By Robert Hunter

You will not see Donaldson, Lufkin and Jenrette’s name featured prominently among the gargantuan financial institutions that dominate the annual Derivatives Strategy rankings. And that’s just fine with DLJ. The investment bank’s recent foray into the derivatives business is predicated on the belief that it’s not the size of the book that counts, it’s the quality of the relationships therein.

After years on the sidelines, DLJ is going after its own piece of the derivatives market.

During the 1980s, the firm built up its reputation as a top-notch equities house, primarily on the quality of its research and strong relationships with institutional investors. It didn’t make its move to expand its core business until the market crash of 1987 and the failure the following year of Drexel Burnham Lambert. DLJ hired scores of investment bankers from firms suffering in the post-crash environment, and scooped up bankers and high-yield bond types from the ashes of Drexel. It swiftly built sizable investment and merchant banking businesses, venturing into the waters of high-yield debt shortly thereafter.

In 1994, when the Tequila Crisis sent Wall Street cutting and running from the emerging markets, DLJ decided to staff up again, hiring an entire unit from Bankers Trust. Although the firm’s cash businesses had been flourishing, particularly in the high-yield area, the firm reasoned that in order to remain competitive it had to develop a derivatives capability. The new emerging markets group, which was a part of the firm’s investment banking division, had two components—a derivatives effort and a proprietary trading effort. The derivatives group offered such products as total-return swaps, default swaps, credit-linked notes, local currency pass-through notes and leveraged knockout notes, focusing primarily on Latin America, Russia, Turkey and Asia. Business rolled along nicely, growing to approximately 375 structured trades outstanding by the middle of 1998.

Then last year, the stars of the financial world aligned again—this time in the form of a spate of massive bank mergers—presenting DLJ with an opportunity to expand its derivatives business further. It couldn’t have come at a better time. The fixed-income division had enjoyed big business for years, but realized that it had to offer its clients the financial equivalent of one-stop shopping to compete with the Street’s bigger houses. The firm’s raison d’être—building and maintaining client relationships—had become a mantra. “If we were going to bring a high-yield issuer to the market,” says John Paganucci, managing director and head of the firm’s new fixed-income derivatives group, “we left open the opportunity that by making the issuer go across the street to do the corresponding swap, the client would develop another banking relationship along the way.”

Making the move

In the second quarter of 1998, DLJ pounced. It brought in Paganucci, a casualty of the Union Bank of Switzerland/Swiss Bank Corp. merger, and Pat Blake, a Salomon swaps trader before the Salomon Smith Barney/Citicorp merger, to build a full-fledged derivatives unit within the fixed-income division in order to capitalize on the firm’s increasingly profitable cash businesses. Paganucci was originally charged with developing a credit derivatives business, which is now under the direction of David Carlson in New York, while Blake was to create an interest rate derivatives capability.

The goals of the interest rate business were twofold. First, DLJ sought to build on the relationships forged by its banking and fixed-income sales efforts, offering relatively vanilla products to keep customers in-house and, not coincidentally, to make margin on the transactions. Second, DLJ wanted to offer clients capabilities that they hadn’t considered or could not find elsewhere. “Some of our high-yield clients never even thought of doing swaps,” says Paganucci. “In some cases, we were dealing with, say, a high-yield telecom issuer who had never heard of the swaps market or conceived of the fact that it could issue fixed-rate paper and swap it into floating. Many of these companies have deep relationships with DLJ, and we want to cultivate those relationships further.”

“There’s no miracle in doing an interest rate swap; we’re simply applying these techniques to clients who didn’t really have access to the market.” —John Paganucci

Another way it sought to bolster its relationships was by offering derivatives products to below-investment-grade-rated clients. “Even if these clients knew about the swap markets, most dealers would never do deals with, say, a triple-C swap counterparty,” says Paganucci. “We believe we understand credit, we’re comfortable with our counterparties, and we can price swaps with them. There’s no miracle in doing an interest rate or foreign exchange swap; we’re simply applying these techniques to a new market—to clients who didn’t really have access to the market.” In the past, he notes, clients wanting liabilities in foreign currencies had little choice but to issue debt in those currencies. Now, DLJ can offer the option of issuing in dollars and swapping into, say, euros, if that’s where the efficiencies are greatest. Even in the commoditized, low-margin vanilla swaps business, DLJ’s client-driven approach is paying off: The firm has transacted $11 billion of such trades to date.

DLJ uses its high-yield cash desk as the foundation for its credit derivatives business as well. The firm “has more information about how credit trades in the secondary market than anyone else in the business,” says Paganucci, and it uses this knowledge to repackage illiquid high-yield debt into more appealing structures, usually via special-purpose vehicles—taking margin along the way. The most common structures are collateralized debt obligations, in which DLJ takes poorly traded high-yield debt, changes the risk profile of the asset (for example, maturity, currency or interest rate risk), and resells the structured debt. The credit derivatives desk has also done collateralized-bond-obligation transactions, tailoring generic CBOs to specific maturities and risk profiles, and selling them in different tranches.

The credit derivatives group serves another important purpose: It acts as a hedging vehicle for the high-yield cash desk, which inevitably finds itself exposed to the overall high-yield market as a result of its secondary positions. In those days, its hedging options were limited to going into the illiquid high-yield repo market, borrowing debt and shorting it—quite an expensive proposition. At the time, the cash desk most often simply kept its long position and hoped for the best. Now, the derivatives desk structures hedging deals—generally total-return swaps or structured notes—and sells them to counterparties. Total-return swaps offer a simple vehicle for maintaining a term position in the market. Structured notes are written against DLJ’s own high-yield index, giving the counterparty exposure to the broader high-yield market. The benefits are twofold: The high-yield desk is provided with an efficient hedge, and the derivatives desk, having structured and sold the product, takes in a small margin.

Another area the credit group has begun to exploit is convertible bonds. “You can look at them as the credit risk of a corporation with some warrants attached,” explains Paganucci. “There is a market for that hybrid risk, but there are also markets for each of the individual risks, and sometimes the two don’t match—sometimes there’s an arbitrage opportunity.” DLJ breaks a bond into two components, selling the equity option to an equity buyer or equity volatility buyer, and selling the credit component to a credit buyer. The individual components are generally worth more than the whole. “A lot of that business has been arbitraged away in the United States,” says Paganucci. “In Asia, arbitrage opportunities still exist, but there are fewer and fewer as the Asian convertible business grows. The next place to apply that business is the European convertible business, because that area, like the European high-yield, is relatively new.”

Streamlining

Last year’s emerging-markets turmoil precipitated strategic rethinks at many Wall Street houses, and DLJ was no exception. The firm decided to abandon its emerging-markets proprietary trading business altogether, and to merge its successful emerging-markets derivatives team, currently run by Pedro Beroy, with the fixed-income group’s derivatives unit. “The business is totally on target right now,” says Paganucci. “Credit, high-yield, investment-grade and emerging-markets derivatives are working side-by-side.”

DLJ has also taken a different approach in the way it uses credit models. At many firms, credit derivatives are priced using a model based on historical data or one that incorporates assumptions about current market conditions (such as assumed rates of default or recovery values of defaulted debt). But at DLJ, credit models are far less important. “I don’t believe in the model-based approach to pricing and hedging such transactions,” sniffs Paganucci. “These types of models are bound to blow up—they will work until they don’t. We run a flat book, not only with respect to model risk but also outright risk—interest rate exposures, credit exposures and so on. I’m not here to take a view on credit. I’m here to repackage it and find the person who wants to take a view on credit, and to do so in a more efficient mechanism. That could be DLJ’s own desks, because they are paid to take a view on credit risk, or it could be an external counterparty.”

DLJ’s biggest goal for the future: growth in Europe, which is currently being driven by another ex-UBS professional, Jonathan Chung. The firm is spending a “substantial amount of resources” trying to replicate its New York business in London. It has eight derivatives professionals on the ground there now, and plans to go to 14 shortly—an important move in a business whose motto is “staff up or shut up.”

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