryrates for different periods.”

There are now a number of accepted and sophis-ticated models used for the pricing of CDSs, rang-ing from structural to transitional and reduced-form pricing models.

In what form is compensation made?The form of compensation paid to a buyer of pro-tection if a credit event occurs will depend onwhether the original terms of the contract dictatethat payment is for a physical settlement or for acash settlement.

In a contract for physical settlement, the sellerof protection will agree to buy back the distressedloan or bond at par. This distressed loan or bondis known as the ‘deliverable obligation’. Clearly –given that the trigger event will have reduced thesecondary market value of the loan or bond inquestion – this will result in the seller incurring aloss. This is the most common means of settle-ment in the credit default swaps market and willgenerally take place no later than 30 days after thecredit event.

In a contract for cash settlement, the seller ofprotection will pay the buyer the differencebetween the notional of the default swap and a finalvalue for the same notional of the reference obliga-tion. According to a Goldman Sachs analysis, “cashsettlement is less prevalent because obtaining pre-cise quotes can be difficult when the referencecredit is distressed”. A cash settlement will typicallytake place within five business days of the creditevent triggering payment. ■

The CDS is often referred to as a ‘building block’upon which a number of other successfulinnovations have been designed, the most well-known and popular of which are probablyportfolio-based products including thecollateralised debt obligation (CDO) and credit-linked note (CLN), both of which are defined anddiscussed in greater detail on pages 30 to 34.

Among other applications using the CDS is a‘first-to-default basket swap’ where investors areexposed to the first default to occur in a well-defined basket of credits. In return, the investormay earn a premium well in excess of that onindividual names. First-to-default baskets alsooffer complete transparency in that the investorselects the names in the basket. According to areport published by Deutsche Bank in February2002, “for banks in many countries, first-to-

default baskets provide a more efficient way todeploy capital than individual bonds or loans. Inaddition, the major rating agencies havedeveloped criteria for rating first-to-defaultbaskets. In many cases these transactions canobtain investment-grade ratings, which makethis product accessible to investment-gradeinvestors.” Less common are second- and eventhird-to-default products, in which payment willonly be triggered if a credit event occurs onmore than one of the reference entities withinthe basket.

A total return swap, meanwhile, is acustomised, off balance sheet transaction thatallows for the transfer of the total economicperformance of a specific asset or portfolio ofassets by the buyer of protection in return for fixedor floating interest payments. ■

More complex examples of CDS applications


documentation

One critical element that limited the expansion ofthe CDS market in its early days was the absence

of any broadly accepted and standardised documen-tation clearly defining the precise terms and condi-tions of contracts. Instead, even after the publicationof a 19-page ‘form of confirmation’ by the Interna-tional Swaps and Derivatives Association (Isda) in1998, these tended to be negotiated between buyersand sellers of protection on what amounted to an adhoc basis, which inevitably opened the way for dis-putes between the two parties when credit eventsoccurred. As the BIS puts it, “risk shedders appearsometimes to have been able to exploit the terms ofcredit derivative agreements at the expense of risktakers, insofar as payments under CDS contracts arenot conditional on actual losses.”

The Russian default of 1998 brought some ofthe disagreements between buyers and sellers ofprotection into the public eye. As the Bank of Eng-land explained in its Financial Stability Review, pub-lished in June 2001, one dispute arising from theRussian default concerned a short delay in pay-ments due on the City of Moscow’s debt. “Some

market participants had entered into CDSs that didnot include any specific provision for grace periodsto allow for technical delays in making payment bythe reference entity,” this explained. “The Englishcourts ruled that the delayed payment was a creditevent under the terms of these contracts and theprotection seller should settle.”

An essential breakthrough for the development ofthe CDS market came in 1999, when, in response todisagreements prompted by the Russian crisis, Isdapublished its new ‘master agreement’ designed tostandardise credit derivatives contracts, formalising

the guidelines on standard documentation originallypublished at the beginning of the previous year. Oneyear in the making, and applicable to contracts onsovereign and non-sovereign names alike, theseguidelines, according to Isda, were “developed by aworking group of Isda member institutions, includ-ing most of the world’s leading participants in pri-vately negotiated derivatives activity”.

Delegates at the Isda conference in Vancouver inMarch 1999 were given a sneak preview of thesenew definitions, which were formally unveiled inJuly the same year. As Isda commented in 1999,the new definitions enshrined within the masteragreement were “viewed as critical to the growth indemand for these types of transactions”.

While these guidelines represented an importantstep forward for the CDS market, they did not con-stitute a watertight and definitive solution applica-ble to all developments impacting on the market.One example of a situation not decisively addressedby the Isda guidelines came in November 2000with the demerging of the UK power company,National Power, into two successor entities,Innogy (which focused purely on the UK market)and International Power, which concentrated onbusiness development in all other markets.

According to a Fitch analysis, this demergerresulted in a question as to the identity of the refer-ence entity in connection with a number of creditdefault swaps – given that the Isda definition of asuccessor company referred to the entity thatassumes “all or substantially all of the obligations”.

In a market as young, fast-expanding and opento innovation as the CDS market, it is inevitablethat determining documentation standards shouldbe a dynamic rather than a static process, and thedebate over the status of a successor company pro-vided one good example of Isda’s flexibility in re-drafting its guidelines to bring more clarity andtransparency to the derivatives market.

In this instance, Isda released a supplement onsuccessor events in November 2001, advising that

Laying down the ground rulesAs with any ‘watertight’ contract, holes inevitably appear. And so Isda has been forced tocontinuously revisit the documentation guidelines on credit default swaps in an attempt torespond to new concerns and the changing market

Isda faces the unenviable task oftrying to manage conflicts ofinterest between protectionsellers and protection buyers


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it was replacing the “all or substantially all” lan-guage in its definitions with a numerical threshold.This would determine that if an entity succeeds to75% or more of the bonds or loans of the originalreference entity, “then the sole successor would bethat entity”. The same supplement outlined alter-native approaches in the event that the 75% thresh-old is not met.

While this supplement clearly removes uncer-tainties regarding the specific issue of successorobligors, Isda will probably be called upon to pub-lish many more such amendments as additionalunanticipated ‘special situations’ emerge in the fast-evolving CDS market. A report published by Fitchin October 2002 neatly sums up the problem thatIsda has inevitably needed to grapple with in thedrafting of watertight documentation standardsthat are universally acceptable. “In attempting tostandardise documentation for credit default swaps,Isda faces the unenviable task of trying to manageconflicts of interest between protection sellers whowant the narrowest possible definition of a creditevent and the narrowest possible interpretation ofdeliverable obligation characteristics and protec-tion buyers who need the opposite,” this explains.

Trigger eventsIt is important to recognise that the contractualterms of credit default swaps provide no protectionagainst ‘events’ such as disappointing earnings,rating downgrades and other market-relateddevelopments that may lead to spread wideningand potential losses for bondholders. Nor, there-fore, do credit default swaps provide much of adefence for investors who have simply made a poorinvestment decision.

In broad terms, the events that will trigger apayment by sellers of protection in the CDS marketinclude the following:● Bankruptcy: this refers to a corporation’s

insolvency or its inability to pay its debts, andis therefore the most immediately visibleevent that would trigger payment on a creditdefault spread.

● Failure to pay: if after expiration of theapplicable grace period, the reference entityfails to make payment with respect to principalor interest on one or more of its obligations.Failure to pay sets a minimum dollar threshold.

● Repudiation/moratorium: if the referenceentity or government authority indicates thatone or more of its obligations is no longervalid, or if the entity or government stopspayment on such obligations. This provisionnow applies only to sovereign reference entities.

● Obligation acceleration: when an obligationhas become due and payable earlier than itwould otherwise have been due because of aborrower’s default or similar condition. Likefailure to pay, obligation acceleration issubject to a minimum dollar thresholdpayment amount.

● Restructuring: this has proved to be the mostthorny of the credit events originally outlinedby Isda, and refers to a change in the terms ofa borrower’s debt obligations that are deemedto be adverse for creditors. The sticking pointhere has often been defining what is or isn’tnecessarily ‘adverse’ for bondholders orlenders, which has led to a lively andprotracted debate (see below).

Credit event proceduresIn the event of one of the above developmentsoccurring, a so-called ‘credit event notice’ will bedelivered by the protection buyer, protection seller,or both, indicating that a trigger event has takenplace and providing two sources of publicly avail-able information describing the occurrence of thecredit event.

The debate over restructuringCredit derivatives market terminology would sug-gest that credit default swaps are contracts that, bydefinition, provide buyers of protection with a formof insurance against default – that is to say, againstthe failure of a borrower in the loan or bond mar-ket to meet its interest obligations. Although thatdefinition would appear to be clear enough, therehave already been a number of well-documentedcases where technical loopholes have beenexploited by signatories to CDS contracts, in turnforcing a reassessment of accepted definitionsamong participants in the market.

Perhaps the best known of these took place inSeptember 2000, when the US life insurance com-pany, Conseco, announced that it was planning torestructure $2.8 billion of its debt, extending the


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maturity of some of its loans and prompting a rowbetween sellers and buyers of protection as towhether or not restructuring qualified as a creditevent triggering payment.

The squabble over Conseco led to the emer-gence of what many bankers described as a ‘two-tier’ CDS market. One of these tiers, championedby many market participants in the US, adopted theview that the restructuring of bank loans shouldnot represent legitimate triggers for pay-outs onCDS contracts, because restructuring did notalways lead to losses for bondholders, and couldtherefore be unjustifiably exploited by buyers ofprotection at the expense of sellers. The second tierof the market, resolutely espoused in Europe,maintained that a loan restructuring should still beviewed as a negative credit development, andshould therefore remain a trigger event in the termsof CDS contract documentation.

Although it may seem curious that, within aglobal financial services market, there are still differ-ences in opinion about restructuring on either sideof the Atlantic, there is an element of logic to thisapparent schism in views. US bankruptcy lawsenshrined in Chapter 11 legislation are generallymuch more accommodating towards troubled com-panies failing to meet liabilities than those in forcethroughout the UK and continental Europe. Theresult is that companies entering into restructuringstriggered by Chapter 11 proceedings in the US can(and frequently do) emerge relatively speedily fromthe process as strong and healthy credits.

The same cannot be said of companies plunginginto bankruptcy in Europe, which has generallyprotected sellers of protection in the CDS marketon this side of the Atlantic. As Fitch explained in ananalysis published in October 2002: “Europe hasnot encountered a restructuring where protectionsellers incur losses due to soft credit events, asoccurred in the case of Conseco.”

Following the Conseco episode, Isda publisheda ‘modified restructuring clause’ in spring 2001,

adding a number of limitations to the 1999 guide-lines. One of these was a ‘restructuring maturitylimitation’ restricting to 30 months the maturity ofobligations that can be delivered following arestructuring, and therefore preventing the deliv-ery of long-dated securities that may be trading at adiscount.

When the restructuring supplement was pub-lished in May 2001, Isda’s chief executive officer,Robert Pickel, announced that “the supplementrepresents the consensus of a diverse range of con-stituents in the credit derivatives market, includingportfolio managers, credit protection sellers anddealers. Completion of the supplement should helpto ensure market integrity, which will promote con-tinued growth in the use of credit default swaps.”

The debate over convertiblesAside from the controversy over the impact of cor-porate restructuring on the CDS market, anothercause célèbre revolving around the terminology ofthe credit derivatives market unfolded as a result ofuncertainty over the status of convertible bonds(fixed-income securities convertible into equity) asdeliverable securities following a credit event.

In February 2003, Nomura won a landmark rul-ing against Credit Suisse First Boston when a HighCourt judge ruled that the buyer of protection(Nomura) was entitled to deliver Railtrack convert-ible bonds as physical settlement in respect of aCDS transaction. The controversy dated back toRailtrack’s default in October 2001 that, Nomurainsisted, qualified as an ‘event’ triggering paymenton a credit default contract bought by Nomurafrom CSFB as a hedging tool.

When CSFB refused to accept the validity ofthis claim, arguing that convertible securities didnot qualify as ‘non-contingent bonds’, Nomuraexchanged its Railtrack convertibles into straightbonds, which were trading at a more expensivesecondary market level than the convertibles.Nomura was encouraged to pursue its claimwhen Isda expressed the view that convertibleswere eligible for deliverability under the terms ofthe CDS agreement.

The demise of Railtrack exposed the EuropeanCDS market to one of the sternest challenges in itsshort history, with some estimates suggesting thatcontracts worth in excess of £1 billion had been

The demise of Railtrack exposedthe European CDS market to oneof the sternest challenges in itsshort history


documentation

written on the credit, which would have lookedappealing to many sellers of protection because ofthe perception that it carried an implicit govern-ment guarantee. That the vast majority of thosecontracts were settled quickly and efficiently is atestimony to how far the CDS market has come inso short a time, with the Nomura-CSFB disputevery much the exception rather than the rule.

For the two banks concerned in the controversyover the Railtrack CDS, the financial implicationsof the settlement appeared to be of much lessimportance than the clear precedent it establishedfor future activity in the CDS market. “This is anexcellent result for the credit derivative market andclarifies an important point of interpretation,”

Nomura announced following the conclusion ofthe case. “Any other decision would have risked theintegrity and unity of the market; a risk Nomurawas prepared to fight to avoid.” A statementreleased by CSFB after the ruling, meanwhile,noted that “we are disappointed by the decision,but grateful for the certainty and clarity that wehope the decision will bring to the market.”

Isda had already helped provide that level of cer-tainty and clarity in the event of similar future dis-agreements over CDS documentation. Prior to thesettlement, it had recommended that all new CDScontracts included a clause clearly stating whetheror not convertible debt would be eligible for deliv-ery in the event of a credit trigger. ■

Definition of bankruptcy as a credit eventUnder the new definitions, a bankruptcy can nowonly be deemed to have occurred if the default dueto bankruptcy occurs with respect to the referenceentity itself. For all other credit events, the defaultdue to the credit event can occur on any obligation.

To reduce subjectivity with respect to identifyinga bankruptcy, Isda has removed a clause stating thata bankruptcy can be deemed to have occurred if acompany has taken any action towards, or indicatedconsent to, approval of, or acquiescence in adefault. In the new definitions, a written admissionof a company’s inability to pay its debts must bemade in a judicial, regulatory or administrative filing.

Four choices for restructuringRestructuring as a credit event has been one ofthe most contentious issues in the creditderivatives market, prompting Isda to significantlyrecast its definitions to offer counterparties fourchoices when buying/selling CDS protection:● No restructuring: This option eliminates the

possibility of the protection seller incurringlosses from a ‘soft’ credit event – one thatdoes not truly constitute a default and wouldtherefore not necessarily result in losses if theinvestor owned the actual reference obligation.

● Full restructuring: This option allows theprotection buyer to deliver bonds of anymaturity after any restructuring of debt.

● Modified restructuring: This option has beencommon market practice in North Americasince the publication of Isda’s restructuringsupplement in 2001. Modified restructuringlimits deliverable obligations to bondsmaturing in no less than 30 months after arestructuring of debt.

● Modified modified restructuring: This is a newprovision aimed at addressing issues raised inthe European market and limits the maturityon deliverable obligations to 60 months after arestructuring of debt.

Definition of deliverable obligationsThe 2003 definitions allow obligations to bedefined to suit the needs of the counterparties.These obligations can be:● The direct obligations of the reference entity● The obligations of a subsidiary entity, or

“downstream affiliate”. These obligations areknown as “qualifying affiliate guarantees”. Toqualify as a downstream affiliate, thesubsidiary’s voting shares must be more than50% owned by the reference entity, eitherdirectly or indirectly.

● The obligations of third parties guaranteed bythe reference entity, known as “qualifyingguarantees”. However, these obligations areonly deliverable if “all guarantees” is selectedin the confirmation. ■

Key changes to Isda’s credit derivatives definitions


CDS growth

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In the early days of the credit derivatives market,pinning down precise figures for the volume out-

standing in the CDS market was notoriously diffi-cult, with trading conducted over-the-counterrather than via an exchange, and banks and otherintermediaries reluctant to reveal much detailabout their activity in the market.

That partly reflected the fact that the CDS mar-ket originally evolved as a successor to a series ofinformal, privately tailored agreements betweenbanks and their customers. Indeed, participantsreport that in contrast to, for example, theEurobond market (which has a readily identifiablestart date of 1963, when Autostrade launched thefirst Eurobond) it is impossible to pinpoint pre-cisely when the CDS market was inaugurated.

Although as recently as June 2001 the Bank ofEngland was reporting that “comprehensive,global data [on the size of the credit derivativesmarket] do not exist”, it is self-apparent that infor-mation on the size, structure and historical evolu-tion of the market is now much more readily avail-able than it has ever been, with the British Bankers’Association (BBA) having collated figures on thesector since the mid-1990s.

According to that data, the global credit deriv-atives market was worth $180 billion in 1997.Thereafter it expanded rapidly, to $350 billion in

1998, $586 billion in 1999, $893 billion in 2000and $1,189 billion at the end of 2000. Histori-cally, according to the BBA figures, so-called sin-gle-name CDSs have comprised the largest shareof the overall credit derivatives market, althoughtheir share fell from 52% in 1997 to 45% in 2001,reflecting the increased diversification andsophistication of the market. In addition to theabsolute figures, the BBA compiles statistics giv-ing important insights into which market partici-pants are the most active in terms of buying andselling protection, as well as forecasts on the out-look for the market.

Other valuable sources of information on thesize of the credit derivatives market are Isda itselfand the Office of the Comptroller of the Currency(OCC) in the US, which “charters, regulates andsupervises national banks to ensure a safe, sound,and competitive banking system that supports thecitizens, communities and economies of theUnited States”.

The OCC started to compile data on the creditderivatives positions of US commercial banks inearly 1997, and its statistics put the modest size ofthe credit derivatives market into vivid perspective.According to its third-quarter review published inDecember 2002, “86% of the notional amount ofderivative positions was comprised of interest ratecontracts with foreign exchange accounting for anadditional 11%. Equity, commodity and creditderivatives accounted for only 3% of the totalnotional amount.”

According to the BBA’s 2001/2002 analysis,London continues to be the dominant centre in the

The size of the CDS marketFrom an uncertain inception date, the credit default swap market has blossomed to becomea major asset class in the capital markets. For this growth to continue and the market toreach its full potential, certain impediments will need to be removed

The most actively traded CDSsare on reference entities that arealso the most prolific issuers inthe cash bond market

1997 1998 1999 2000 2001 2002 2003 2004

5000

4000

3000

2000

1000

0

$ b

illio

ns

No

su

rvey

co

nd

uct

ed

Growth in credit derivatives

Source: British Bankers’ Association

global credit derivatives market, well ahead of NewYork and the fragmented Asian financial centres,with a limited amount of trading taking place inTokyo and Sydney. In terms of market share, theBBA advises, London accounted for 49% of theglobal market in 2001. It forecasts that the Londoncredit derivatives market will grow to $2,450 bil-lion by the end of 2004, giving the City a globalmarket share of about 51%.

Trends in underlying assetsSince the emergence of the credit default swapmarket in the mid 1990s, there has been a notice-able shift in the types of assets on which protec-tion has been sought. According to the BBA, in2001 only 15% of products were written on sov-ereign assets, down from 46% in 1996 when itfirst conducted the survey. “The vast majority ofcredit derivatives are now written on corporateassets, with 60% of credit derivatives written onthe asset class in 2001,” the BBA noted. “This

trend is expected to continue in 2004.” Thattrend, of course, reflects the vastly increased sizeof the corporate bond market since the mid-1990s, as well as the deterioration of credit qual-ity that gathered momentum between 1996 and2001, prompting lenders and investors to seekincreased levels of protection.

More specifically, research published in March2003 by rating agency Fitch identifies the mostactively traded CDS as being for reference entitiesthat are also the most prolific issuers in the under-lying cash bond market, but in which the probabil-ity of default is remote in the extreme. Accordingto the Fitch data, the most commonly cited refer-ence entities among respondents to its survey wereGeneral Motors, DaimlerChrysler, Ford, GeneralElectric and France Télécom.

Beyond these credits, bankers confirm that thediversification of corporate names being traded inthe CDS market is on the rise. As a report pub-lished by Dresdner Kleinwort Wasserstein


CDS growth

If it is indeed the case that the CDS market isnow more liquid than the cash bond market in anumber of sectors or individual credits, thisimplies that pricing in the CDS market provides amore reliable bellwether of credit quality thanthe cash market. By extension, the CDS marketought to emerge as a more reliable benchmarkthan the cash market for the pricing of bonds inthe primary market. One caveat to thisargument is that as the universe of players thathave access to the CDS market is smaller than itis in the cash market, volatility can be moreacute in the former.

Nevertheless, there is little if anything tosuggest that other potential guides to fair valuein the bond market are more accurate than theCDS market, with the rating agencies oftenmaintaining investment-grade ratings oncompanies which, according to the CDS market,are heading rapidly towards non-investmentgrade territory – making them so-called ‘fallenangels’. Pricing in the loan market can also, intheory, be used to assess fair value in the bondmarket. In practice, however, it is broadly agreed

that the reliability of the loan market as a pricingindicator for the bond market is seriously flawed.This is chiefly because, in spite of pressures onbanks’ capital, loans are seldom priced strictly inaccordance with their risk profile. Instead, pricingis based on a bank’s relationship with theborrower and on the ancillary flows of businessthat the bank believes will flow in moreprofitable market segments as a result ofmaintaining that relationship.

If there is a negative side effect of the liquidityin the CDS sector, as far as many investors areconcerned it is the degree to which the success ofthe CDS market is now reducing liquidity in thecash market. That can clearly create difficulties forinvestors who are restricted to investment in thecash bond market and unable to participate incredit derivatives.

Indices and index-based productsSolutions, however, are increasingly beingprovided for those investors unable, for whateverreason, to trade directly in the CDS market. Evenfor those that may be free to participate in the

By-products of liquidity

(DrKW) in November 2002 notes: “According toour credit derivatives desk, around 500 credits,mostly investment grade, are now activelytraded.” The same report adds that “the industrydistribution is relatively even, with industrials thedominant sector followed by financial services andbanks”. This degree of relative diversificationwithin the CDS market in Europe is in markedcontrast to the underlying cash market, in which ahandful of industries continue to account for adisproportionately high share of the most activelyfollowed benchmarks.

For example, according to the figures publishedby DrKW, as of late 2002, outstanding bondsissued by telecoms companies accounted for 20% ofthe iBoxx euro corporate bond index, but for only5% of outstanding CDSs; for autos, the shares were14% and 4% respectively; and for banks, 20% and6% respectively. Conversely, while at the same dateindustrial issues accounted for only 8% of the iBoxxindex, they represented 20% of the CDS market.

Growth prospectsIn its third-quarter review for 2002, the Office ofthe Comptroller of the Currency reported thatthe notional amount of credit derivativesreported by insured commercial banks increasedby more than 16%. That is a very appreciable rateof growth, and would appear to support the esti-mates of those who believe the global market willcontinue to expand at breathtaking speed overthe next few years. One of those forecasts, madeby the BBA, is that the total market will reachwhat it describes as a “staggering” $4.8 trillionby 2004.

That rate of growth, advises the BBA, couldbecome even more dramatic if and when variousuncertainties and legal impediments to the mar-ket’s expansion are removed. “Regulatory uncer-tainty, for instance over the outcome of the Basel IInegotiations, constitutes one of the major con-straints to the growth of the credit derivatives mar-ket,” noted the BBA.


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market, many manage portfolios that may be toosmall to make direct participation practical. As oneinvestor told Credit in November 2002, while thetypical size of a CDS contract is between $5 and$10 million, an institution’s exposure to any givencredit might only be in the $1–$5 million range,meaning a CDS contract is too large for hedgingthe bonds. As this particular investor put it:“Unless you have a large portfolio or aconcentrated one then you can’t use them.”

Index-based products are being developed toaddress this particular shortcoming, making theCDS universe more accessible to managers ofsmaller credit positions. For example, in March2002, JPMorgan announced the launch of a newEuropean credit index-linked security with theacronym of Jeci. As JPMorgan explained at thetime: “The new security, based on 100 of the mostactively traded names in the European creditmarkets, provides investors for the first time [with]the ability to conveniently buy and sell a diversifieduniverse of European credits. The first of its kind,Jeci-100 (pronounced Jessie) is a five-year tradableinstrument that can be issued in funded,unfunded, fixed or floating form.”

Targeted predominantly at portfoliomanagers, banks and hedge funds, Jeci isconstructed on a rules-based approach by whichthe 100 most liquid issuers (75 corporate namesand 25 financials) are selected from the cashmarket, with each component weighted toreflect the sector and rating allocation of thecash bond market.

The availability of index-based products wasfurther expanded in February 2003, whenDeutsche Bank and ABN Amro launched andpriced the first two new issues of a family of CDSproducts linked to the iBoxx indices. The headlineiBoxx 100 Note reflects the performance of the top100 names in the iBoxx euro-denominatedcorporate index, weighted by their duration-adjusted market capitalisation. The iBoxx 100Corporate Component Note, meanwhile, strips outfinancial issuers and is made up of the 62 purecorporate names in the iBoxx 100 Note. Bothproducts are in the form of €500 million floatingrate notes (FRNs), with both Deutsche Bank andABN Amro committed to quoting two-waymarkets for trades up to €50 million at a bid-offerspread of 5bp “under normal conditions”. ■

For the time being the jury is out on how theBasel II guidelines on bank capital will affect thecredit derivatives market. The principal element ofBasel II is that it will impose a risk weighting of20% for assets rated triple-A to double-A, 50% forthose with a single-A rating, 100% for triple-B todouble-B rated assets, 150% for those rated belowdouble-B and 100% for unrated assets. The pro-posed new guidelines, which the BIS describes asbeing based on a “more risk-sensitive framework”,are intended to “leave the total capital require-ment for an average risk portfolio broadlyunchanged”. How much of an impetus thesemeasures will have on encouraging participants inthe credit market to search for more protection ontheir exposure is open to question.

However, bankers point out that in sharp con-trast to, say, the market for interest rate and cur-rency swaps, the potential for the addition of newreference entities in the credit derivatives marketrepresents what is almost a bottomless pit, giventhat CDSs can be written on any borrower in thebond or loan markets, and that the universe ofissuers is constantly expanding.

LiquidityIn the immediate aftermath of the Enron crisis atthe end of 2001, while liquidity in the cash bondmarket dried up dramatically, activity in the CDSmarket remained resilient. Bankers reported that,in turn, this strength in the CDS market helped liq-uidity to return to the cash market more quicklythan would otherwise have been the case, givenderivatives’ capacity to allow traders to express longand short views on individual credits.

The liquidity and transparency of the CDS mar-ket has improved dramatically over recent years asan increasing number of intermediaries haveentered the market, quoting indicative two-way(bid and offer) prices for the more actively tradedcorporates and sovereigns on their websites, as wellas on electronic data vendor screens. While thosespreads are frequently much wider than thosequoted on the underlying cash market, the avail-ability of transparent prices is an important step for-wards for the CDS market.

The transparency of the market has also beensubstantially enhanced by credit derivatives brokerssuch as GFI, which was founded in 1987. GFI’s

credit derivatives data collection includes tradedlevels as well as bid and offer prices for sovereignand corporate entities from all regions and marketsectors. The data is made up of almost 300,000price points across 1,700 reference entities datingback to 1997, and is made available to subscribersvia a web-based portal.

“By nature, our credit default swap data pro-vides a forward insight into credit trends beforemost other indicators,” GFI explains. “This can beused to mitigate credit risk, measure market con-centration risk in credits, industries and companies,and maintain a daily market perspective on creditquality across a wide universe of names. In contrast,

most other methods rely on historic rates of recov-ery…and are therefore backward looking and donot reflect current market trends.”

Another helpful initiative in terms of liquidityand transparency was the launch of Mark-It Part-ners in 2001. At launch, the firm explained that“the demand for definitive, transparent creditinformation is intensifying. Until now, findingdata that combines accuracy, range and ease ofuse has been impossible.” Mark-It describes itsservice as one that is “revolutionising credit pric-ing”. The firm offers a “ground-breaking creditpricing concept that offers a total on-line solu-tion for today’s market”.

Understanding the basisThe difference between the CDS market price andthe credit spread on cash bonds is known as the‘default cash basis’ or the ‘default swap basis’ – andthis ‘basis’, which in the majority of cases is posi-tive, can and does vary appreciably depending on arange of technical and fundamental market circum-stances. As a result, exploiting the differencebetween CDS and cash bond prices, known as‘trading the basis’, can be a highly effective arbi-trage strategy and has become especially popularamong hedge funds. ■


CDS growth

After Enron, liquidity in the cashbond market dried up butliquidity in the CDS marketremained resilient

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It is often said that CDS prices are a very tellingindicator of the credit quality of their referenceentities. But the closeness of the relationshipbetween CDS prices and trends in underlyingcredit quality is much less frequently proven, eventhough a cursory retrospective glance at pricinghistory in the CDS market demonstrates veryclearly that credit derivatives can act as an earlywarning signal for credit deterioration. By the sametoken, of course, they can serve as an equally help-ful barometer of an improving credit climate forindividual reference entities.

Anticipating bad newsHistorical evidence suggests that the CDS marketcan anticipate rating downgrades with sometimesuncanny accuracy. In the corporate sector, take theexample of the US natural gas company, El Paso.The cost of five-year CDS protection on El Pasomore than doubled between September 12 andSeptember 23, 2002, from 575 basis points to1,250bp. On September 24, Moody’s confirmedwhat the CDS market had anticipated, putting thecompany on review for downgrade. Two monthslater, El Paso was downgraded from Baa3 to B2.

Equally striking, in 2001, was the CDS market’scapacity to foretell negative rating action on the USretailer Gap, not once but twice within a fewmonths. In May 2001, CDSs on Gap’s five-year dol-lar bonds were being offered at just 50bp. BetweenSeptember 6 and October 11, with the marketunsettled by slowing sales, this price leapt from 87bpto 180bp, with Moody’s announcing that it was put-ting the company on review for downgrade onOctober 12, subsequently lowering Gap’s rating toBaa2 on October 29. A fortnight later, on Novem-ber 8, there was another sudden spike in the price ofGap’s CDSs, from 250bp to 315bp within a singletrading session. Three days later Moody’sannounced a further review for downgrade.

Similar trends are clearly detectable in thebanking sector, with the behaviour in October

2002 of CDSs on Commerzbank’s five-year eurobonds providing an illustrative example. Withinthe first week of that month, CDS protection onthe troubled German bank almost doubled, from110bp to 215bp.

On October 8, Standard & Poor’s downgradedthe bank’s rating from A to A-. At the time, S&Pcited Commerzbank’s “further weakened businessand risk profile, as the prolonged economic down-turn will cause further delays in restoring the bank’score profitability and improving its capital strengthin the medium term.” Although equity markets aregenerally supposed to discount developments suchas this, it is clear that in this instance the CDS mar-ket acted as a more reliable indicator of market sen-timent, with the Commerzbank share price plung-ing by more than 7% in response to the S&Pannouncement, to its lowest level since 1996.

Anticipating good newsOn a more positive note, the CDS market can alsofunction as an accurate litmus test of the market’sperception of changes in corporate management orstrategy leading to an improvement in credit qual-ity. A good example here is provided by the heavilyindebted France Télécom, which at the start ofOctober 2002 appointed a new CEO in the formof Thierry Breton, who was well-respected in themarket as a specialist in corporate turnarounds.CDS traders clearly responded positively to Bre-ton’s appointment and to the de-leveraging strat-egy he announced soon after his arrival.

Between October 10 and November 1, theoffered price of the CDSs on France Télécom’sfive-year euro bonds almost halved, from 500bp to260bp. Again, this trend foreshadowed other keymarket developments: in December, Moody’sconfirmed its Baa3 rating on France Télécom witha stable rating, while between mid-November andthe middle of January, the spread on the com-pany’s benchmark 2011 bond fell from 360bp to264bp over swaps.

The ability to ‘trade rumours’The credit default swap market has rapidly become recognised as one of the most responsivefinancial indicators, in some cases foreshadowing even the equity markets. From Ahold toWorldCom, the CDS market has priced concerns in long before other asset classes


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In other words, the CDS market anticipatedboth the action of the rating agencies and the per-formance of France Télécom’s benchmark bonds inthe secondary market.

Sudden actionsInevitably, the CDS market is less effective in pre-dicting sudden credit events, such as the bombshellreleased on February 24 by Dutch retailer Ahold,which rocked all securities markets when itannounced that it had been massively overstating itsprofits in the previous two years, leading to the res-ignation of its CEO and finance director. On thatday, Ahold’s equity market value collapsed by 63%,while the price of the CDSs on its five-year bondsmore than doubled, from 215bp to 500bp. The fol-lowing day, Moody’s downgraded the company.

Probably more revealing than the performanceof Ahold’s CDSs on February 24, however, waswhat the credit derivatives market had been sayingabout the company over the months leading up tothe revelations of February 2003. In this instance,clear and protracted misgivings among CDStraders are detectable over the credit quality of thecompany which, even after a $5.8bn acquisitionspree in the US in 2000 and 2001, was still tradingin the 50s at the start of April 2002. Thereafter, theCDS price rose dramatically, marked up from 65bpin early May to 140bp in July.

That month, Ahold revised its target of a 15%growth in EPS to a rise of between 5% and 8% – atarget which, later in the year, was further reviseddownwards to minus 6% to minus 8%. July 2002also saw an announcement from Moody’s that itwas putting Ahold on review for a possible down-grade, and in the months that followed, the price ofCDSs on Ahold continued to rise, breakingthrough the 200bp level in early October.

The most dramatic movements in the recentbehaviour of CDS prices, however, have tended tobe those that have preceded bankruptcy, withWorldCom in the US providing a graphic illustra-tion. In June 2001, investors were able to buy pro-tection for their exposure to WorldCom in theCDS market at just 60bp in spite of the company’smounting debt pile; by early 2002, WorldCom hadsome $29bn of debt outstanding, much of whichwas accounted for by a record-breaking $11bnbond it had sold in May 2001.

A key warning sign for investors in all classes ofWorldCom securities came when the companyunveiled surprisingly poor revenue and earningsfigures on Friday, April 19, 2002. Between the fol-lowing Monday and Wednesday, its $4bn 7.5%2011 bonds nosedived from 83 cents in the dollarto 59 cents. Poor sentiment spread across thebroader telecoms sector over the following week,with AT&T’s bonds, for example, widening bysome 150bp in the fortnight following the World-Com results.

The decline – predictable in hindsight – inWorldCom’s credit quality had been clearlyreflected in the price of the credit default swapson its five-year dollar bonds, which rose from225bp in early March to 700bp on April 19. OnApril 23, the day on which Moody’s downgradedthe company from A3 to Baa2, bids were putthrough for WorldCom’s CDSs at 1,000bp,1,100bp and 1,150bp, and by the end of April,when CEO Bernie Ebbers resigned, they wereoffered at 1,500bp.

By early May, WorldCom’s 2011 bonds werechanging hands at 43 cents in the dollar, althoughby now the CDS market was clearly anticipating thecompany’s decline into non-investment grade ter-ritory, with its CDSs quoted at more than 2,000bp.

Towards the end of June, WorldCom continuedto shock investors when it announced a $3.9bnaccounting fraud. By that time any liquidity in thecompany’s CDSs had dried up completely, with notrades recorded by GFI after mid-May. ■

$1,000,000

$500,000

January February March April

5000

4000

3000

2000

1000

0

FebruaryJanuary March April May

May

WorldCom (1$bn, 7 7/8% 2003)

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Source: GFI / Merrill Lynch

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Av. yearly cost of CDS protection on $10m of WorldCom debt

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market participants

Unsurprisingly, commercial banks are the largestplayers in the CDS market. According to fig-

ures compiled by the British Bankers’ Association(BBA), banks accounted for 52% of the protectionbuyers market and 39% of the protection sellersmarket in 2001. The BBA expects both these sharesto drop by 2004, to 47% and 32% respectively. Thatwould still make banks dominant in the market forprotection buying, but in terms of protection sell-ing they would be overtaken by insurance compa-nies, the share of which will remain steady at 33% in2004 – identical to their share in 2001, accordingto BBA forecasts.

Benefits for banksFor banks, one of the most important benefits ofcredit derivatives in general – and credit defaultswaps in particular – can be traced back to 1988and the publication of the Basel Capital Accordwhich forced many lenders to reappraise the size oftheir exposure to corporate borrowers, many ofwhom would have been long-standing customers.For lenders, this presented an obvious conundrum:how could they reduce their exposure (or simply

leave their exposure static) to borrowers withwhom they had developed close links dating backmany decades without seriously jeopardising thoserelationships? The CDS market provides a valuablesolution to that dilemma.

For banks with limits on their credit lines toindividual borrowers, the credit default swap mar-ket is an effective means of transferring risk onoutstanding loans without physically removingassets from the balance sheet. Granted, there arealternative means of offloading these assets via, for

example, the secondary market for syndicatedloans. But in the European loans market, second-ary trading has yet to take off in a meaningful way.Even if there was a liquid and flourishing marketfor secondary loan trading in Europe, in manyinstances loan documentation prohibits lendingbanks from passing their exposure on to third par-ties in this way. And even if documentationincludes no clause preventing a lending bank fromsubsequently offloading a facility, the process ofselling loans in the secondary market can be onethat entails considerable legal and administrativecosts for the banks involved.

The most powerful incentive for lending banksto use the CDS market as a means of transferringthe risk on their loan books, however, is that itallows them to do so without the knowledge ofthe borrower. This in turn allows them to free upadditional lending lines for prized customers thatmay be very important sources of ancillary busi-ness in, say, corporate finance. Alternatively, CDSscan be used as a means of reducing banks’ con-centration in individual industrial sectors or geo-graphical regions. Use of the CDS market cantherefore help banks to promote as well as tomaintain their client relationships, allowing themto open up new credit lines that might otherwisehave remained closed.

Room for growthEven though commercial banks are the most activeparticipants in the CDS market, it should be notedthat even in the US, where the credit derivativesmarket is most developed, the market remainsdominated by a handful of the largest banks, withJPMorgan, Citibank and Bank of America account-ing for the lion’s share of activity. According toOCC statistics compiled in the second quarter of2002, fewer than 400 of the 2,200 institutionsunder its supervision held credit derivatives. Thatsuggests that there is room for considerable growthamong bank users of the market in the US.

Buyers and sellers of CDSsGreater regulation on the extent to which banks are exposed to corporate clients has meantbanks have eagerly adopted credit default swaps to transfer risk, however concerns have beenexpressed in certain quarters about where the transferred credit risk is going

In many instances loandocumentation prohibits lendingbanks from passing theirexposure on to third parties


market participants

www.creditmag.com

In Europe, according to a report released inMarch 2003 by the rating agency Fitch, bankshave been net buyers of protection via the creditderivatives market to the tune of some €65bn,although only about 30% of European banks activein the market are protection buyers. The reportobserved that German Landesbanks have becomevery active players in the CDS market, largely assellers of protection, although they are by nomeans alone in this respect.

“The conventional view is that banks are prima-rily net buyers of protection,” the Fitch reportnotes. “Nearly three-quarters of the banks sur-veyed are net sellers. The banks are using creditderivatives as an integral part of their revenue-gen-erating business, enabling certain European banksto diversify by gaining exposure to regions and sec-tors where they are underweighted.”

Other sources confirm that European banks’overall use of the CDS market remains limited, but isgrowing rapidly. According to a report published in

January 2003 by the working group established bythe BIS Committee on the Global Financial System:“Although the scale of their current involvement inCRT [credit risk transfer] differed greatly across thebanks interviewed by the Working Group, almost allstressed its importance and expressed their intentionto step up their activities in this area.”

However, the same report adds that in total, “thenumber of institutions actively involved across therange of CRT markets remains quite limited at pres-ent. While, for example, the use of ABSs has becomemore widespread within the banking industry ofsome countries, the number of institutions usingCDSs on any scale is still relatively small.”

A number of commentators, including the ratingagencies, have voiced misgivings about banks’ rela-tively poor disclosure of their precise exposure tothe credit derivatives market. For example, an analy-sis of the annual reports of 30 banks in 10 countriesby the BIS working group found that none of these

made “comprehensive disclosures”. That, adds thereport, “may give grounds for concern”.

Conflicts of interestAnother cause for concern about the role played inthe CDS market by commercial banks that areactive participants in the syndicated lending marketis the potential for conflicts of interest among theselenders. Some newspapers have alleged that Chi-nese walls between banking and trading desks havebeen broken, with lenders privy to much morecomprehensive information about their borrowersthan investors in the capital market or sellers of pro-tection in the CDS market.

Investment banksInvestment banks are also active participants in theCDS market, both as providers of liquidity for theircustomers and as proprietary traders. The CDSmarket can offer a highly efficient means of remov-ing assets from the balance sheets of investmentbanks, an objective that has become more andmore important in recent years as the leadinginvestment banks seek to offer a ‘one-stop shop-ping service’ to their corporate clients. Given therelatively limited size of investment banks’ capital,the CDS market provides them with a useful meansof demonstrating their commitment to corporateclients by supporting syndicated lending facilitieswithout exerting unsustainable strains on their bal-ance sheets.

Insurance companies and other investorsInsurance companies’ participation in the CDSmarket, predominantly as sellers of protection, ison the up. While many insurance companies willprovide protection as writers of single-name defaultswaps, they are also active in the market as buyers ofCDOs and credit-linked notes (see page 28).

It is important, however, to dif ferentiatebetween the different types of insurance compa-nies active in the CDS market. Life assurancecompanies, for example, act as an importantsource of investor demand for ABSs and CDOs.US monoline insurance companies, meanwhile,are pivotal players in the CDS market, often assellers of credit protection on the senior (or so-called ‘super senior’) triple-A rated notes in struc-tured portfolio transactions.

A number of commentators, havevoiced misgivings about banks’poor disclosure of their preciseexposure to credit derivatives


market participants

Barriers to involvementA number of insurance companies prohibited fromentering into derivatives transactions directly,meanwhile, have addressed this problem by estab-lishing subsidiaries known as ‘transformers’ func-tioning largely as sellers of credit protection, basedin offshore locations, with Bermuda the most pop-ular in this respect.

Other mainstream institutional investors, suchas pension and investment funds, are less activeplayers in the credit derivatives market. In part, thisis because a substantial number of institutionalinvestors in Europe are unable to trade creditdefault swaps, maybe as a result of direct regulatoryprohibition or a lack of the necessary back-officeinfrastructure or expertise. Demand for skilledcredit derivatives technicians comfortably outstripssupply, explaining why derivatives specialists arenow among the best-paid professionals in financialcentres such as London. For all but the largest insti-tutional investors, recruiting experienced teams ofderivatives experts remains a prohibitively expen-sive exercise.

The German Banking Act, for example, restrictsGerman mutual funds from using credit deriva-tives, while swap contracts and over-the-counterderivatives also remain legally out of bounds formutual funds in a number of Scandinavianeconomies. An exclusive survey of 32 credit assetmanagers in Europe, the results of which werepublished in the October 2002 edition of Credit,

offered valuable insight into the extent to whichfund managers remain restricted from tradingCDS contracts.

From the survey’s respondents, 22% indicatedthat they were permitted to invest in CDSs undertheir current investment mandates, while 28% saidthat although they were not yet allowed to tradeCDSs, they expected to be able to do so within thenext 12 months. A further 16% expected to beactive in the market within two years, with theremaining 34% unsure as to when they would befree to trade CDSs.

But the response to the survey suggested thatthere is a high awareness of the value of the CDSmarket even among those institutions that arenot yet active in the sector – 10 of the 32 respon-dents, for example, said that they use the CDSmarket as an indicator of where prices may beheading in the underlying cash market. In thewords of one investor: “We do use CDSs forresearch purposes, and as the market is more effi-cient than the cash market, it is a good indicatorof where a credit is moving.”

For all but the largest institutionalinvestors, recruiting experiencedteams of derivatives expertsremains prohibitively expensive

Does your mandate allow you to tradeCDSs? If not, when do you expect to beable to use them?

Source: Credit survey

28%No (able to tradeCDSs within 12months)

16%No (able totrade CDSswithin 24months)

34%No (don’t knowwhen able totrade CDSs)

22%Yes

What do you/would you use CDSs for?

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market participants

www.creditmag.com

From some other respondents to the same sur-vey, however, came some outspoken criticism of theCDS market. One UK investor felt that “the CDSmarket does not have any sound economic reasonfor us to invest in it,” and that “it is not cheapenough. The bid-offer is too wide and the banks ripyou off.” However, that seems to be a minorityview and it is probable that as the CDS marketdevelops and matures, reservations such as these –already dismissed by intermediary banks asanachronistic – will recede.

Flexibility for investorsAmong those investors that are allowed to tradeCDSs, perhaps one word sums up most compre-hensively the benefits afforded by the market:flexibility. For example, the CDS market hasproved to be an especially useful means of takinga bearish position on any individual issuer in thebond or loan market, allowing market participantsto go short of credit risk by buying protectionusing CDSs.

As one market participant points out: “CDSsallow you to trade on a rumour”, something thatthe illiquid bond market and static loan market donot. But there are numerous other examples offlexibility enjoyed by investors in the CDS market.As Goldman Sachs advised in a report published inMay 2001: “Investors who employ default swapsenjoy the flexibility to structure the terms of theirinvestment, including maturity, recovery, call fea-tures and coupon type. Default swap overlays pro-vide an efficient tool to reposition an existing bondor loan portfolio – either short or long term – toreflect changing risk requirements or to take advan-tage of market opportunities.”

Nevertheless, mutual funds accounted for just2% of the market for protection buyers in 2001,according to BBA data, with pension fundsaccounting for 1%. Both these shares are expectedto rise to 3% by 2004.

One group of investors that has becomemarkedly active in the credit default swap market inrecent years is hedge funds, with the BBA reportingthat these funds accounted for 12% of the marketfor buyers of protection in 2001, a share that isexpected to increase marginally to 13% by 2004. Inthe market for protection selling, the hedge funds’share is expected to rise from 5% to 7% over thesame period.

Alternative means of access for investorsFor those investors that are still unable to tradecredit default swaps directly, a number of proxyproducts have been developed by intermediarybanks allowing for them to enjoy many of the ben-efits of exposure to the CDS market. For example,in February 2003, JPMorgan announced thelaunch of Credit Elect, a new derivative tradingplatform designed for investors unable to tradeCDSs outright, “either for regulatory, credit orinfrastructure reasons”.

Credit Elect is a synthetic balance sheet whichprovides these investors with a liquid and flexibletrading platform actively to manage a portfolio ofCDSs. According to JPMorgan: “Credit Electenables the investor to build and trade a diversifiedcredit portfolio based on the wider universe ofnames that trade in CDS format. The investor hasthe ability to go long and short the market infunded format, and trade the basis between CDSsand bonds, loans and equity.”

Other buyers of protection riskTheoretically, CDSs can be used by a number oforganisations outside the confines of the financialservices industry. Corporates, for example, mightuse the credit default swap market as a means ofinsuring themselves against trading with poten-tially risky commercial counterparties – be it sup-pliers or customers.

In Europe, however, corporate use of the CDSmarket appears to have remained muted. Accord-ing to a Bank of England report: “Judging fromthe Bank’s regular contacts with UK companiesand market intermediaries, corporate involvementin the credit derivatives market remains limited to ahandful of large multinationals. Intermediaries do,however, see potential for a number of applicationsas the market matures.” ■

CDSs allow you to trade on arumour, something that theilliquid bond market and staticloan market do not


new structures

This guide has focused principally on the single-name default swap, which is commonly

described as the ‘building block’ for a number ofother products – chiefly for portfolio-based onessuch as collateralised and credit-linked instruments,which have become increasingly important prod-ucts in recent years.

In a collateralised obligation of any form, aninvestor is provided with exposure via a single secu-rity to a pool of assets, which may be made up ofloans (in a collateralised loan obligation, or CLO),bonds (in a CBO) or, more recently, funds (in aCFO). Securities that are collateralised by a combi-nation of these assets are known more generally ascollateralised debt obligations (CDOs), although ithas become increasingly fashionable and conven-ient to use this term to describe the entire assetclass. More recent innovations have been the devel-opment of collateralised synthetic obligations (orCSOs, described in more detail below), and ofCDOs in which the asset pool is made up of otherCDOs. Recognisable to plain vanilla bond orequity investors as the equivalent of funds of funds,these are now known as CDOs squared.

An essential and common element of all collat-eralised obligations is that the asset pool is trans-ferred from the originator to investors via a specialpurpose vehicle, or SPV. An SPV may equally wellbe described as a ‘single’ or ‘only’ purpose vehicle:it does not take deposits, lend or invest money, orprovide consultancy services of any kind. Its solepurpose is to isolate asset pools from the originator,ring-fencing those assets in such a way as to ensurethat their credit quality is to a certain degree

divorced from that of the originator. This explainswhy SPVs, the majority of which are serviced byskeleton administrative staffs and domiciled in tax-efficient offshore locations, are usually described asbeing ‘bankruptcy remote’.

Collateralised debt obligationsCDOs were originally a US invention used princi-pally as a means of repackaging high-yield or ‘junk’bonds in the late 1980s, with the first recordedtransaction generally believed to have been a CBOlaunched by Kidder Peabody in 1989. The ration-ale underpinning the expansion of CBOs backed bypools of high-yield bonds in the US in the late1980s was that they provided investors with expo-sure to large, diversified portfolios of bonds.

That in turn allowed them to access a popular andrapidly expanding asset class without assuming thelevel of risk that would inevitably have been associ-ated with exposure to single-name issuers. Since theearly CDOs, which repackaged higher yieldingbonds, the same mechanism has been applied to abroad range of other assets, including asset-backedsecurities, bank-preferred shares emerging marketsecurities and derivatives products.

In a conventional CDO, pools of assets aretransferred from an originator to an SPV, removingownership of the assets from the balance sheet ofthe originator, which is usually (but by no meansexclusively) a bank. The regulatory capital reliefachieved as a result of this transfer of credit risk hasoften been the principal motivation for banks’release of assets via the conventional CDO market.

A typical CDO is structured to appeal to thebroadest possible spectrum of investors by offeringthem a number of differently rated tranches, rang-ing from low risk triple-A rated notes through tothe highest risk equity tranche generally referred toas the ‘first loss’ piece and usually accounting foraround 10% of the CDO’s total value. In this way, ahierarchy of cashflow payments to investors is

CDSs as building blocksCredit default swaps are no longer purely used as a form of insurance for lenders or an alter-native method of gaining exposure. Their commonality and tradability has allowed people tocreate new and innovative financial products

CDOs were originally a USinvention used principally as ameans of repackaging high-yieldor ‘junk’ bonds


new structures

www.creditmag.com

established – sometimes known as the ‘cashflowwaterfall’ – with this process of subordinationforming the basis for what is commonly referred toas ‘credit enhancement’, or the provision of addedsecurity for investors. The precise details of thissubordination structure are clearly set out in theoffering circular for each CDO issue.

There are a number of other mechanisms aimedat providing credit enhancement for investors in theCDO market, such as the creation of surplus cashreserves from note proceeds that can be earmarkedas first loss protection for investors. In the US mar-ket, additional credit enhancement for CDOinvestors frequently takes the form of so-called‘wraps’ by triple-A rated monoline insurance compa-nies, although this is much less common in Europe.

Constructing a CDOConstructing a CDO is a very detailed exerciseinvolving extensive interaction between its managersand rating agencies, investors and legal counsel. Thecomplexity of this process depends on the nature ofthe assets gathered together within the CDO.

The phase during which the collateral or refer-ence assets of a CDO are accumulated is referred toas the ‘ramp-up period’, which will typically last

between 60 and 180 days after the closing date,although in some European CDO transactions, theramp-up period has been longer. The year in whicha CDO was originally ramped up is known in futureyears as the ‘vintage’.

Pricing a CDOThe price of CDOs in the primary market is usuallylinked to Libor or, more recently, to Euribor, withpricing based on the rating of each individualtranche. As a recent example of the typical tranchingof prices within a CDO, take a transaction such asthe Jazz 2 CDO launched in December 2002 by AxaInvestment Managers, offering leveraged exposureto a portfolio of principally investment-grade corpo-rates and asset-backed securities. In this €756mstructure, the triple-A rated class A notes were pricedat three month Euribor plus 75bp, with the double-A class B tranche offering Euribor plus 115bp. Thetwo class C pieces, both rated A-, were priced at a220bp spread, while the class D notes, also rated A-,were set at six month Euribor plus 375bp.

CDOs generally trade at cheap levels relative tocorporate bonds of the same rating, which hasprompted some market participants to speak of the‘free lunch’ available to investors in the CDO market.

According to figures published by the BondMarket Association, total outstanding volumes inthe CDO market in the US rose sharply in themiddle of the 1990s, from $1bn in 1996 to$19bn in 1997, $48bn in 1998, $85bn in 1999,$125bn in 2000 and $167bn in 2001. Europeanissuance, meanwhile, rose from $42bn in 1999 to$114bn in 2001. The UK’s NatWest Bank isaccredited with kick-starting the evolution of theEuropean CDO market in 1996 with its RoseFunding CLO transaction, which was a $5 billionsecuritisation of more than 200 corporate loansdesigned to free up credit lines.

The landmark CLO deal in Europe in 1998,however, was a Deutsche Bank securitisation ofover 5,000 loans to some 4,000 companies wortha total of $2.4 billion (Core 1998–1), which at thetime represented the largest number of corporateloans ever packaged together in a European CLO.

Meanwhile, 1999 saw the process of Europeanbanks transferring credit risk through CLOsgathering impressive momentum, with debuttransactions from leading banks such as SociétéGénérale, Crédit Lyonnais and Banque Paribas ofFrance, and Italy’s BCI.

While banks have spearheaded issuance in theCDO market for readily identifiable reasons, theyhave not been the only constituents to put theinstrument to good effect. In May 2000,Deutsche Bank’s asset management arm, DWS,launched a privately placed €318m CDO, largelyintended as a means of expanding its businessscope by bringing in new sources of investmentcash. Later the same year, Axa InvestmentManagers launched its first CDO backed by high-yield bonds, while other fund managementcompanies to launch CDOs have included M&G,Henderson Global Investors, Pimco and others. ■

Issuers in the CDO market: a brief history


new structures

The main reason explaining the price differentialbetween CDOs and comparably rated corporatebonds is the much greater liquidity available in thecash bond market.

There is virtually no secondary market forlower-rated and equity tranches of CDOs, whichtend to appeal to buy and hold investors. There ismore liquidity in the higher-rated tranches ofCDOs, although this is generally confined totransactions arranged by banks on a so-called‘reverse enquiry’ basis. Reverse enquiry refers to

the process by which investors approach banks orissuers with specific details of securities tailored totheir specific requirements.

Collateralised synthetic obligationsThe high liquidity levels in the CDS market havegiven rise in Europe to the rapid evolution ofCDOs that are backed not by cash bonds or loans,but by credit default swaps. These are known as‘synthetic’ CDOs or collateralised synthetic obliga-tions (CSOs), and have quickly become an impor-tant part of the European landscape. While theassets remain on the originator’s balance sheet in aCSO, the credit risk does not. By very logicalextension, if the regulator acknowledges that therisk of exposure to credit has been removed fromthe originator’s balance sheet, it stands to reasonthat the transaction should allow the originator toachieve regulatory capital relief. This technique hasbecome especially popular among continentalEuropean banks, with German Landesbanks, forexample, active users of the synthetic CDO marketas a means of transferring large blocks of lumpy andilliquid credit risk through portfolios of shipping oraircraft loans, or commercial real-estate exposure.

CDO credit quality and product developmentAlthough CDOs are bankruptcy remote fromtheir originators, this does not mean that they areimmune from credit deterioration. Far from it.

The ratings of CDOs remain inextricably linkedto the credit performance of the underlying ref-erence entities within the CDO, and are there-fore hostage to declining credit quality in theglobal credit market. A study published byMoody’s in February 2003 found that between1991 and 2002, CDOs had an “extremely highdowngrade rate (10.9%) and a very low upgraderate (0.6%)” which, the agency explained, is “pri-marily due to the extraordinary number of down-grades and defaults in the corporate bonds thatunderlie these securities”.

Declining credit quality in the market hasencouraged extensive adaptation and innovationamong issuers and managers of CDOs. “The sus-ceptibility that some earlier synthetic CDOs haveshown to negative rating action has not led to thedemise of the product,” explained an analysis pub-lished in November 2002 by Dresdner KleinwortWasserstein (DrKW).

“But waning investor demand has promptedbanks to look more closely at how transactions arestructured,” continues the report. “As a result, weare seeing structural evolution and a new genera-tion of deals has begun to emerge. These structuresseek to address the weaknesses of their predecessorsand incorporate features designed to make themmore robust in the current environment.”

Specifically, the DrKW report added, thisdevelopment has led to the emergence of staticportfolios that are much more granular anddiverse in their construction. It has also encour-aged the more frequent use of structures in whichreference portfolios are much more actively man-aged – “the theory being that a good managercan avoid the downgrades and defaults thatmight occur in a static deal and thereby poten-tially outperform.”

CDO volumesIn 2002, according to figures published by Stan-dard & Poor’s, publicly rated CDO volumes(including CBOs and CLOs), fell by 5% to end theyear at $51.4 billion, compared with $54.3 billionin 2001. In the publicly rated domain, according tothe same source, a total of 116 transactions closedin 2002 compared with 62 in the previous year,while the average transaction size fell to $0.5 bil-lion compared with $0.8 billion in 2001. An

Collateralised syntheticobligations have quickly becomean important part of theEuropean landscape


new structures

www.creditmag.com

important caveat to these figures, S&P pointedout, was that “a number of large, privately rated,pure synthetic CDO transactions were executedover the course of 2002,” which were not includedin the agency’s statistics. According to S&P, “thismasks the true size of the market and understatesits real growth.”

“Publicly rated volumes for 2002 were relativelyflat, but a privately rated, synthetic market existedin tandem,” said S&P. “Privately rated, syntheticissuance using credit derivative technology willcontinue to drive the CDO market in the yearahead as more and more European originators seekcost-effective platforms to manage balance sheetobjectives….An increased number of originatorsare taking this route as the structures can realisegreater flexibility in terms of risk management.”

This anticipated expansion in synthetic struc-tures, added S&P, will inevitably place an increasedemphasis on the quality of the collateral manager,with only a small number of European managershaving extensive CDO experience. “Managed syn-thetic CDOs require the involvement of a collateralmanager that understands the intricacies of com-bining CDO techniques with the credit defaultswap market,” S&P said. “The expertise of tradingdesks at large financial institutions in the creditdefault swap market makes them strong candidatesfor both structuring and managing synthetic CDOsin particular.”

Credit-linked notesA credit-linked note (CLN) is a structured notecombining both a debt instrument and a CDS. Asresearch published in September 2002 by DrKWputs it, a CLN can be thought of as a note with an

embedded CDS, or as a collateralised CDS with theinvestor receiving a payoff that is dependent on theperformance of one or more reference credits. If acredit event on one of the reference credits occurs,redemption for the CLN investor is equal to parminus the loss on the defaulted credit.

“This is the basic design,” said the report, “but aCLN can be structured with additional featuresaccording to investor requirements. It could beprincipal protected, meaning the investor is repaidpar at maturity regardless of whether a credit eventhas occurred or not. A credit event would simplymean that the coupon stops being paid. Alterna-tively it could be structured with coupon protec-tion instead. Other variations include linking aCLN to credit spreads rather than credit events as

such, or referencing it to an equity or a commodityindex.” Clearly, then, a large attraction of CLNs istheir extreme flexibility and adaptability to suit abroad range of investors and to cater to a widespectrum of circumstances.

Theoretically, CLNs look and behave like bondsand are typically structured in one of two ways. In aeuro medium-term note (EMTN) CLN the note isissued directly by a bank or corporate, exposing theinvestor to the credit risk of the issuer and the ref-erence credits. In a SPV CLN, the notes are issuedby a special-purpose vehicle and reinvested in top-rated collateral – generally triple-A rated govern-ment bonds or, in the case of German issuers,triple-A Pfandbriefe (bonds collateralised by publicsector loans or mortgages).

Pros and consCLNs owe much of their popularity to their capac-ity to open up a much broader range of opportuni-ties for investors in at least three ways. First, forthose that are constrained by ratings considera-tions, they can offer exposure to lesser rated assets(or to unrated assets) via a triple-A instrument. Fol-lowing the Mexican financial crisis in 1995, forexample, notes were structured to allow investors

CLNs can provide investorsprohibited from investing directlyin CDSs with an effective means ofaccessing exposure to the market

1997

180160140120100806040200

1996 1997 1998 1999 2000 2001

Growth in the US CDO market

Source: Bond Market Association

$1bn


new structures

unable to invest directly in the country to express abullish view on Mexico’s longer term prospects viathe CLN market.

Second, CLNs can provide investors prohibitedfrom investing directly in credit derivatives with aneffective means of accessing exposure to the market.And third, CLNs can give investors exposure toassets that might not otherwise be accessible to them– either because they are sourced from a borrowerthat has not issued securities in a format or maturitythey can buy, or because the assets referenced in theCLN are too small, fragmented or illiquid.

A good recent example of securitisation pro-grammes that combine all three of these advantagesare the Promise and Provide platforms, initiativeslaunched by Germany’s 100% state-owned devel-opment bank, Kreditanstalt für Wiederaufbau(KfW), which is rated triple-A and which enjoys anexplicit guarantee of its existing and future obliga-tions from the Federal Republic of Germany. As azero-weighted borrower, KfW has increasinglybeen seen by international investors as an effectiveproxy for German government bonds (Bunds).

Via these programmes, fragmented portfolios ofloans to small and medium-sized companies (SMEs)or residential mortgages are bundled together byKfW, with the risk transferred to a special purposevehicle which then transfers some of that risk to thecapital market through the issuance of tranchedcredit-linked notes. KfW is paid a fee for its interme-diation services by the originating bank which,according to KfW, need not be a German entity.

Promise (the acronym for KfW’s Programme forMittelstand Loan Securitisation) was launched inDecember 2000, with IKB Deutsche Indus-triebank the first to use the platform as a means ofsecuritising almost 2,300 loans to small businessesworth €2.583 billion. As IKB Deutsche Indus-triebank explained soon after its second Promisedeal, “thanks to this CLO transaction, IKB, actingin co-operation with KfW, has succeeded in struc-turing a large number of unrated Mittelstand loansinto individual tranches, and then having themrated separately. The resulting risks will be placedwith German and international investors. Theseinvestors would otherwise have no opportunity toinvest in Germany’s medium-sized companies, fewof which turn directly to the capital market for theirfinancing needs… By transforming conventional

corporate loans into publicly tradable instruments,non-listed companies gain indirect access to capitalmarkets.” According to KfW, meanwhile, “Germaninvestors in particular, but also investors from otherEuropean countries and Japan, value the CLNs as adiversified, high-yield investment product.”

Theoretically, given that they are constructed tolook and behave like bonds, CLNs can be tradedactively in the secondary market. In practice, trad-ing in CLNs is patchy in the extreme. Indeed, a sur-vey of investor attitudes towards the credit deriva-tives market published in Credit’s October 2002issue found that 56% of respondents are notallowed to invest in CLNs and a further 16%choose not to. Illiquidity in the market was high-lighted by 45% of respondents as the main reasonthey did not invest in CLNs. ■

Does your mandate allow youto invest in CLNs?

16%Yes (anddo not)

56%No

28%Yes (and do)

What benefits do you see in CLNs?

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conclusion

www.creditmag.com

This guide has focused exclusively on the evo-lution, structures and benefits of the marketfor credit default swaps – of which there are

clearly plenty. As with any relatively new product,however, widespread concern has been expressedabout the broad credit derivatives market, andthose concerns appear to be mounting rather thanreceding, with Warren Buffet, for one, famouslydescribing derivatives as financial weapons of massdestruction in March 2003.

Most market analysts attributed Buffet’s diatribeto his personal unhappy experience with deriva-tives. But a number of far more objective observershave also expressed reservations over the develop-ment of the CDS market. For example, in a surveyof potential banana skins facing banks, published inFebruary 2002, the London-based Centre for theStudy of Financial Innovation (CSFI) identified“complex financial derivatives” as the fourth mostworrying threat on the horizon for the bankingindustry – up from tenth in 2000. That, explainedthe CSFI at the time, “reflects sharpening concernabout credit derivatives, which are increasingly seenas a potential rogue product, little understood andcapable of transmitting risk to all sorts of unwittingparts of the financial system.”

Others within the financial services industry havealso expressed wider concerns about the apparentopacity of the market, with a report published byFitch in March 2003 calling for “increased trans-parency in the credit derivatives market” and for theneed to “achieve a better understanding of financialinstitutions’ total net credit derivative exposure”. Inmaking that call, the rating agency seemed to beechoing the misgiving voiced by a spokesman forthe UK financial regulator at a seminar in Septem-ber 2002: “We acknowledge the credit risk is trans-ferred away through the use of credit derivatives,but we still want to know where it ends up.”

Certainly there have been instances in whichbanks have publicly acknowledged the perils ofoverexposure to the credit derivatives market. InJune 2001, for example, US financial services group

American Express, announced that it had incurredsubstantial losses on its investments in CDOs. Per-haps more important, its chairman was quoted atthe same time as very frankly conceding that thegroup “did not comprehend the risk” of the CDOexposure it had built up during the 1990s.

At a wider level, however, a number of influen-tial commentators have expressed their satisfactionwith the way in which the credit derivatives marketis helping to disperse risk in the financial servicessector. An IMF Global Financial Stability report hasadvised that “particularly as the markets matureand grow over time, credit risk transfers have the

potential to enhance the efficiency and stability ofcredit markets overall and improve the allocation ofcapital. By separating credit origination from creditrisk bearing, these instruments can make creditmarkets more efficient. They can also help toreduce the overall concentration of credit risk infinancial systems by making it easier for non-bankinstitutions to take on the credit risks that bankshave traditionally held.”

Scepticism has been articulated in some quartersthat the credit derivatives market would be unable towithstand the pressures exerted by multiple defaultsand an economic crisis. But even against the back-drop of a very weak global macroeconomic climateexacerbated by accounting scandals and characterisedby plummeting credit quality, the CDS marketappears to have proved its resilience and efficiency.

Many agree that the losses sustained as a resultof defaults ranging from Argentina to Enron andWorldCom were all minimised as a direct conse-quence of the expansion of the credit derivativesmarket, which has helped to disperse the concen-tration of risk highly effectively. ■

Risks to the systemWith the credit default swap market developing at exponential rates, are the doom-mongers justified in their concerns?

Credit risk transfers have thepotential to enhance theefficiency and stability ofcredit markets overall


index

AAhold 24, 25

BBank for International Settlements (BIS) 6, 9, 14, 22, 27Bank of England 9, 14, 19, 29Bankruptcy 12, 15, 17, 18, 25, 30, 32Banque Paribas of France 31Basel I & II 6, 21, 22, 26BBA 19, 20, 21, 26, 29, 35

CCashflow waterfall 31CDO 13, 27, 30, 31, 32, 33, 35CLO 30, 31, 32, 34CSO (Synthetic CDO) 30, 32Commerzbank 24Conseco 15, 17Convertible bond 17, 18Credit enhancement 31Crédit Lyonnais 31CRT 9, 27CLN 13, 33, 34CSFB 17, 18

DDaimlerChrysler 20Default swap basis 22Default cash basis 22Deutsche Bank 13, 21, 31DWS 31

EEl Paso 24EMU 6

FFailure to pay 15First loss 30, 31First-to-default basket 13France Télécom 8, 20, 24, 25

GGap 24GFI 22, 25

IIMF 35Innogy 14

International Power 14International Swaps and Derivatives Association (Isda)14, 15, 17, 18, 19

JJazz 2 CDO 31

KKidder Peabody 30

MManaged synthetic CDO 33Mark-it Partners 22Master agreement 14Modified restructuring clause 17, 18Monoline insurance 27, 31

NNational Power 14Nomura 17, 18

OObligation acceleration 15Office of the Comptroller of the Currency (OCC)19, 21, 26

PPromise and Provide 34

RRailtrack 17, 18Ramp-up period 31Repudiation/moratorium 15Restructuring 15, 17, 18Rose Securitisation (NatWest) 31

SSpecial purpose vehicle (SPV) 31, 34Synthetic CDO (see CSO) 30, 32

TTotal return swap 13

VVintage 31

WWorldCom 12, 25, 35Wraps 31

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