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The Long-Awaited Arrival of Credit Derivatives

Credit derivatives are finally being used to manage the last remaining dimension of financial risk

By Robert McDermott

The advance hype about credit derivatives has been unrelenting and high-pitched. For more than four years, dealers have predicted that their entrance into the mainstream derivatives world was just a matter of months or even weeks. And there's been no shortage of skeptics who, in the absence of any significant volume, have dismissed credit derivatives as a financial engineering pipe dream.

Now, at last, the skeptics have been proven wrong. There are now definitive signs that these revolutionary new instruments are actually being used in the real world by real financial institutions. Though credit derivatives have not developed into the commodity products that dominate the interest rate and currency markets, credit derivatives are nevertheless reaching critical mass.

It is a positive development. Credit was always the one piece that was difficult to isolate in the risk equation. Credit derivatives allow issuers, investors, banks and dealers a full panoply of options in managing risks. By quantifying and pricing each risk component-interest rate, duration, currency and credit-the whole can be unbundled. The risks can then, theoretically, be parceled out to the holder able to handle them most efficiently. In the ideal world the effect should be increased access to and decreased cost of credit. Even falling short of this utopian vision of global capital market efficiency, the benefits will still be enormous, as the relationship between the supply and demand for credit is adjusted.

Big numbers

If you need more than theoretical evidence as to why credit derivatives are important to watch, just take a look at the surging growth in contracts over the past three years. Depending on who you believe, the notional volume of contracts has jumped from an estimated $5 billion in 1993 to $40 billion, according to CIBC Wood Gundy. "Volume is starting to grow exponentially," says John Tompkins, head of credit derivatives at Prebon Yamane. "We'll see this soar over the next year." Prebon is one of the two broker-dealers, with Garvin, Guy, Butler, that act as market-makers in credit derivatives.

Blythe Masters, global head of credit derivatives at JP Morgan, estimates that total outstandings, which were in the "low-digit billions" as recently as last year, have mushroomed dramatically. "Sometime during this year that number surpassed $50 billion, and it's possibly closer to $100 billion than to $50 billion," she says. "Clearly we are on some kind of exponential growth path."

Volume and liquidity have been helped by at least one very large benchmark transaction. In August JP Morgan structured and sole-managed a mammoth $594 million note linked to the credit of Wal-Mart Stores. The note was placed globally with a broad range of investors in the U.S., Asian and European capital markets, many of whom do not normally buy U.S. public debt.

"The product has clearly evolved beyond the interbank market," says Masters. "When you have broad distribution of a large transaction like that, investors become significantly more familiar with the specifics of how documentation works and what synthetic credit risk really means. A lot of America's largest pension funds, banks and investment managers can now say they've bought a credit derivative."

The JP Morgan transaction was followed a few weeks later by another mega-deal. In mid-September Chase revealed it arranged for the issuance of an investment-grade security based on a $625 million managed portfolio of non-investment-grade bank loans. The structure, which it calls a Chase Secured Loan Trust Note, was issued by a trust and lets investors effectively purchase high-yield bank loans on margin without the risk of a margin call. "This type of structure allows a variety of investors including insurance companies, hedge funds and money managers to get exposure to bank loans on a protected, investment-grade basis," says Gregg Whittaker, global head of credit derivatives at Chase Securities. "They can now get exposure to bank loans in a security form with relatively little administrative burden at a fraction of the capital ordinarily required."

Actual and perceived illiquidity has been a major hurdle since credit derivatives first appeared as over-the-counter contracts in 1991. But today that barrier appears to be falling. As recently as 1995 there were no two-way prices on credit derivatives. Now inter-dealer brokers offer quotes on dozens of U.S. credit swaps, options and indices, and active institutional traders have begun to quote both sides of default and total return swaps, offering both bid and ask prices.

Banks with big research and development efforts in fixed income and derivatives markets-Bankers Trust, Chase Manhattan and JP Morgan-dominated the nascent credit derivatives markets. But the recent surges in volume have come from the flurry of new entrants-banks and brokers as diverse as Citibank, Credit Suisse Financial Products, CIBC Wood Gundy, Lehman Brothers, Merrill Lynch and Bank of Montreal. And waiting not too cautiously on the sidelines are the Japanese, German, U.K. and Swiss banks, which hope to play a major role in the development of the business outside the U.S.

In the U.S. the dominant share of credit derivatives trading involves a universe of perhaps 500 names-financial institutions and corporations with large, liquid debt issues outstanding. Still, a recent list of swaps quoted offered a fair selection of relatively obscure names, and contract amounts as low as $10 million.

On the buy side the major banks are joined by hedge funds and insurers which play increasingly prominent roles in the market, typically seeking incremental yield from buying credit risk. For the roughly 25 major U.S. insurance companies seen regularly in the market, taking on credit risk is a natural extension of their core business and capabilities. "We see insurers actively doing total return swaps and default puts to pick up an extra spread of 10 basis points, as well as trading bond indices to hedge against price changes in the underlying issues," says one trader. Hedge funds, which are key players in the high-yield bank loan sector, have also helped push up volume.

In Europe the lack of two-way prices is one factor still hampering market growth, according to Paul Hattori, vice president at The Chase Manhattan Bank in London. Bank loans play almost no role in the market; in Europe it is all about bonds. Some dealers, however, say they are seeing new activity in credit structures on secondary European and Asian currencies.

Risk splitting

Attempts to peel off credit risk have been around for decades in the form of credit enhancements and default guarantees such as bond insurance. But the neater package known as a credit derivative is generally dated from Bankers Trust's 1991 introduction of collateralized loan obligations. By repoing a commercial loan portfolio and breaking the package into tranches, BT held the loans and sold the default risk-essentially creating the first credit derivative.

One indication of the speedy development of the credit derivatives market is how far it has moved from the original BT collateralized loan obligation structure. "Since 1993," says Robert Reoch, director of special financial products at Nomura Capital International in London, "when credit derivatives really emerged, buyers of credit risk were solely interested in yield enhancement. Today, by contrast, they are using credit derivatives to tailor the terms of transactions to meet their needs precisely in regard to currency, duration and setting caps on maximum exposure."

At the heart of every credit derivative is the recognition of a credit risk premium. The capital markets charge for varying degrees of default risk by setting a price spread between corporate bonds with different ratings. This premium not only makes it possible to isolate and price the credit risk component, but is itself a variable that fluctuates over time. Credit risk, then, is more than the risk of potential default. It's also the risk that credit risk premiums will change, affecting the par value of the underlying bonds.

Credit derivatives are typically priced off of instruments that permit some type of price discovery. The reference asset for a credit derivative used to hedge the credit risk of bank loans, for example, is often a publicly traded bond issued by the same borrower, or less commonly a widely syndicated loan or loan portfolio. "The challenge is to build an integrated business marrying derivatives and corporate bonds, not just to create new structures," says Nicholas Mumford, global head of credit derivatives at Citibank in New York, whose team interacts continuously with the bond and loan sales desks.

Although most credit derivatives deals are highly customized, they consist primarily of two core building blocks: default swaps or puts and total return swaps. In a default swap contract, a credit risk seller pays a counterparty for the right to receive payment in the event an agreed change takes place in the credit status of reference credit, typically a corporate bond. These types of changes are usually triggered by default or debt repackaging, not by a downgrade. Default swaps normally contain a "materiality" clause requiring that the change in credit status be significant and be validated by third-party evidence-typically the plummeting of the bond's price in the market. The payment is sometimes fixed by agreement, but a more common practice is to set it at par minus the recovery rate, a figure determined by the market price of the defaulted bonds some months after the actual default.

Total return swaps, by contrast, allows the credit risk seller to retain the asset and receive returns that fluctuate as the credit risk changes. The seller pays the total rate of return on a reference asset, typically a bond, including any price appreciation, in return for periodic floating rate payments plus any price depreciation.

Investor attraction

From these two building blocks, bankers have churned out a bewildering variety of synthetic credit instruments to meet investor demand. Buyers of credit derivatives are often hedge funds or insurance companies looking either to pick up incremental yield or to diversify their portfolios.

The yield pickup on credit derivatives can be substantial. With five-year single-A corporate bonds going for LIBOR plus 15 basis points, it's increasingly difficult for corporate bond investors to make any serious money.

Credit derivatives can be particularly attractive for fund managers benchmarked to the major bond indices. Bond managers can use total return swaps to hedge part of their portfolio to an index. Building a hedged position in the cash market would not only be difficult to accomplish, but certain to influence prices.

The derivatives alternative is also likely to be considerably cheaper. Total return swap quotes are readily available, especially for short-term hedges. The repo market for high-yield bonds, by contrast, is so thin that it is difficult to finance the bonds themselves.

Offloading loans

Credit derivatives were first called into service to hedge bank loans. The early growth of credit derivative instruments, in fact, was helped along by a key secular trend: More and more financial institutions were becoming originators, rather than long-term holders, of credit. The explosive growth of securitized instruments was the most successful outgrowth of this trend. On the theory that anything can be bundled up into a security, banks found that their balance sheets would benefit from selling off their loan portfolios.

Selling loans, however, can put banks in a difficult situation. A bank needs to maintain the relationship with the company to which it made the loan, and selling off the loan can threaten a carefully nurtured banking relationship. On the other hand, each commercial loan exposes a bank's balance sheet to a very specific kind of credit risk. Credit derivatives have become popular because they enabled banks to retain the asset-and the relationship with the customer-while segmenting and laying off a part of the risk.

For commercial banks, credit derivatives represent a dramatically different way to approach balance sheet risk management. "The inherent nature of commercial bank loan portfolios is to concentrate credit risk geographically and by industry," says Shaun Rai, head of credit derivatives at CIBC Wood Gundy. Loans are originated locally, and banks tend to build depth and expertise in particular industries. This balance sheet inflexibility has helped fuel a steady stream of bank lending disasters. By using credit derivatives, banks can potentially diversify these risks globally, separating the funding decision from the credit decision.

In practice, this means that a bank can free up lines of credit and continue to lend to a valued customer, even when exceeding its credit exposure limits to the company or industry, by laying of all or part of the credit risk through a total return or default swap. And it can focus on lending to the sectors where it has a strong franchise and depth of expertise without worrying about excessive risk concentration. Less credit-worthy banks whose lending margins are squeezed by a higher cost of funds could potentially get higher returns and exposure to better credit risks from credit derivatives than from direct lending.

Corporate tool

Corporate issuers have their own uses for the products. One basic strategy is to hedge credit risk exposures to key customers and suppliers, either directly through default swaps or via the proxy of derivatives based on a basket of comparable risks. Since all the suppliers whose business is heavily dependent on major customers such as Boeing or DuPont share common credit risk characteristics, access to liquid public debt issues becomes a key factor.

Corporate treasurers who have secured financing through a complex capital structure often find that the market prices different tranches of debt unpredictably, based on differences in both seniority and term. Credit derivatives allow them to arbitrage out the spreads. "Going long zeros and shorting coupons is almost always a good trade for corporate treasurers to narrow the spread," according to Philip Borg, managing director of global credit derivatives at Bankers Trust. "There is always a premium paid on zeros."

Corporate bond issuers can also use credit options to hedge the credit risk premium component of future borrowing costs. Since the spread paid by borrowers in different rating tiers against Treasuries or comparable assets tends to widen during economic downturns, the purchase of call options on the spread protects against an overall rise in the risk premium. Should the premium rise-which historically it has done both quickly and sharply at times in the economic cycle-the payoff on the option offsets some or all of the increased funding costs.

Derivatives can also be used to alter the tenor of debt issues. They can shorten maturities though puts, effectively converting an eight-year note into five years, for example. And credit spread forwards can be used to strip out the near term while retaining the out years.

Valuation and pricing

While a number of major money center banks are continuously developing models to quantify and price credit risk, the market currently functions largely by referencing the cash market. "You essentially reference the underlying cash market and the spread of the credit over a comparable asset of Treasury of like duration," explains one trader. The bulk of activity is in the two-to-four-year range. If XYZ bond trades at Libor plus 100 basis points, a two-year credit default swap can be expected to trade somewhere around 100 basis points or tighter.

This makes perfect sense to Chase's Hattori. "The principles and goals of managing credit risk remain the same as they have for centuries. The tools available to do the job are just becoming more refined and flexible," he says.

The direct reference pricing to the cash market makes credit swap pricing fairly straightforward and transparent for investors and corporate end-users to understand and evaluate. Synthetic credit instruments such as first-to-default baskets are another story. The pricing in the more complex instruments is based on the ability to analyze and value not simply the default or expected loss risk, but the correlation risk among different credits in the swap. Building bases of historical data to quantify and price loss probabilities is also critical.

Not everyone agrees that pricing is such an efficient process. "Six months ago it tended to be fairly primitive," says Prebon Yamane's Tompkins. "It wasn't unusual to see prices 100 basis points apart. Since then, however, it has become more efficient, with dealers making two-sided prices; a 50-point spread would be considered very wide." Other dealers also perceive that prices are converging and spreads tightening.

Trouble ahead

Regulatory capital requirements remain a formidable barrier for many potential bank participants. Current bank regulations require that banks hedging loans via credit swaps reserve capital against both the loan and the derivative contract, rather than netting the position. Recent statements by the Federal Reserve Bank and the Office of the Comptroller of the Currency express what most view as a positive attitude toward the development of the credit derivatives market, and a commitment not to place unnecessary hurdles in its path. Explicit in the regulators' views are an intent to review capital requirements as the market develops. The Bank for International Settlements (BIS) has also begun to indicate the direction, generally received as positive, that its guidelines for credit derivatives will take.

Documentation is another head-ache. Every credit swap references a specific rather than a generic risk, making standardization of swaps documents an elusive goal. The lack of standardized documentation for credit swaps, in fact, could become a major brake on market expansion.

To smooth out the process, the International Swaps and Derivatives Association is advocating simplified, "menu-like" contractual frameworks for the transactions. ISDA began circulating draft forms of documentation for comment in January of this year, and issued a draft model for a credit default swap confirmation in August.

For some, standardization can't come too soon. "For this market to prosper, standardization of documentation is pivotal," says Patrick Gallaway of Nomura Capital. "Documentation is a high priority for a lot of firms in this market," adds an attorney who is a member of the ISDA credit derivatives working group. "There is wide participation in developing documentation standards, and a consensus is within reach. We might see something from ISDA by the end of this year."

Virtually everyone in this market expects substantially increasing volumes of supply from both financial institutions and corporations in the next few years. "Last year we saw $1 billion or more in bank loan capital, leveraged 10 to 20 times, enter the credit derivatives market, largely through loan swaps," says Citibank's Mumford, who adds that the sharpest rise in activity was in non-investment-grade loans. "Revenue streams from credit derivatives should parallel those of equity derivatives within two years." The reasoning: The credit universe is not only much larger, but more liquid. And more capital means more players and more flexibility.

Dealers predict that the new supply of product will come from stricter and more aggressive loan portfolio management by commercial banks. "We are getting several queries a week from banks who are newly interested in looking at opportunities in the market, chiefly from Europe," says Prebon's Tompkins. "Demand is such that you're starting to see bank portfolio managers arranging one-off swaps with other banks, with no intermediary dealers involved," says Barry Campbell, manager of the loan portfolio department at Bank of Montreal.

Dealers also see increasing demand as investors perceive bank loans as an attractive asset from which attractive comparative value can be won. Many investors have come to believe that bank loans offer risk-adjusted rates of return superior to bonds, since recovery rates in defaults have tended to be higher historically and interest rates are commonly reset monthly or quarterly.

Big picture

CIBC's Rai believes credit derivatives will profoundly change the bank loan markets on a global scale. By giving investors access to bank loan portfolios, credit risk will be more widely and efficiently traded among an expanding universe of players. He envisions massive diversification of credit risk in loan portfolios that will lead ultimately toward greater liquidity in the credit markets. The more efficiently credit risk can be diversified, hedged and traded, the more rationalized its pricing will become. The ultimate result will be to lower the costs of credit.

He also believes credit derivatives will create new bridges between separate capital markets in the coming decade, just as currency and interest rate products did in the previous decade. "Globally, the credit markets are immense and highly fragmented," Rai says. "Most holders of credit risk have overwhelmingly domestic exposures and resulting high concentrations of risk." In practice this may allow banks to diversify credit risk exposures in a loan portfolio globally, across economies with differing cycles and characteristics.

Few of these grand scenarios are likely to materialize before the millennium. But if the financial logic holds, credit derivatives could transform the financial world in the coming decade as profoundly as interest rate and currency derivatives did in the previous decade.

Credit Derivatives in Emerging Markets

Emerging-market credit derivatives account today for the largest share of the outstanding volume. But their function is less to diversify and rationalize credit risk than to create access to markets by synthesizing assets that are difficult or impossible to purchase directly. "Emerging markets are a very different sector," according to BT's Borg. "The focus is primarily on sovereign rather than corporate risk and on creating customized risk parameters. And there is more speculative play."

Credit derivative structures are frequently used to create long or short exposure to the behavior of an overall debt market, as well as to customize duration. Brady bonds, for example, can provide an attractive vehicle for participation in the Argentine or Brazilian debt markets, since their principal is guaranteed. But 30-year maturities, local regulations, reservations about transparency in trading markets and nondollar settlement issues can make holding the bonds themselves far less efficient than customized synthetic instruments structured around credit derivatives. "Derivative structures can separate out the sovereign risk of default, convertibility risk and currency risk for both investors and issuers," says ING Barings' American derivatives head Robert Hedges. "More emerging-market debt issues can be now be cleared through Euroclear and paid in dollars."

There are also some signs that a few U.S. banks are using the instruments to get out of risk associated with foreign loans. Hal Holappa, head of credit derivatives marketing at CIBC Wood Gundy, tells of one U.S. bank that recently found itself uncomfortable with the credit risk inherent in a loan to a Chinese borrower in the face of tense relations between the countries. The bank decided to transfer the its default risk to an Asian investor. The bank retained the asset, while paying an acceptable premium to shed its discomfort.

A growing share of activity in emerging market credit derivatives is being driven by corporations seeking to hedge capital exposures and receivables. For U.S. corporations with substantial Argentine receivables, a default option on Argentine government bonds can provide an imperfect but still effective hedge. "For a U.S. company looking to hedge one-to-two-year receivables in Brazil, we'd look first at the credit market's pricing of Brazilian bonds, and then at the specific characteristics of the receivables to determine whether they are in fact more or less risky than bonds," says Holappa. "There are no formula solutions. Depending on the tenor of the bond market, it might make sense to create a default risk hedge structure by shorting Brazilian bonds, or conversely by creating a structure that synthesizes a long position in two-year Brazilian debt." The core issue, as in all credit derivatives, is to quantify the risk of loss.

Analyzing Multicredit Baskets

An investor is most likely to find satisfaction in the credit derivatives market by doing his or her homework-and that means looking at the offerings from every available angle. First-to-default baskets, for example, offer an alternative whose attractions are difficult to discern at first glance. These notes are issued commonly on a package of four single-A credits. They offer investors incremental yield of 75 basis points or more, but the tradeoff is that the investor takes the loss should any one of the credits default.

At first glance the package doesn't sound wildly attractive because a package of four single-A credits produces a triple-B instrument, not a single-A instrument. The reason: While the expected default rate on a 10-year single-A credit is 3.9 percent, the probability on a basket of four rises notionally to 15.6 percent.

But look again. "Despite a triple-B rating, a basket of four single-A credits will outperform a triple-B bond," says Citibank's Mumford. "Bond investors are already loaded up on triple-Bs, because it's the only part of the market where you can get a current spread. But on an historic basis, the triple-B default rate over five years or more will result in a negative return."

Dealers have used a total return swap on a high-yield bond or loan to create a synthetic bond instrument, or clustered several into a basket and placed in a trust. The result is a kind of indexed derivative product offering investors diversified exposure to the U.S. high-yield market-where credit risk is the key variant in valuation-without risk of principal.

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