The Credit Guide to Exotic Credit

Was the promised annual bonus $3m or $4m? When the head of credit derivative trading was lured from one leading London investment bank to another towards the end of 2003, the gossip among market participants focused on the size of the financial carrot that would have been dangled as an incentive to persuade him to move. It would have needed to be substantial, because for recruitment consultants in London and a number of other financial centres, credit derivatives are the hottest game in town. That reflects the seemingly inexorable growth in demand for structured products within the investor community, twinned with the relative scarcity of bankers with the necessary expertise to structure and trade the products. Over the last decade, the credit derivatives market has grown at a breathtaking speed. When they first emerged, in the US in the early 1990s, credit derivatives were used principally by banks as proprietary instruments to hedge their loan exposure. By the middle of the 1990s, some more sophisticated fixed income investors were starting to dabble in the market, although it was not until the latter part of the decade that credit derivatives were working their way into the mainstream of the financial market. By 1999, Deutsche Bank was observing in an analysis of the sector that “clearly, credit derivatives are no longer an exotic corner of the bond market but must now be considered a market in its own right.” Perhaps. But the resilience and viability of this new market was severely tested in the downturn of 2000 and 2001, when ratings migration, widening credit spreads and sharply reduced liquidity all exposed weaknesses in the broad credit derivatives market in general, and in the market for collateralised debt obligations (CDOs) in particular. “In retrospect,” noted a Deutsche Bank report published in April 2003, “no one foresaw with any

appreciable probability the brutal cresting of the credit cycle that occurred during 2001 and 2002.” It was not just the macroeconomic environment that exerted strong pressure on the evolving credit derivatives market. In the immediate aftermath of the terrorist attacks in the US in September 2001, market makers in the credit derivatives universe continued to sustain liquidity in the market, which was seen as an important stress-test of the long term prospects for credit derivatives. The sensational collapse of Enron in December 2001, however, was perhaps the most important litmus test for the market simply because it was one of the most actively traded reference entities in the credit derivatives market. In the aftermath of the Enron bankruptcy, default swap premiums rose dramatically and prophets of doom speculated that some banks would be nursing unsustainably large losses on their derivatives portfolios. The London-based Centre for Study of Financial Innovation (CSFI) did little to dispel those concerns when it released the results of its 2002 ‘banking banana skins’ survey – an annual poll asking bankers, analysts and regulators to nominate their biggest fears for the immediate future of the global financial system. Soon after Enron, “complex financial instruments” (shorthand for credit derivatives) ranked fourth in this survey, up from 10

th the

previous year. This gloomy view was not shared among many representatives of the investment banking industry. William Harrison, chairman and CEO of JPMorgan – which at the time was rumoured to be among the most vulnerable institutions to a derivatives-led market collapse – was quoted a few weeks after the Enron collapse as describing credit derivatives as “one of the must-haves for a global full-scale investment bank.” With the benefit of hindsight, Harrison’s observation seemed to be justified by subsequent events. As Risk commented in

December 2002, “credit derivatives proved to be resilient. No single company appeared to be left with a destabilising amount of exposure to Enron (although several clearly had an uncomfortable amount). The episode, and the fact that the exercise of the Enron contracts was done in an orderly manner without controversy, showed that the market had come of age.” Time will tell how important the Enron collapse and the relatively calm way in which credit derivatives responded were for the development of the market. But it seems clear that the response of the market suggested that far from leading to a dangerous concentration of risk, the credit derivatives market can function as a highly efficient way of dispersing exposure and hence of reducing risk. Certainly, the Enron upheaval twinned with a succession of other credit events ranging from Argentina to WorldCom did little if anything to decelerate the expansion of the derivatives market in general, or of credit derivatives in particular. “The credit derivatives market has grown dramatically in recent years,” observed Fitch in a report published in June 2004. “From nascent levels in the mid to late 1992, to a market size estimated at over US$3.5 trillion by ISDA at the end of 2003, the sector is one of the fastest growing in financial products. Initially centred on sovereigns, the market has grown to encompass a range of product types that include exposures to corporates, financial institutions and, more recently, tranches of asset-backed securities.”

Precise data on the size of the credit derivatives market is notoriously difficult to pin down, although figures published by the British Bankers’ Association (BBA) are broadly in line with the ISDA estimates quoted by Fitch. In its most recent report published in August 2003, which was based on information supplied by 25 market leaders, the BBA forecast that the size of the global market would reach $4.8 trillion in 2004. To put that figure into context, in 2001 the BBA estimated that the market

was worth a little over $1 trillion, which itself was a 10-fold increase over 1997’s figure. As the BBA announced when it released the report, “the credit derivatives market has experienced unprecedented growth over the last few years and the latest predictions are way ahead of previous expectations. Confidence among market participants for continued growth and development of the credit derivatives market remains high and in a difficult environment credit derivatives have proven their worth as efficient risk transfer and pricing instruments.” Another data source which is more localised in its scope but which is nevertheless a helpful and important barometer of rising activity and credibility in the credit derivatives market among banks is the US Treasury’s OCC Bank Call report, which provides quarterly updates on the size of exposure to derivatives among US commercial banks. In 1997 this report added figures on the banks’ holdings of credit derivatives for the first time, advising that they amounted to $55bn out of total exposure to derivatives of more than $25 trillion. In the first quarter of 2004, according to the most recent figures compiled by the OCC, US commercial banks’ holdings of credit derivatives rose by $201bn, or just over 20%, to $1.2 trillion. While that represented an impressive rate of growth, to put the size of banks’ credit derivatives positions into perspective, the OCC notes that equity, commodity and credit derivatives still accounted for just 3% of the total notional amount of all derivatives in commercial banks’ portfolios.

The OCC figures give an important insight into the size of the market because banks have traditionally been the leading players in the space. According to the Risk Magazine 2003 credit derivatives survey, banks continue to be the most active participants in the market, with a share of about 48% - which reflects their historical importance as users of derivatives as a key means of hedging their loan exposure. Other principal players in the market, according to the Risk survey, are

insurance companies (with a 14% share), hedge funds (13%), reinsurance companies (10%) and third-party asset managers. Looking to the future, it is generally believed that structured products in general and credit derivatives in particular will appeal to an increasingly broad range of investors. In its 2003 survey the BBA reported that banks continue to be the dominant sellers and buyers of credit protection. But the BBA added that over the last few years hedge funds have entered the credit derivatives market in increasing numbers as buyers, and by 2004, insurance companies are expected to overtake banks as the largest sellers. Other users are also entering the market in rising numbers. Corporates, for example, are believed to be using the credit derivatives market more actively as a means of managing counterparty risk.

Credit Default Swaps (CDS)

A credit derivative can be defined as a bilateral financial contract that isolates risk from an underlying instrument and transfers that credit risk from one party to the contract to another. In terms of volume, by far the most important instrument facilitating the transfer of credit risk is the credit default swap (CDS), which by the end of 2003 was estimated to account for about half of the total outstanding volume in the overall credit derivatives market. The rapid development of the CDS market is in line with some recent forecasts made about the market’s potential. For example, in a primer on the CDS market published in 2001, Banc of America Securities forecast that “we believe the CDS market will become as central to the management of credit risk as the interest rate swap market is to the management of market risk.” Although the CDS is now viewed as a relatively simple instrument, it continues to play an essential role as the key building block in a wide range of more complex structures. The simplest way of understanding a CDS is to see it as the

equivalent of an insurance product offering payment for investors to compensate for potential losses on their credit portfolio. Losses arising from credit risk that can be covered in the CDS market arise principally from two sources. The first is default risk, in which the issuer of a security is unable to honour its payment obligations with respect to interest or principal. The second is loss severity, which refers to the amount of an original investment that a lender or investor is able to recover in the event of a default. In a typical CDS contract, the investor – or the buyer of credit protection – pays an annual percentage premium, known as the default spread, for protection on the reference entity. In exchange for this premium, the seller of credit protection contracts to make a default payment in the case of a so-called credit event. The definition of ‘credit event’ has been the subject of considerable controversy in recent years. But in basic terms, the typical credit events specified in CDS documentation are bankruptcy, failure to pay, obligation acceleration and restructuring. In the event of a credit event occurring, compensation can take the form of physical or cash settlement. In a physically settled CDS the protection buyer would deliver an obligation to the seller rather than make a cash payment, which is a much less common settlement mechanism. At the most basic level, the use of the CDS market allows investors to create virtually risk-free assets, because credit default counterparts are generally well-rated banks, insurance companies or other strongly rated financial institutions. By purchasing protection to the maturity of a cash asset, an investor can offset its credit exposure to that asset and replace it with that of the institution selling the protection. As well as insulating the risk associated with a credit, entering into a CDS contract has the added attraction for banks of

reducing the capital charge to that of the institution selling credit protection. Although the return on regulatory capital as well as the yield is reduced, so too is the risk exposure. There are a number of other compelling reasons for banks, in particular, to reduce credit exposure via the CDS market rather than by selling loans outright. In its primer on the market, Banc of America Securities identifies the ease and confidentiality of transferring credit risk as one of the main advantages for banks using the market. “These CDS benefits are particularly notable relative to the significant administrative and legal costs entailed in buying or selling loans, as well as the significant relationship costs that sometimes arise out of loan issuer notifications requirements,” this explains. As an investment vehicle, rather than as a hedging instrument, CDS offer a range of attractions. Perhaps the most important of these is that the CDS market provides investors with much purer exposure to credit than the cash bond market does, for two reasons. First, for many names the CDS market is now more liquid than the underlying cash market, meaning that liquidity premiums or illiquidity discounts play a much less significant role in the CDS arena than in the cash bond universe. Second, CDS prices tend not to be related to supply and demand patterns that act as a strong influence on the prices of cash bonds. For example, highly elusive issuers in the corporate market will tend to be priced at a premium to similarly rated borrowers that tap the market on a much more regular basis. There is no reason why the same premium should apply in the CDS market. For more active investors, the CDS market has opened up substantial opportunities for following more advanced directional strategies. As a guide to the credit derivatives market published by Calyon comments, buying protection as a means of expressing a bearish view on a credit is possible in the cash market, but can be very expensive and therefore not economically viable. Doing so via the CDS market, however,

“offers good upside potential in case of a ratings downgrade or a deterioration of the name’s financial standing.” Another common strategy for more active investors in the CDS market is known as arbitraging the swap/bond basis. The basis refers to the spread differential between the CDS and the cash market, which can be considerable. A spread on the CDS which is higher than in the cash market is known as a positive basis, which is more common than a CDS spread being below the cash price of the reference credit, in which case the basis becomes negative. Clearly, investors believing that the basis has widened or narrowed by a margin unjustified either by fundamental or technical influences can express that view through the CDS market. An important consideration for investors trading the basis is an acceptable level of trading volume in the CDS market. Given that a reasonable amount of liquidity in CDS is also a prerequisite for the development of a panoply of more advanced structured products, the promotion of transparency and liquidity in the CDS space has been a key objective for market participants across the board. The jury is out on how successful this effort has been. When Fitch explored the subject in an analysis published in June 2004, the downbeat title chosen by the ratings agency - Liquidity in the

Credit Default Swap Market: Too Little Too Late – suggested that liquidity levels still leave much to be desired. “Although proponents of the market emphasise the important role that credit derivatives can have in hedging credit risk, others point to a lack of liquidity in the market acting as a constraint on the efficacy of credit derivatives as a hedging tool and alternative investment product,” this advised. It added that “although improving, liquidity in the CDS market can be generally sporadic, partly reflecting its relatively short life.”

In its analysis, Fitch focused on the CDS of 12 European and US high-profile ‘fallen angels’, or companies which have been downgraded to below investment grade. “The theory behind Fitch’s approach,” the agency explained, “is that one way to effectively assess liquidity is to monitor it before a company gets into difficulty, assess how the market behaves during the stress period, and understand how quickly it returns to normality afterwards.” In other words, the study was designed to give an insight into the degree to which protection is available on a credit when it is most needed – in this instance, when a credit stands on the cusp of a downgrade. Because the credit derivatives market operates on an over-the-counter (OTC) basis, with empirical data on trading volumes elusive, Fitch used information on CDS bids, offers, trades and spreads from two leading brokers, GFI and Creditex. The broker market is estimated to account for about one third of trading in CDS, so although the absence of data on the bank-to-bank market is significant, the data amassed by Fitch gives a meaningful insight into liquidity in the market. The results of the Fitch study were ambivalent. Two of the credits under the agency’s microscope – Heidelberg Cement and Toys ‘R Us – showed consistently acceptable levels of liquidity in the period under review between January 2000 and the end of April 2004. But at the other end of the extreme four (ABB, Alstom, Xerox and Williams) were consistently illiquid. For the remaining six, liquidity was “usually available, but very volatile.” One important conclusion drawn by the agency from the survey was that “on balance, while Fitch generally views CDS as an efficient risk management tool helping to facilitate the transfer of credit risk among market participants, not all major corporates are liquid. In addition, even for apparently liquid names, market volumes can quickly dry up. Therefore, until the CDS market matures, it is important that entities using the CDS

market to hedge credit risk do not rely on a purely reactive approach, otherwise they run the risk of being shut out of the market at exactly the point when they need protection the most.” Although there is still room for enhancement in terms of liquidity in the CDS market, it is clear that in a very space of time it has emerged in some instances as an extremely accurate barometer of credit quality – so much so that by 2004 some market participants were nicknaming the market as an additional ratings agency. This is because even in the relatively short period in which the market has emerged, CDS prices have anticipated credit events long before the ratings agencies have responded with downgrades or (less frequently) upgrades. In a recent example, CDS prices of the Swiss temporary employment agency, Adecco, provided one instance of the derivatives market responding well before the ratings agencies. Adecco’s CDS prices had been rising for months before S&P downgraded the company to sub-investment grade in April 2004. The relationship between ratings downgrades and CDS spreads was explored by the BIS in a special analysis published in its Quarterly Review of June 2004. This appeared to confirm the fast-evolving market view that CDS spreads are acting as increasingly accurate anticipations of ratings actions. The BIS report notes that CDS spreads tend to widen well before the announcement of downgrades. Total Return Swaps (TRS)

A Total Return Swap (TRS) allows buyers of protection in the credit market to swap the total economic return of an asset for fixed or floating interest payments. As J P Morgan explained in its primer on credit derivatives published in 1998, a TRS is “a bilateral financial contract designed to transfer credit risk between parties, but a TR Swap is importantly distinct from a Credit Swap in that it exchanges the total economic performance of a specified asset for another cash flow. That is,

payments between the parties to a TR Swap are based upon changes in the market valuation of a specific credit instrument, irrespective of whether a credit event has occurred...The key distinction between a Credit Swap and a TR Swap is that the former results in a contingent or floating payment only following a Credit Event, while the latter results in payments reflecting changes in the market valuation of a specified asset in the normal course of business.” The benefits of TRS to users are similar to those of CDS. TRS can be used by banks, for example, as a means of extending loans beyond their normal internal lending limits by hedging the risk to create more lending capacity. Conversely, as a CreditTrade guide to the market explains, TRS can be used by investors that want to hold an asset to maturity but may be uncomfortable with the asset’s credit exposure for a certain period of time, and will therefore look to hedge the risk to reduce exposure. As with the CDS market, therefore, a TRS allows the holder to hedge out the credit risk of an asset while retaining ownership. While there are similarities between TRS and CDS, it is important to note that the market for TRS, which are generally bespoke instruments, remains tiny relative to the CDS space. According to the Risk 2003 credit derivatives survey, while CDS accounted for 72.5% of aggregate portfolio notional outstandings of $2,306bn, total return swaps contributed just 1.3%. Second Generation CDS products

The success and popularity of the CDS market has led to a number of innovations based on the basic building block of the plain vanilla CDS. In a cancellable default swap, for example, the protection buyer has the right to terminate the transaction under certain circumstances, such as a change in interest rates. In this instance, the protection seller is effectively selling a

spread put option in return for a pick-up. According to an analysis of credit derivatives strategies published by Goldman Sachs, “the protection buyers in these transactions are often motivated by the need to hedge loans that can be repaid at will by the borrower. Once the loan is repaid, the hedger closes out the offsetting default swap position. This strategy potentially exposes the default swap investors to reinvestment risk.” The inverse of the cancellable default swap, which has also become increasingly popular in the recent past, is the extendable CDS, in which terms are subject to renegotiation and extension under certain circumstances. Other variations on the basic CDS theme have also been developed in response to trends within the wider macroeconomy and credit market environment. In the first half of 2004, for instance, the broad market consensus that the US interest rate cycle was on the point of turning led a number of market participants to start to explore variations on the CDS structure offering more flexibility in the event of rising interest rates. In particular, with spreads highly compressed, it led them to look at products offering some degree of protection against the danger of spread rising even in some of the strongest names which would be vulnerable irrespective of the resilience of their credit fundamentals. An example of a product of this kind is the Constant Maturity Credit Default Swap (CMCDS), believed to have been originally designed by Goldman Sachs in 1997, which offer investors access to floating credit spreads. In other words, while in a CDS the premium is cast in stone when the terms of the contract are originally negotiated, in a CMCDS the premium changes as the spread moves. A Deutsche Bank analysis of the mechanics of CMCDS explains that a single name CMCDS has strong similarities with a standard CDS. “First, in case of default, the protection buyer receives par and delivers an eligible defaulted obligation,” this explains. “Second, in exchange for protection, the buyer pays a spread. The main difference with a

standard CDS is that the spread paid is not constant, but is reset according to a multiplier of the prevailing reference CDS spread at each reset date.” As a result, “CMCDS technology allows investors to put capital to work, earn good carry and still retain the possibilities of achieving the yields of 2003, should the market back up,” advised Deutsche Bank. The ISDA Credit Derivatives Definitions

In the early days of the credit derivatives market, the growth of the market was constrained by the absence of standard documentation, with contracts typically drawn up on an ad hoc, case-by-case basis. Today, almost all credit derivatives swap contracts are based on documentation sponsored by the International Swaps and Derivatives Association (ISDA), with buyers and sellers of protection always urged to observe these guidelines closely rather than expose themselves to potential disputes arising from credit events. The importance of establishing clear parameters dictating the procedure in the event of a credit event is immediately evident in the volume of outstanding contracts that have been subject to events of some kind in recent years. According to Fitch, even though the economic environment in the UK and the US continued to recover in 2003, the year still saw a record number of credit events (96) impacting 19 reference entities with notional exposures worth €709m and $403m. “From late 2000 to January 15

th 2004,” according to the Fitch data, “225 credit

events have been called among 39 reference entities, totalling €1,569.9m and $1,228.6m in notional exposures.” The first step towards standardisation was made in April 1998 with the publication by the ISDA of its so-called ‘long form’ confirmation for CDS on non-sovereign reference entities. Soon afterwards, upheavals in emerging markets in general and the crisis in Russia in particular exposed the shortcomings of documentation that failed to address events influencing

sovereign credits. ISDA responded to the need for clearer definitions of credit events in 1999 with the publication of its Credit Derivatives Definitions.

Although that was seen as a seminal moment in the evolution of the credit derivatives market, in the corporate arena definitional standards were severely tested in August 2000, when the US company, Conseco, responded to the threat of a liquidity crisis by restructuring its maturing bank loans. The Conseco restructuring involved extending existing maturities and compensating investors by offering them an increased coupon, a new corporate guarantee and an increased coupon. In spite of these sweeteners, the Conseco restructuring qualified as a credit event under the ISDA definitions that were generally recognised by market participants at the time. Protection sellers protested that banks which had sold protection on the Conseco name were not exposed to any losses as a result of the restructuring of the company’s liabilities and should not therefore have interpreted the restructuring as a credit event. They also argued that as protection sellers were able to offer cheapest-to-deliver bonds in accordance with the physical settlement agreement, some buyers were offered bonds trading at distressed levels as compensation. With a number of other celebrated disputes continuing to cast a shadow over the interpretation of the ISDA definitions, small wonder that as recently as December 2002, one banker was quoted in Risk as saying that “the restructuring issue is definitely holding back market development.” The most recent landmark in the pursuit of a universally accepted interpretation of what does and does not constitute a credit event was the publication of the ISDA 2003 Credit Derivatives Definitions, effective as of June 20

th 2003. These

update the 1999 definitions as well as a handful of supplements published in 2001, and “offer the basic framework for the documentation of privately negotiated credit derivative transactions.”

The 2003 amendments clarified the definition of bankruptcy, eliminating the “action in furtherance” of bankruptcy language and adding a filing requirement aimed at providing concrete evidence that companies claiming bankruptcy are indeed unable to pay their debts. Less satisfactory, as far as the 2003 definition amendments were concerned, was the failure to reach unanimity on a single global standard on the thorny issue of restructuring. For the time being, restructurings continue to be interpreted differently on either side of the Atlantic, with European dealers generally refusing to accept the so-called ‘modified restructuring’ guidelines adopted in the US in 2001. That has created something of a two-tier market which, as a Citigroup report published in June 2003 notes, has arguably led to “some adverse impact on liquidity.” Nevertheless, the ISDA 2003 definitions were very warmly received by participants in the credit derivatives market. A by-product of improved standardisation, commented the Bank for International Settlements (BIS) is its 2003 annual report, has been that “many market participants now perceive liquidity in the CDS market to be greater than that in the corporate bond market.”

Credit Linked Notes (CLNs)

Credit-linked notes (CLNs) are structured notes or medium term notes with embedded credit default swaps. In its simplest, single name form, a CLN offers exposure limited to a single obligor. In other words, from a risk perspective it is similar to lending to a single company, which will generally be a corporation or financial institution issuing the CLN on an unsecured basis. Here, the holder of a CLN is generally paid a coupon and the principal at redemption as long as there has been no credit event impacting the reference credit, in which case redemption is calculated on the basis of par minus a contingent payment. The reference credit can range from being a specific corporate loan

or security through to a portfolio of securities, sovereign debt instruments or other index. Credit-linked structures will also frequently incorporate interest rate or foreign exchange swaps to customise the cash flows according to the investor’s preference. CLNs are appealing to investors for a number of reasons. As on-balance sheet instruments, they are a convenient way for investors unable to access credit derivatives markets directly to gain exposure to the market, and to earn a spread pick-up compared with other securities issued by the reference entity. As CLNs can be created with customised maturity structures they can also give investors exposure to securities with features that may not be available in the cash market. An increasingly popular form of CLN has been the Principle Guaranteed Credit-Linked Note. In this structure, if the market value of the portfolio of reference obligations falls below a pre-determined floor price (typically 30% or 40%), a credit event is triggered and no further interest payments are made on the notes, but at maturity the investor will receive 100% of his original principal. In order to add value for investors, structures of this kind will typically be relatively long-dated (generally with a 10 year maturity). While small in relative terms, the CLN market is expected to continue to play an important role in the broader structured finance universe. In the view of CreditTrade, “the CLN market is small in comparison [with] the CDS market, but continues to show growth in the volume of transactions done, in the universe of credits that are traded and in the breadth of investors active in the market. This is likely to continue for [several] years as the number of institutional investors actively buying CLNs is still very small.”

Exploring Correlation Risk - Basket Default Swaps

Whereas the simple CDS market provides buyers or sellers of protection with a play on the probability of a single default, an increasingly popular area of the broader credit derivatives market has been products that allow market participants to express a view on correlation risk. In simple terms, correlation risk refers to the likelihood of an event of any kind at one credit having a direct impact on another. For the purposes of the credit derivatives market, discussions on correlation risk generally focus on the likelihood of a default of one credit heightening the likelihood of default of another (default correlation). Clearly, default correlation risk is much higher among credits within the same industrial sector or – in some circumstances – within the same geographical region than among those that operate in different industries. As a very obvious example, a hypothetical default of a US airline would mean that there is a high correlation risk associated with other US airlines. By extension, there would also be a correlation risk (albeit probably a lower one) associated with airlines in Europe exposed to many of the same macroeconomic, geopolitical and cyclical influences, but a low or zero correlation risk associated with, say, a telecoms company in Europe. Default correlation, however, seldom refers to the likelihood of outright default per se, assuming that following the default of one company within a given industry, a number of other competitors within the same industry will default like dominoes. Instead, it would be more accurate to define this risk as one arising from spread correlation. This is because a negative event impacting on the spread of one credit will typically result in the spreads of companies within that credit’s peer group widening regardless of credit fundamentals. That pattern was vividly illustrated in the late 1980s, when investors in the US credit

market were given a brutal introduction to event risk and, by extension, correlation risk. When news of RJR Nabsico’s planned leveraged buy out (LBO) broke in October 1987 spreads on its most liquid single-A rated bonds widened from 100bp over US Treasuries virtually overnight – spread widening that was unprecedented in the investment grade segment of the US corporate bond market. Equally striking, however, was the spread widening suffered by holders of bonds in comparable companies such as Anheuser Busch and Sara Lee, in an example of correlation risk par excellence.

That relationship will also be very familiar to investors in the equity market, in which declines in share prices sparked by events such as profit warnings will tend to bring down the equity prices of other companies within the same peer group. That movement is relevant for investors in the credit market because it provides a yardstick of correlation measurement. Indeed, ratings agencies and credit analysts will often use the historical performance of equities as a means of building credit default correlation models (for more details see section xx, Ratings Agency Methodology). Models of this kind helping users to understand the relationship of default probability within issuers’ peer groups are an essential component of the analytical armoury of investors aiming to create an optimal portfolio based on the efficient frontier of achieving maximum return and minimum credit risk. In the structured finance market, so-called basket products allow buyers of protection to hedge themselves against mark-to-market risk as well as broader default risk. The most basic of the correlation-based products are those related to baskets of credits, with the First to Default (FtD) basket swap the most familiar of these. Investors in FtD structures sell protection on a reference portfolio of names and assume exposure to the first default to take place within the pre-defined basket of credits. As a guide to the market published by Calyon explains, on occurrence of a

default, the FtD swap functions like an ordinary CDS. This means that the protection seller needs to indemnify the protection buyer for the loss on the defaulted credit calculated on the basis of the full face value of the FtD basket. FtD baskets typically offer credit exposure to between three and 10 companies, although some have been structured with as many as 20 credits. There are no hard and fast rules about the number of entities included within the basket, although as a general rule the more credits there are within a basket, the higher will be the spread. Nor need investors be exposed to the first credit within the basket to default: the structure could equally well give investors exposure to the second, third, or fourth credit to default – or to a pre-defined combination of these credits. For this reason, FtDs are sometimes alternatively referred to as Nth to Default swaps. From the perspective of investors, the principal attraction of a FtD structure is that it offers a higher yield than any of the individual credits within the basket and limits investors’ downside risk in the event of default. An additional attraction for investors is the transparency of FtD swaps, because the credits included within the basket are generally the choice of the investor. For sellers of protection, the FtD structure also offers an attractive element of leverage, because they will generally be exposed to credit risk across a basket of credits, and therefore be paid a much higher fee than for assuming the risk of a single name. The investors’ maximum loss, however, is restricted to the notional amount of the transaction. For investors in FtDs, a key determinant of pricing and risk is the degree of default correlation among the credits within the basket. In general, according to a Deutsche Bank analysis, the correlation inputs for a basket swap are derived from empirical analyses of correlations for spreads and stock price movements.

“As a rough rule of thumb,” this explains, “implied correlation values for a basket swap range from a low of about 25% for a reference pool that is very well diversified by industry and geographically to upwards of 85% for reference pools made up of companies from a single industry and country – e.g. Italian banks.” The Deutsche analysis is a valuable reference to a hypothetical case study of a default basket of five credits with a low correlation factor of 35%, which reflects the industrial, geographical and ratings diversification of the names within the basket. In this case the credits in question were Deutsche Telecom, ST Microlectron, Daimler Chrysler, LVMH and Rank. The premiums for default spreads on each of these names ranged from 70bp to 115 for one year swaps, to between 115bp and 210bp for five year swaps. In this instance, Deutsche Bank explains, focusing on the five year example, if an investor were to invest in the companies outright, the average spread to Libor of the portfolio, which has an average credit quality in the mid to high triple-B range, would be 152bp. By contrast, the default spread on this hypothetical basket is 445bp per annum, or about triple the average spread on the names. “To put this in perspective,” notes the Deutsche analysis, “this is in line with the spread on five year low double-B industrial bonds even though the investor is investing in a basket of triple-B credits. Absent the basket swap it would be necessary to invest in substantially lower credit quality assets to generate similar returns. The basket strategy is fully transparent, allowing the investor to do detailed credit work on a small selection of names, and arrive at his own assessment of the credit risk of the basket.” Basket-based products have been adapted to allow investors to express views on more detailed and comprehensive market forecasts. For example, as the Calyon guide explains, hybrid credit derivatives address not just credit risk but also other

market risks. These products allow users to put multi-market strategies in place with one single product. By overlaying a view on interest rates, for example, investors can earn enhanced yields on FtD structures. The Calyon guide offers the example of an investor using the market to express a view that interest rates will remain in a range (or ‘corridor’) of between 1% and 5% during the next five years. “A FtD CLN corridor incorporates this expectation while boosting the yield on the FtD,” explains Calyon. Alternatively, a user might wish to express a view on the outlook for inflation. “You think a strong economic recovery is underway and, given the historically low level of interest rates, inflation will pick up which you wish to take advantage of,” notes Calyon. “To this end, it is possible to index the FtD coupon to the inflation level.” Beyond these examples, Calyon points out that “generally, the investor can combine any type of exposure (such as to equity or commodities) with credit risk exposure.” The possibilities opened up by derivations of the simple basket-based structure are therefore an excellent example of the flexibility of the structured finance market and its ability to provide investors and other market participants with highly customised solutions. Pricing models for basket-based products are continually evolving. According to Calyon, the underlying pricing model for FtDs is based on the impact that time has on the implicit default probability. “Technically,” notes Calyon, this model “carries out thousands of (Monte Carlo) simulations against different risk scenarios (represented by the number and timing of defaults) to arrive at the most appropriate spread for the basket.” While the market for Nth to default products has been expanding in recent years, it is important to keep that growth in perspective: according to the Risk 2003 credit derivatives survey, Nth to default baskets accounted for a very modest 0.3% of aggregate current portfolio notional outstandings in 2002.

CDOs

If FtD baskets offer exposure to a limited number of credits, a natural extension of this concept, says Calyon, are products providing exposure to a much larger pool of underlying credits – which is the basic premise of the market for Collateralised Debt Obligations (CDOs). The term CDO has evolved in recent years into a generic name for securitisations of assets such as mortgages (collateralised mortgage obligations), loans (collateralised loan obligations) and bonds (collateralised bond obligations). In broad terms, in all these structures a portfolio of securities is transferred to a special purpose vehicle (SPV) which in turn issues tranches of securities of different seniority to investors in the capital market, to fund the purchase of the portfolio. Issuance of CLOs exploded in the mid to late 1990s, which was principally a reflection of their increased popularity among bank issuers using the technique as a means of transferring credit risk for regulatory capital management reasons. In the US market, issuance of CLOs broke through the $10bn threshold for the first time in 1996, although by 1997 volumes in Europe were eclipsing those seen in the US market. By the late 1990s, the broader market for collateralised obligations was also being characterised by a much higher level of diversification, both in terms of the assets backing these transactions and in terms of the geographical regions in which they were originated and sold. That broadening of the market has helped CDOs flourish as an asset class in their own right. According to figures published by the European Securitisation Forum (ESF), CDOs accounted for 13.7% of total issuance in the securitisation market in 2003, or for €29.8bn, which was second only to residential mortgage-backed securities (RMBS), which is the staple commodity of the market.

An important recent trend in the CDO universe has been the conspicuous improvement in credit quality in the market, following a steep decline between 2000 and 2002. Of 325 ratings actions by Fitch on 124 CDOs in the first quarter of 2004, 67% were affirmations and 17% were upgrades, compared with 50% and 4% respectively in 2003. “This shift is indicative of an improving credit climate across all global CDO sectors,” noted Fitch in its review of activity in the first quarter of the year. Arbitrage versus Balance Sheet CDOs

The first generation of CDOs were largely so-called balance sheet transactions used by financial institutions to manage their loan portfolios. In a balance sheet CDO, existing assets are removed from a bank’s balance sheet, repackaged into a marketable security and sold to investors. From an issuer’s perspective, the principle objectives of balance sheet CDOs include the minimisation of regulatory capital allocated to credit risk, tapping a cheaper and more diversified funding source compared with the primary bond or equity markets, and managing credit risk by disposing of unwanted credit exposures. Arbitrage CDOs, meanwhile, first appeared in the European market in 1999, with the first deal of its kind a €400m CDO – Eurocredit I – for Intermediate Capital Group (ICG) which securitised a portfolio of high yield bonds, senior debt and mezzanine loans. The motives for the issuance of arbitrage CDOs are quite different from those behind issuance of balance sheet instruments, with the aim being to take advantage of the yield differential between the assets within a CDO portfolio and the cost of funding the CDO through the sale of notes to investors in the capital market. Arbitrage CDOs are generally set up as so-called “bankruptcy remote” special purpose vehicles (SPVs) domiciled in tax-efficient locations such as Dublin or the Cayman Islands.

For investors in the arbitrage CDO market, the yield pick-up can be highly attractive. This is because an arbitrage CDO, according to the Calyon credit derivatives guide, exploits the difference between the historical and implicit default probabilities of a debt issuer – which can be very considerable. “The implicit default probability (as deduced from spreads quoted in the market) is between three and six times higher than the historical probability (as published by the rating agencies),” notes Calyon. “Since a CDO tranche pays a spread which is determined with reference to implicit default probabilities, CDO tranches typically offer substantial spread pick-up versus similarly rated underlying collateral.” Cash Flow and Synthetic CDOs

Balance sheet and arbitrage CDOs can be structured either as cash flow or synthetic transactions, or as hybrid instruments combining elements of both structures. In a cash flow transaction, which dominated the market in its early days, the notes issued by the CDO are collateralised by a portfolio of cash assets, with payments to noteholders made from the interest and principal flows of the collateral pool. Synthetic CDOs, meanwhile, date back to 1997, and were reckoned to be worth almost $500bn according to the 2003 Risk

Magazine credit derivatives survey. The principal difference between a cash and a synthetic CDO is that in the latter, no transfer of securities takes place, with the underlying reference pool of assets remaining on the balance sheet of the originator. Instead, the CDO’s collateral pool consists of credit derivatives – usually in the form of credit default swaps (CDS), although these can also be total return swaps (TRS). For originators, there are a number of benefits associated with credit risk transfer via synthetic CDOs. One of these is that the process allows bank originators to ensure that client relationships are not jeopardised through the sale of loans in the

secondary market. Synthetic CDO structures are also an attractive option for originators securitising multi-jurisdictional portfolios or loans made in countries where the local legal framework does not allow for the transfer or true sale of assets, or where local tax laws make a so-called ‘true sale’ uneconomic. Until the recent establishment of its “True Sale Initiative,” for example, tax-related disadvantages made Germany a very fertile market for synthetic CDOs. For investors, there are a host of attractions associated with the synthetic CDO market. One of these is the opportunity to gain access to a highly diversified portfolio of ‘pure’ credits. As research published by Citigroup explains, “synthetic CDOs allow investors to make a ‘pure play’ investment in credit because the structures bifurcate the credit risk component of a reference asset and other risks associated with the asset, including interest rate risk, prepayment risk and currency risk.” Other analysts have expressed similar enthusiasm about the new vistas that have been opened up by the market for synthetic securitisations. “Arguably the most dynamic corner of the CDO sector,” was how Deutsche Bank described the investment grade synthetic CDO product in a report published in April 2003. In part at least, that reflects the appeal of synthetic CDOs which, in the words of Deutsche Bank, “increasingly combine CDO and credit derivatives technology to offer some of the most innovative and compelling relative value opportunities in the structured finance and corporate market.” More specifically, the same report observed that the mezzanine triple-A notes within a synthetic CDO can offer spreads in the 110-125bp range, or nearly double the level earned on mainstream high yield CDOs. In the triple-B sector, meanwhile, synthetic CDOs can pay spreads of up to 450-500bp versus 300-350bp for the comparable tranches of high yield CDOs. Over and above these attractions, adds the report, the synthetic structure can also offer a credit curve advantage in that the

maturity is typically five years, compared with between seven and 10 years for high yield CDOs. Those compelling opportunities have led to a surge in demand for synthetic CDOs. In an update published in May 2004, S&P reported that “investor demand for flexible structures has fuelled innovation and growth in Europe’s CDO market...some 92% of European CDO transactions rated by Standard & Poor’s in 2004 have been synthetic, highlighting the popularity of bespoke transactions with Europe’s fragmented investor base.” The growing dominance of synthetic deals in Europe makes the market very different from the US, which remains principally a cash market: of the CDOs rated by S&P in the US in 2004, only 31% were synthetic. The principal driver behind the dramatic increase in issuance in the market for synthetic CDOs in Europe has been the explosive growth in the CDS market. That has allowed for portfolios of default swaps to be assembled (or “ramped up”) much more quickly than those of cash instruments. “This is especially important in such markets as European investment grade cash, where the liquidity in the corporate bond market does not permit the ramp-up of a diversified portfolio within such a short time,” explains the Citigroup analysis. With the CDS market continuing to expand at a breathtaking pace, and with demand for exposure to synthetic CDOs showing no sign of slowing, analysts expect issuance levels to expand further in the coming years. Added impetus for the further growth and diversification of the market for synthetic CDOs will also come from regulatory change, with countries such as Spain expected to pass legislation soon allowing for the issuance of synthetic securitisations. Small wonder that Deutsche Bank should have noted recently that “we expect issuance in this asset class to persist as participants continue to find synthetic technology an effective mechanism to hedge credit risk.”

CDO Tranching

As Calyon’s guide to the credit derivatives market observes, even though the motives behind the creation of each CDO differs widely, the principles underlying the structuring of a transactions remain similar. At the heart of these principles is the division or slicing of the credit risk of the reference portfolio into different classes, known as tranches. In accordance with its seniority, each tranche enjoys rights and priorities concerning payments generated by its collateral. Alternatively known as a waterfall structure, this is the process whereby in bankruptcy the proceeds from liquidated cash CDO assets will first be used to meet the claims of the most senior, triple-A rated debt tranche. Only then will proceeds flow to the next most senior tranche of notes, and so on. The most junior tranche within this waterfall structure is the equity piece, sometimes referred to as the ‘first-loss piece’, which is generally unrated and will account for anything between 2% and 15% of a CDO’s total capital structure. To compensate for their subordination within the cash waterfall, which entitles holders only to the cash flows left over after all debt tranche claims have been satisfied, investors in the equity class of CDOs generally look for returns of between 15% and 20%. Equity tranches of CDOs can be placed with investors attracted by the high returns available. Indeed, a Fitch report published in February 2004 commented that “as markets have developed and the number of potential investors has grown, they have become more capable of absorbing the riskier pieces of an issue.” In practice, however, the equity tranches of CDOs are still often bought and held by originators. A key component of the tranching structure of CDOs is the use of coverage tests embedded into the covenants of deals and aimed at maintaining a minimum level of credit quality and

therefore protection for noteholders. Coverage tests can include rate coverage ratios, over-collateralisation (OC) ratios and par ratios. In the event of these thresholds not being maintained on a payment date, the manager would generally be required to liquidate sufficient collateral to ensure that the ratios are satisfied. There are no pre-determined rules on how many tranches an individual CDO may contain. The minimum is usually three, and although there is no maximum, the Aria CDO launched in June 2004 by Axa Investment Managers, which references a pool of 140 corporate names, is exceptional in that it is divided into 28 tranches denominated in five currencies – Swiss francs, sterling, dollars, euros and yen – and incorporating fixed, floating and inflation-linked tranches. An important difference between the tranching structure of cash CDOs compared with their synthetic counterparts is the role played in the latter by the so-called unfunded super senior tranche, which will generally account for between 80% and 90% of a synthetic deal. Here, the risk embedded in a portfolio of assets is transferred to a super senior counterparty – in other words, the CDO agrees to pay a premium to a protection seller in return for a commitment from the counterparty to pay compensation to the CDO in the event of any defaults in the reference portfolio. Monoline insurance companies have been especially active super senior counterparties in the CDO market in recent years. According to a Deutsche Bank analysis published in April 2003, monoline insurance companies have been able to purchase protection on super-senior tranches for as little as between 8 and 15bp, “far less than the 45 to 60bp spreads on the mezzanine triple-A class.” Managed versus Static CDOs

In the early days of the market, most CDOs were ‘static’ or ‘passive’ instruments where a pool of assets are selected and

held constant over the life of the transaction. “The early static deals appealed to investors because of their simplicity, transparency, shorter maturities and relatively wide spreads,” comments a Deutsche Bank report published in April 2003. More recently, however, the very well documented credit events at companies such as Enron and Worldcom in the US, and at Parmalat in Europe, have exposed the weakness of the static structure. Given that the universe of highly liquid CDS names remains limited, the collapse of an individual credit can have a much more dramatic impact on a synthetic CDO than on portfolios of other asset classes. As a recent example in Europe, take the impact of the Parmalat debacle, which according to an update published in June 2004 by S&P was single-handedly responsible for a decline in the global average recovery rates on synthetic CDOs in the last quarter of 2003. This fell from 35.2% in the third quarter of the year to 23.2% with S&P observing that “this decline was entirely the result of the low valuations on Parmalat, which experienced an average of 9.6% recoveries across all transactions rated by S&P.” The Parmalat credit event alone affected about $2.7bn in notional exposure in rated deals, according to S&P. In response to the very damaging impact that individual credit events can have on the portfolios of synthetic CDOs, an increasingly popular alternative to the static option is the managed or dynamic transaction, in which a manager is employed to monitor and, if necessary, to trade credits within the pool in order to protect against the impact on the portfolio of a deterioration in credit quality. Reference portfolios can either be “lightly managed”, which allows for some substitution in the context of a defensive management strategy, or “fully managed”, which suggests much more active management of the underlying pools of credits within pre-defined criteria. Noteholders in static transactions are not powerless to protect their interests in response to a deterioration in credit quality. As

a Deutsche Bank analysis published in 2003 advises, “to protect themselves, investors can monitor the performance of the pool, and if a credit shows signs of deteriorating, they can buy protection on that name, thus hedging themselves to [a] certain degree against loss and eroding mark-to-market performance of their investment.” Clearly, in a fully managed CDO the experience and quality of the asset manager will be pivotal to the performance of the transaction, and the importance of the manager is such that a number of the agencies have launched ratings services focusing on CDO managers. As Fitch points out, just like any other investment vehicle CDOs are subject to investment manager risk, which is why the agency publishes scores ranging from CAM1 to CAM5 for asset managers based on a number of criteria. These range from company and management experience, financial condition, staffing, procedures and controls and credit underwriting and asset selection through to portfolio management, CDO administration, technology and portfolio performance. The importance of these ratings are not to be underestimated. As Fitch explains, “CDO asset manager ratings will serve as the basis for determining an asset manager’s suitability for specific CDO transactions and the level of adjustments, if any, to be made in Fitch’s modelled expected default rate stresses on specific transactions.”

Single-Tranche CDOs

Single-tranche CDOs, sometimes known as bespoke mezzanine or equity tranches, tailor-made, tranche-only or credit select structures have become increasingly popular with investors in search of incremental yield, although precise figures on the size of this private market are impossible to pin down. “The sheer number of single-tranche trades being executed on a private, bilateral basis means it is more difficult than ever to track synthetic CDO volumes,” noted a report published by Dresdner Kleinwort Wasserstein (DrKW) in May 2004.

The key difference between a multi-tranche and a single-tranche CDO is that in the letter a specific level of the portfolio credit risk is transferred to the investor with the remaining risk dynamically or delta hedged by the dealer. “In other words,” explains a Fitch analysis, “risk transference is achieved using a derivatives model in the case of single-tranche synthetic versus a securitisation model in the case of traditional synthetics. Moreover, a single-tranche synthetic is unsyndicated or could be thought of as a bilateral contract (between the protection buyer and one protection seller), versus a traditional synthetic, which is typically syndicated.” Clearly, another difference between the multi-tranche and single-tranche products is that in the latter there is no “waterfall” structure of payment claims. Instead, in a single-tranche deal investors are offered an indicated coupon on an outstanding notional which may be reduced in line with defaults on the reference portfolio. The bilateral nature of the single-tranche CDO is an important reason for its appeal to investors, who enjoy a very high level of influence over a transaction’s structure – explaining why they have sometimes been referred to as “CDOs on demand.” As Fitch explains in a recent report, “the ability of the investor to have a higher degree of input to the characteristics of the transaction is a common element of the single tranche synthetic. Portfolio composition, tranche size, desired spread, management/substitution rights, and, importantly, rating can be all selected to a greater or lesser extent by the protection seller [CDO investor].” Although management and substitution rights are obviously an attraction of customised CDO tranches for investors in single-tranche CDOs as well as in the broader structured finance market, there are inevitably limits to the extent to which these rights can be exercised. As a case study presented by Calyon

explains, as the arranger of a customised transaction, it will give some substitution rights to an investor or other third party as long as certain conditions are observed. These include taking into account the arranger’s hedge adjustment costs, ensuring that the substitution is feasible, that the incoming name is sufficiently liquid and complies with ratings agency criteria, and that the arranger’s delta hedge management strategy is not jeopardised as a result of the substitution. Single-tranche CDOs are also popular with structuring banks for a number of reasons. Most obviously, they can be created much more quickly than multi-tranche CDOs, in turn allowing dealers to respond more rapidly to reverse enquiry from their client base. Because single-tranche CDOs do not need to be marketed to a broad investor audience with conflicting interests and return targets, the costs associated with arranging these deals are also much lower than in a conventional CDO. The downside, for arranging banks and dealers, is the need to hedge the residual risk when they buy protection on just one tranche. But according to Fitch, “inherently, increased deal volume along with economies of scale associated with such volume may lead to improved profitability for dealers.” As they have grown in popularity, single-tranche CDOs have become increasingly controversial. Concerns have arisen, for example, over so-called arbitrage ratings on the part of dealers, some of which have been accused of mis-selling single-tranche structures by exploiting differences between default rates based on ratings agencies’ historical data and market rates extrapolated from CDS prices. Misgivings about the lack of visibility associated with so-called ‘black box’ models have, however, led a number of dealers to launch new initiatives aimed at improving the transparency of single-tranche CDOs. As the market for single-tranche structures continues to evolve, investors will increasingly demand that dealers adopt the highest standards of transparency. It is to be hoped that they will also

demand to be paid heft premiums for opaque, ‘black box’-style structures.

CDOs of ABS

An increasingly popular variant on the CDO theme in recent years has been CDOs of asset-backed securities (ABS), also sometimes known as resecuritisations. The growth of the market for CDOs of ABS reflects the very rapid growth of the securitisation market in recent years, especially in Europe. According to figures published by the European Securitisation Forum (ESF), new issuance volume in the market rose in 2003 to a new record of €217.2bn, up from €157.7bn in 2002, which itself had been a record. That expansion shows no sign of slowing. In its review of activity in the market in 2003, the ESF forecast that growth would continue to expand in 2004. “Higher new issuance activity will be buoyed by prevailing low interest rates, improving credit quality and attractive yield spreads,” the ESF predicted. The growth of the securitisation market, however, tells only half of the story behind the expansion of the market for CDOs of ABS. Equally important, as far as investors are concerned, has been the stability of ratings and low level of defaults in the securitisation sector, which has made ABS especially attractive material for CDOs, giving CDOs of ABS something of a safe-haven status. It was a combination of those attractions that led to the launch by Credit Agricole Indosuez (CAI) in January 2003 of TRIPLAS, a €600m synthetic CDO of triple-A rated European ABS. That transaction has since been followed with a number of other TRIPLAS deals, with TRIPLAS series four the most recent in the family, having been launched and oversubscribed by 30% in April 2004. The TRIPLAS transactions have established a strong track record as bullet safe haven investments, with no default or ratings downgrade experienced

in any of the deals. As well as referencing triple-A rated ABS, TRIPLAS IV references three custom-made synthetic CDOs rated Aa2 (see CDOs squared, below). Recent CDOs of ABS have continued to offer investors exposure to very highly diversified portfolios of securitised assets. Take the example of Camber 1, a $1bn CDO of ABS which closed in March 2004 and is managed by Cambridge Place Investment Management, a global ABS specialist set up in 2002. Camber 1 is an elusive true sale CDO backed by a portfolio consisting of a diversified pool of triple-A rated ABS denominated in US dollars and euros and offering exposure to residential as well as commercial mortgage-backed securities (RMBS and CMBS), consumer ABS, non-performing loans and small and medium-sized business loans. While that means the transaction covers a broad range of securitised asset classes, it does not include riskier or more volatile assets such as aircraft leases which have traditionally been regarded as inappropriate material for CDOs of ABS. The structure of transactions such as Camber 1 conforms to the generally very high credit quality characterising CDOs of ABS. A Calyon presentation on structured credit investment opportunities indicates that an ABS bucket will typically avoid asset classes such as whole business securitisations, aircraft ABS and single tenant CMBS, contain up to 45 triple-A rated bonds, none of which are on negative watch, and have a maximum credit concentration level of 5%. It adds that in order to compensate for natural amortisation of the portfolio, the arranger will be authorised to make substitutions and replenishments to the reference portfolio. CDOs Squared

Another sub-section of the CDO market that has expanded rapidly over the last 12-18 months and is closely related to the CDO of ABS sector is the market for CDOs of CDOs,

alternatively known as CDOs squared. Credit for invention of the CDO squared concept is generally given to Christian Zugel, a former bond trader at JP Morgan who set up the ZAIS Group in July 1997, which launched the first CDO of CDOs two years later. CDO squared transactions are typically leveraged single-tranche CDOs in which the underlying assets are CDO tranches or, more often, a mixed pool of CDO tranches and ABS. While the market for CDOs squared was originally a static one, a more recent trend reflecting the growing expertise of asset managers has been the emergence of more actively managed transactions. The emergence of the CDO squared has been heralded by analysts as an important step forward for the broader development of the structured finance market. As a report published in May 2004 by Dresdner Kleinwort Wasserstein (DrKW) explained, “the CDO squared marks the latest stage in the synthetic CDO evolutionary stage. The leverage and correlation inherent in this product creates a different risk profile to a regular synthetic CDO and results in higher spreads for investors.” More specifically, according to the DrKW analysis, typical synthetic CDOs squared will pay 70bp for a five year triple-A tranche compared with 65bp for a straight synthetic. Moving down the credit curve this rises to 140bp, 225bp and 425bp for the double-A, single-A and triple-B tranches, compared with 125bp, 200bp and 350bp for the same rated tranches of straight synthetic CDOs. For noteholders across the credit spectrum, the pick-up is therefore considerable, reaching more than 20% for investors in the triple-B tranches. Because of the limited number of liquid CDS in the market, there is inevitably a high degree of overlap among the underlying portfolios. As the DrKW analysis observes, “name overlap is not a new phenomenon, as CDO investors have always had to consider the overlap between deals they own, but the difference here is that the overlap is within a single transaction.” The same report notes that the average level of overlap in deals analysed by DrKW has been 30%, although it

adds that overlap levels within the broader market have ranged from 0% to 80%. S&P notes that a typical CDO squared transaction rated by the agency might reference as many as 1000 corporate names. But given that the most liquid corporates in the CDS market numbers no more than about 400, it is highly likely that each name will appear in more than one CDO tranche. As a result, the default of one name could effect several CDO tranches. Unsurprisingly, arrangers of CDOs squared or of CDOs of CDOs and ABS generally aim to restrict credit overlap to a minimum. In a case study of a synthetic CDO of ABS presented by Calyon, for example, in which 80% of the underlying portfolio is accounted for by ABS with the balance contributed by CDOs, there is an assurance that none of the names within the portfolios will appear more than three times. With market participants believing that the market for CDOs squared will continue to expand, reflecting investors’ search for yield, formidable challenges will emerge in areas such as the management of data on the market. Continued expansion in the market will inevitably lead to the emergence of second, third and fourth generation products in which CDOs squared have CDOs squared within their asset pool – in other words, CDOs cubed will emerge. A number of leading software companies are already developing products aimed at helping banks to manage new hybrid structures of this kind. Repo CDOs

Another recent addition to the family of CDO products are Repo CDOs. According to a JPMorgan analysis, repo CDOs “make their money by taking on exposure to credit spread duration, that is, they buy short term securities that earn a term spread and fund these assets with shorter term debt.” As a result, according to the same analysis, repo counterparties gain access to

incremental yield and a liquidity management tool, while term CDO investors achieve a lower cost of funds and CDO asset managers are able to increase their funds under management and often retain a portion of the first loss risk. CDOs of Equity Default Swaps (EDS)

A recent variation on the CDS theme has been the invention of the equity default swap (EDS), which functions along very similar lines to its credit counterpart. An EDS is a contract in which payment to the protection buyer is triggered when the underlying equity price falls below a pre-determined level. As S&P explains, “the price decline is often referred to as an “equity event”, analogous to a credit event within a credit default swap contract.” Given that the ‘equity event’ can be quantified so precisely, there would appear to be less room for disputes over event definitions than there are in the CDS market. A Moody’s analysis explains that “the trigger event definition, being objective and verifiable by all the parties, benefits from a considerable degree of simplicity and clarity.” In January 2004, Moody’s assigned its first private rating to Odysseus, a hybrid deal arranged by JP Morgan offering exposure to 100 reference entities, of which 10% were equity default swaps, with the other 90% accounted for by CDS. But the first publicly rated CDO of pure EDS was launched in February 2004 by Daiwa Securities SMBC, with Zest Investments V referencing a static portfolio of 30 Japanese blue chip companies worth a notional ¥45bn. This transaction sells protection against a fall to 30% or below of the reference companies’ stock price at the time of the deal’s launch.

Other Second Generation CDO Products

The emergence of EDS has led to the development of a market for more EDS/CDS hybrid structured products following in the footsteps of the JP Morgan Odysseus transaction. But beyond hybrid EDS/CDS products, the emergence of a range innovative structures linked to other asset classes testifies to the adaptability, flexibility and dynamism of the basic CDO template. For example, equity-linked structures have been tailored in which the coupon on a CDO’s mezzanine tranche reflects a movement in an equity index. Structures have also been designed linking pay-outs to commodity price developments. A more recent variant has been the emergence of transactions linked to inflation, which mirrors the expansion of the market for unsecured inflation-linked bonds spearheaded by European sovereign borrowers such as France and Italy. In June 2004, S&P announced that it had assigned a triple-A rating to an issue of £100m inflation-linked variable-interest notes launched by Deutsche Bank (Linker Finance PLC). In this instance, noteholders will receive semi-annual interest payments which will fluctuate in line with the UK’s Retail Price Index (RPI). As S&P announced at the time, “this transaction is a clear sign of the increased maturity of the global synthetic CDO market, in that it is to be a credit linked to a public index of corporate names.” While equity-linked structures have been launched as a means of leveraging volatility in stock markets, other modifications on the CDO concept have been developed in response to volatility in other markets. For example, the repackaging or restructuring of existing CDOs (CDO repacks) is a phenomenon that emerged as a by-product of the poor performance of CDOs during the downturn of 2002 and 2003, a period characterised by a raft of downgrades. “In a typical repack the terms of the existing CDO are restructured, with changes in seniority, notional amount,

coupon, maturity and waterfall priority,” explains a Moody’s report on this sector. “The cash flows of the existing debt are used to support restructured debt securities to achieve the desired ratings.” Another relatively new development is the emergence of products with fixed recovery rates, which in turn has given rise to a more active market for recovery swaps, in which dealers can hedge the risk of their exposure to recovery rates. In its Thunderbird III transaction, for example, which is a CDO of CDOs and ABS, BNP Paribas offered investors pre-determined recovery rates of 90% for ABS and 40% for corporate CDS. BNP Paribas is known to be exploring a range of options aimed at separating default and recovery risk.

Credit Options

“Credit was the last major traded asset class not to have a liquid form of option market,” noted a paper on the market written by JP Morgan in May 2004, and as recently as 2003 there was still scepticism about the development potential of the credit options market. As Risk Magazine commented in May 2003, “several dealers have begun to trade options on credit default swaps. But despite a race among dealers and brokers to establish themselves in this nascent market, the goal of a liquid market in credit volatility remains some way off.” The same piece reported that five firms had submitted figures for CDS options to Risk’s 2003 credit derivatives survey, adding that “the total notional outstandings from that survey – just over $1.5bn, as of November 1 2002 – may significantly underestimate the total size of the market.” That was chiefly because much of the optionality in the credit derivatives market is hidden from public view. Anecdotal evidence suggests that trading in options on credit default swaps is now gathering important momentum. “These contracts have now been actively trading for about a year, and

volumes have picked up significantly since the beginning of the calendar year,” according to the JP Morgan report, adding that between the start of January and early May 2004, JP Morgan in London alone had traded “a notional of CDS options in the multi-billions.” But as the same report concedes, the market is by no means the sole preserve of JP Morgan, with most major banks now actively involved, or aiming to beef up their existing options structuring and trading capabilities. Beyond the European market, signs are emerging to suggest that the foundations for a more active market in CDS options trading are being laid in other geographical regions. In June 2004, the interdealer broker ICAP announced that it had completed the first ever street trades in CDS options in Asia, with two $10m CDS option trades closing with a six month option to buy five year protection on the Hong Kong-based Hutchison Whampoa. Bear Stearns, BNP Paribas, JPMorgan Chase and Merrill Lynch were counterparties on the CDS option trades, which market participants viewed as an important breakthrough for the credit options market in Asia. ICAP itself commented that “we expect Asian CDS options to grow quickly in line with the overall expansion of the Asian credit markets. The response from the market has been positive and further growth is likely to be supported by the increasing number of market participants and early agreement on industry standard documentation for swaptions.” ICAP reported at the same time that it was underscoring its commitment to the development of the Asian market for credit options by setting up a new Asian structured products desk to cover swaptions, FTDs, recovery trades and equity default swaps (EDS). In spite of these encouraging developments, the relative novelty of the CDS options market inevitably means that pricing remains less efficient than in more developed options market. As a result, as Risk commented in May 2003, “lack of

knowledge about the credit volatility structure and patchy CDS liquidity means dealers are very careful about the option trades on which they will act as a counterparty.” Options on CDS function in much the same way as interest rate or currency options. In a so-called European-style option the holder has the right to buy or sell protection on a specified reference entity for a pre-determined period, typically of five years. The option will generally knock out if the reference entity defaults during the life of the option. As JP Morgan comments, “the documentation of an option on a CDS looks remarkably similar to the confirmation of a traditional interest rate swaption.”

Indices and Index-based Products

The potential for trading of options on indices of CDS has been given an important boost following the recent and – in the view of many market participants – long overdue merger of the two principal providers of CDS indices, Trac-X and iBoxx Ltd. Trac-X was originally set up early in 2003 by JPMorgan and Morgan Stanley, with iBoxx - a joint venture between Deutsche Borse and seven investment banks – offering its own range of CDS indices soon afterwards. This inevitably led to something of a branding war between the two providers, which in turn left investors confused as to which indices to follow and therefore frustrated the development of growth in the credit derivatives market. Following months of occasionally very acrimonious debate and negotiation, the two providers announced the agreement of their long-awaited merger in April 2004. That belated announcement was very welcome news to dealers and brokers who saw the merger as a critical step towards the establishment of a single set of tradable indices and, in turn, to the evolution of a much more liquid credit derivatives market. The new flagship CDS

index is called Dow Jones iTraxx and is managed by a newly created company, International Index Company, the shareholders of which are ABN Amro, Barclays Capital, BNP Paribas, Deutsche Bank, Deutsche Borse, Dresdner Kleinwort Wasserstein (DrKW), JPMorgan, Morgan Stanley and UBS. Other indices in the DJ iTraxx suite include the DJ iTraxx HiVol index, which is made up of the top 30 names in the DJ iTraxx benchmark with the widest default swap spread received from market makers at a certain date; the DJ iTraxx Corp Index, which is referenced to the non-financial corporate bond index; and the DJ iTraxx Crossover, composed of 30 names selected by a dealer poll. General consensus in the market appears to be that the new family of indices will prove to be an improvement on its predecessors, with 125 constituents in the DJ iTraxx Benchmark index, compared with 100 in each of the legacy indices, drawn from a broader range of industrial sub-sectors. “While liquidity until now has been split between the iBoxx and DJ Trac-X indices, the new DJ iTraxx index will build on liquidity from both sides – likely resulting in an even deeper market with tighter effective bid-offer spreads,” explains a JPMorgan analysis of the new index. This adds that “DJ iTraxx will incorporate the strongest and most popular features of both the legacy indices, but the instrument will also evolve in its own right. As was the case for DJ Trac-X, the inclusion criteria are based on trading volumes in the underlying single name CDS. However, there are now a total of 19 dealers contributing data on trading volumes. The increase in the number of contributors will provide a more complete and accurate picture of the most liquid names in the European credit derivatives market.” Others agree that the new CDS index is likely to position itself quickly as a cheap and efficient way of trading the general direction of credit spreads. As a report published in June 2004 by BNP Paribas comments, there are a number of advantages

associated with using the funded note as a means of accessing exposure to market direction. First, it offers investors immediate diversification across a number of industries with a single liquid transaction. Second, it gives access to accurate market tracking, with the inclusion of only the most liquid names and the fact that these are updated every six months ensuring that DJ iTraxx Europe accurately reflects the composition of the European credit market. Third, DJ iTraxx Europe has the lowest bid/offers spread of any instrument in the euro investment grade market. “At a bid/offer spread of between 1bp and 2bp, transactions in DJ iTraxx Europe are below the cost of the cheapest benchmark instruments,” notes the report. And finally, the large number of banks that act as DJ iTraxx market makers ensures that investors are able to trade large sizes without influencing the direction of the market. Market Transparency

The publication of clear, rules-based CDS indices has made an important contribution to transparency in a market that is still subjected to criticism for its relative opacity. So too have initiatives from leading inter-dealer brokerage, market data and software providers such as GFI, which was set up in 1987. As GFI puts it, “our credit default swap data provides a forward insight into credit trends before most other indicators. This can be used to mitigate credit risk, measure concentration risk in credits, industries and companies, and maintain a daily market perspective on credit quality across a wide universe of names.” In more exotic products, GFI’s recently developed FENICS Credit 2.1 is billed as a new benchmark for pricing and managing credit derivatives. Developed by GFI in partnership with academics from the University of Toronto, FENICS Credit 2.1 provides extensive market data twinned with pricing and analytical tools allowing user to value a broad range of credit derivatives. Over and above simple CDS, these include CDS baskets, CDS options, forward CDS and cancellable CDS.

Credit 2.1 also allows users to calculate implied default correlation rates and implied volatility levels from CDS option prices, and to perform relative value analysis on non-senior debt classes and illiquid names, using benchmark credit spreads and default probability curves. Beyond the broker community, the Bond Market Association (BMA) has also been an active advocate of enhanced transparency in the credit derivatives universe on either side of the Atlantic, setting up a comprehensive library on CDO transactions and promoting the use of standardised templates in the production of monthly CDO trustee reports. In spite of these initiatives, there remains widespread suspicion about transparency levels in the credit derivatives market. That was clear enough from the findings of the 2003 CSFI survey on banking banana skins, which suggested that credit derivatives remain the single biggest threat to the stability of the global financial system. In the words of one respondent to the survey, “there is a daunting lack of transparency in reporting, and it is not readily apparent who holds the risk or what concentration of risk exists.” Ratings agencies and other external analysts also clearly still have concerns over lack of transparency in the global credit derivatives market. In a report published in September 2003, entitled Global Credit Derivatives: A Qualified Success, Fitch acknowledged the benefits that would accrue to “what is, at present, a very opaque market” if more improvements could be made in terms of transparency and disclosure. “Fitch believes that improved disclosure is one of the key issues for the credit derivative market’s continued healthy development,” noted the agency. “Traditional measures of financial strength and performance are at risk of becoming increasingly distorted in the absence of a minimum standard of disclosure via-a-vis credit derivatives.”

A persistently negative factor in terms of transparency in the derivatives market identified by Fitch is the reluctance of hedge funds to provide basic information on their exposure to credit derivatives. In preparing its 2003 survey, Fitch wrote to 50 hedge funds asking for this basic data, none of which agreed to share the necessary information with the agency. “The ongoing absence of hedge funds is important given that they are one of the fastest growing and more influential segments of this market, increasingly acting as both buyers and sellers of protection,” Fitch reports. Ratings Agency Methodology

The three leading ratings agencies – Fitch, Moody’s and Standard & Poor’s (S&P) - are essential and highly influential participants in the credit derivatives market. As custodians of what is probably the most detailed information on historical default rates, the agencies’ mine of data that provides important input into structured products’ pricing models. It is also their statistical methodologies and analysis of the CDO market that subjects pools of assets to extensive stress tests and hence helps to determine the levels of over-collateralisation or credit enhancement required for the respective credit ratings of each tranche of securities. There have traditionally been a number of ways in which the methodologies of the ratings agencies in the structured finance market have differed. But as the CDO market, in particular, has expanded and evolved, the methodology of the three leading agencies has showed increasing signs of converging. One of the clearest indications of this trend has come in the progressive changes that Moody’s has made in its approach to rating CDOs, which, according to the agency, are “in accordance with Moody’s continuing efforts to enhance its rating methodologies and address developments in the CDO market.” Some commentators, however, suggested that the change in the Moody’s approach was a response to an erosion of its market

share arising from the more conservative correlation assumptions it has traditionally applied to CDOs. Many of the recent amendments made by Moody’s to its methodology have focused on its approach to correlation. In May 2004, for instance, the agency unveiled two new Monte Carlo Simulation-based models to measure the underlying credit risk and determine the appropriate tranching of static synthetic CDOs and static synthetic CDOs squared. The main change introduced by Moody’s in May 2004 was in its approach to assessing correlation between industries and within industries. Specifically, having previously assumed that there is correlation only between credits within the same industry, the new Moody’s methodology acknowledges that there is limited correlation even between reference entities in different industrial sectors. The ratings agency explained at the time that “this evolution in Moody’s rating methodology is partly in response to the emergence of new correlation-intensive structures...which can be more efficiently modelled using a Monte Carlo correlation. Additionally, Moody’s research indicates that a Monte Carlo simulation is an elegant alternative to the multiple binomial approach that is often used to rate synthetic CDOs with static corporate reference pools. Moreover, the findings of a six-month, in-depth Moody’s study of corporate correlations, involving the analysis of rating co-movements and MKMV’s asset correlations, further supports a shift to the use of Monte Carlo simulation models for these structures.” The Moody’s models compete with S&P’s CDO Evaluator and Fitch’s CDO Vector. S&P’s Evaluator, which was launched in November 2001, uses Monte Carlo simulations (100,000 runs) to arrive at a collateral default rate for each rating level. The S&P model assumes a fixed, 30% correlation for credits within the same industry and a zero correlation for credits in different industries.

Fitch’s Vector, meanwhile, which was developed jointly with Gifford Fong Associates, is the agency’s main quantitative tool to evaluate the default risk of credit portfolios in CDO transactions. Fitch points out that measuring asset correlation between corporates directly is not possible given that historical asset value time series are generally not available. Fitch therefore used equity return correlation as a proxy for asset correlation, advising that “while there are various approaches that can be taken, only equity price data meet the criteria of being readily available, with a deep set of live trade prices covering global assets and industries.” Fitch therefore analysed 989 and 1584 publicly listed companies in Europe and the US respectively, which it grouped into 25 industry classes and five geographical regions. Unsurprisingly, the correlation within individual industries (intra correlation) was found to be generally higher than between industries (inter correlation). The average intra-industry correlation based on historical analysis of equity returns was between 21% and 30%, while the average inter-correlation rate ranged between 13% and 22%. The correlation between geographical regions, meanwhile, ranged from between 6% and 20%. Beyond correlation models of this kind, the agencies are continually updating and refining their methodology in the structured finance market. In June 2004, for example, S&P announced the introduction of a new Credit Risk Tracker (CRT) information system used to determine the creditworthiness of small and medium sized companies (SMEs). The new system was developed in response to the rapid growth in the market for CLOs of SME loans, and covers close to one million companies. Outlook

Given the speed with which the market for structured finance products in general and credit derivatives in particular has expanded and developed in recent years, it should come as no

surprise that there is still a wide diversity of views about the value of its impact on the broader capital market and financial services sector. Although many saw the market’s calm response to the Enron debacle as proof positive of the merits of credit derivatives, time and precedent have apparently been powerless to persuade respondents to the CSFI’s annual “banking banana skins” survey of the sustainability of the credit derivatives market. Its 2003 survey, based on replies from 231 bankers, analysts and regulators in 31 countries identified complex financial instruments (chiefly credit derivatives) as the biggest threat to the global banking system. The issue of whether credit derivatives act as agents of risk dispersion or risk concentration is one that has been analysed by ratings agencies. In its assessment published in September 2003 Fitch Ratings reported that on balance its view is that credit derivatives have been “a positive development for the global financial system.” Its analysis of CDOs’ exposure to credits such as Worldcom suggested that credit risk can be efficiently diffused through the capital markets. That is not to say that Fitch is entirely relaxed about the market. It continues to be concerned about information asymmetry in the credits derivatives universe, and about the concentration of exposure among a small group of counterparties. Fitch points out that about 70% of the market is still concentrated among the top 10 global banks and broker-dealers. “While these are generally solid investment-grade entities,” Fitch observes, “the market could be negatively affected if one or more of these institutions withdrew from the market for either strategic or financial reasons.” Other influential observers also appear to be becoming progressively more comfortable not just with the potential of credit derivatives to disperse rather than concentrate risk, but

also with the broader capacity of the market to make a positive contribution to enhanced efficiency in the capital market. For example, in its 2003 annual report, the Bank for International Settlements (BIS) noted that “prior to the introduction of credit derivatives, credit markets were among the least liquid of financial markets. Corporate bond issues are often small in size; many have options or other unique features that make them complicated to price; they are difficult to borrow and so to sell short in expectation of a widening of spreads; and there tends to be very little trading once they have been placed in institutional investors’ portfolios. As a result, in the past temporary or idiosyncratic factors frequently drove movements in corporate bond prices. This raised the costs of using corporate bonds for speculation or risk management...the development of credit derivatives markets, and in particular of the credit default swap market, lowered such costs,” added the BIS. The growing conviction that credit derivatives can help to disperse risk for banks and other investors and simultaneously reduce borrowers’ costs will provide an increasingly stable platform for its growth going forward. As a CreditTrade guide to the CDS market observes, in the basic CDS market, which provides the essential building block for the broader credit derivatives market, there is abundant room for further growth given that the proportion of underlying credit risk that has so far been mobilised by credit derivatives remains modest – “probably in the order of a few percentage points.” By contrast, the interest rate swaps market is worth “multiples of its underlying cash market.”