By Andrew Webb

The credit derivatives market has survived the great credit crunch of 1998. During the peak of the crisis, there were times when some skeptics doubted the long-term viability of the market. When cash bond dealers refused to quote prices on corporates, credit derivatives dealers were left without the reference points they depended on to structure their deals.
Since then, much of the market has bounced back; credit derivatives, after all, represent the only viable way to short corporate credit. The lack of a repo market for most corporate credits makes shorting the bonds unfeasible, and buying puts on a company’s stock isn’t a clean credit bet since other factors apart from credit rating also affect the stock price.
Credit derivatives often protect banks from losses on their underlying cash bonds. “In the midst of the credit crunch last year, it was in many cases the credit derivatives desk that came out unscathed, because it had the ability to go short credit cleanly,” says James Kenny, director of credit derivatives at Prebon Yamane. Bond desks that simply dumped bonds on a collapsing market sustained huge losses.

Kenny estimates that January and February 1999 volumes were up 100 percent over the same period last year and believes that liquidity in most markets is increasing. “I think it’s now pretty much true that there’s always some price available, which probably wasn’t the case 18 months ago,” says Kenny. One important factor in this increasing liquidity and activity has been the ease of doing repeat business, as an increasing number of counterparties consummate their first credit derivative trade. While the first trade between two specific counterparties may take a day or so of haggling over documentation and terms, next time around the process is much faster since the ground rules have been laid.

In emerging markets, it’s a different story. “From what we’re seeing and from talking to others in the marketplace, there’s clearly not a lot going on, just a few trades a week,” says Kevin Murphy, director of structured products at BankBoston. Although he notes that volume has picked up since the Russian default, he attributes much of the current state of the market to the aftermath of the default and the legal battles that have ensued, as well a need for liquidity, which confines many investors to the cash market.

The emerging-market shops that are still around have cut back drastically, and with many of them not even trading the underlying credits, credit derivatives have inevitably been hit. Extensive personnel changes and litigation woes involving some of last year’s emerging-market credit derivatives deals have only added to the misery.

One product business that seems to be prospering is credit spread options, which allow purchasers to take a position on a bond’s spread over a benchmark, typically Libor. They are still regarded in many quarters as products more talked about than actually traded, and were particularly popular as a “conference trade” in the run-up to European monetary union. In Europe, however, the current size of the market is estimated at around $100 billion. “The market is definitely buoyant, with demand from both investors looking for yield-enhancement strategies and banks wishing to adjust their exposure for regulatory or other reasons,” says Richard Bruyere, credit derivatives structurer at Societe Generale in London.

One attraction of credit spread options is their relative simplicity. Investors eager to buy a particular asset in the market that they feel is overpriced may decide to sell a credit spread put. For example, the investor may wish to buy the asset at +25 basis points and feels that it will ultimately reach that level, but it is currently trading at +20 basis points. The investor would then sell a put to a bank at a strike of +25 basis points. If the spread widens as anticipated, the put is exercised and the investor enters the position at the anticipated level and makes money on the option premium as well. “That premium can be considerable since many of these trades are based on quite volatile assets,” says SocGen’s Bruyere. The bank may also have a credit line constraint for this particular credit, but by purchasing the put from the investor, this problem is alleviated. There seems to be considerable new interest in credit derivatives associated with collateralized debt obligations as well. “I’m seeing a much greater use of credit derivatives in structuring products such as CBOs and CLOs,” says Larry Isaacson, a partner at the law firm Fried, Frank. The increasing use of “regulatory arbitrage”—using credit derivatives to shunt banking assets from the banking to the trading book in an attempt to reduce capital charges—has also made banks receptive to any product that allows them to do this cleanly.

Are credit derivatives being sold to people who don’t understand them?

One factor that has probably acted as a damper on the growth of the credit derivatives market more generally has been the cost of setting up shop. While the margins may look attractive to the outsider, being a successful player doesn’t come cheap. You need top-flight sales, trading and legal teams in place, all with a thorough understanding of the products. Since this is a fledgling market and experience is in short supply, the laws of supply and demand take their inevitable toll. At the moment, there appear to be quite a few institutions on the sidelines frantically haggling over a handful of helmets and pads.

Although improving liquidity in major markets may encourage optimism, credit derivatives still have a handful of question marks hanging over them.

1. Are credit derivatives being sold to people who don’t understand them?

We all know the scenario: An end-user struggles through a number of explanations from his or her investment bank without fully comprehending the product, then signs up rather than admit ignorance. Something unexpected happens. The next call is to the end-user’s lawyer.

“Unlike other financial products that have remained largely in the professional markets, one of the most alarming things about credit derivatives is the way they have been packaged into numerous deals that have been sold to relatively small institutions and even occasionally to high-net-worth individuals, which I think has the potential to cause problems,” says Satyajit Das, an Australia-based derivatives consultant. Das points to many banks, both commercial and investment, that in the past year have been putting together deals involving credit derivatives and a special purpose vehicle. Most cases involve some form of collateralized debt obligation, a synthetic instrument that pays an extremely high yield in return for taking some credit risk—typically high yield in the case of U.S. deals, and emerging market in the case of European deals. “I am not at all sure that investors were necessarily entirely clear about the risk that they were running,” says Das. The banks involved in these deals often do not provide a mark-to-market value for this type of product. While that refusal may or not be a sign that the deal is already underwater, the fact remains that retail investors will have a tough time working out the real value of these deals if they want to unwind them.

Others see this as an overstated worry at this stage. “The bulk of credit derivatives origination and trading is occurring among the largest players who should know what they are doing, so at present I don’t see this as too much of an issue,” says Richard Roby, analyst at the Tower Group. In the U.S. market, activity is still confined mostly to the banks trading among themselves, often to cover their own risks to large industrial companies. Roby believes, however, that it is only a matter of time before a sophisticated industrial player gets involved in a deal it does not fully understand.

Roby also has a more specific concern. “In certain instances,” he says, “traders do not understand the scale of the exposure they are assuming when they enter into a credit derivative.” He argues that the majority of traders are accustomed to trading conventional derivatives, where the actual exposure is usually only a small percentage of the notional amount. Depending on the wording in the contract, the exposure on a credit derivative can be anything up to the principal amount. “That requires far more rigor when evaluating counterparty exposure than does a plain vanilla derivative,” says Roby.

Others, such as Prebon’s Kenny, believe that the specter of a derivatives scandal ŕ la Procter & Gamble hitting credit derivatives is little more than scare-mongering. “The very nature of these trades limits their investment audience, so that those going into these trades are going in with their eyes open,” he says, noting that dealers are much more sensitive to compliance issues, and traders are far more aware of the large litigation risks inherent in putting investors into trades that they don’t understand.

2. Can the industry agree on credit documentation standards?

As in any nascent derivatives market, a lack of consensus on documentation is proving something of a damper on activity. The International Swaps and Derivatives Association has been addressing this problem for some time. Although a level of consensus has emerged at this point, a comprehensive set of common standards seems quite a ways off.

“I think the market’s ability to design and sell credit derivative products has run ahead of the legal infrastructure necessary to support some of those products, which inevitably increases the risks,” says Tower Group’s Roby. Although the situation is improving and there is optimism that ISDA’s input will have a favorable effect, every participant has his or her own views on the most suitable enhancements, with each market event generating a new set of further considerations.

Can the industry agree on credit documentation standards?

A case in point here has been the confusion surrounding the exact definition of default with regard to Russia. The litigation that has arisen here has largely centered on the fact that in the first instance Russia announced a rescheduling in its local debt market that might or might not (depending on your viewpoint) be construed as a default. A similar legal conundrum arose with respect to the non-payment on foreign exchange deals by Russian commercial banks. Since the banks were actually prohibited from honoring those transactions by the Russian government, rather than defaulting of their own volition, some counterparties are still arguing that this did not constitute a default within the terms of the then-prevailing documentation. (The fact that most Russian banks concerned were probably incapable of making the payments anyway seems almost a legal afterthought.) Nevertheless, for an aggressive counterparty, the prospect of delaying payment and saving a not insignificant funding cost by quibbling over the documentation must seem attractive.

Many see this sort of legal testing and litigation as natural as the market refines the process and documentation for credit derivatives. “I think it’s a good thing for the development of the market,” says Shane Henderson, a senior consultant at TCA Consulting and former senior risk analyst in SFA’s financial risk division.

A meeting between ISDA and the major market participants last December raised a number of important documentation issues, including settlement procedures and the definition of credit events. Consensus was reached on the majority of outstanding issues, and a new version of the ISDA definitions was expected to be issued by late last month. One particular anomaly that looks certain to be resolved is that New York and London have not been trading on the same legal basis using the same definitions. There have been, for example, differing standards relating to exercise; in New York, either the buyer or the seller of protection can exercise the contract, but in London it is typically more restricted and only the buyer has the right to exercise.

The rapid evolution of credit derivatives documentation, while beneficial in the longer term, does have its disadvantages—one being documentation basis risk. One could, for instance, buy credit protection at 50 basis points and a year later look to turn it round for a profit at, say, 70 basis points, but in the intervening period the market standards in relation to documentation might have shifted. “You therefore might have bought at 50 basis points with ABC terms, but now at 70 basis points be only able to get XYZ terms. The risk is small but it is a basis risk and the smarter banks set aside capital against that eventuality,” says Kenny.

Apart from precipitating a bout of document-gazing, the credit events of last year have also changed the speed at which credit derivatives documentation is processed. Early last year, many credit derivatives agreements were taking a long time to be signed and returned. As a result, when the credit crunch hit later in the year, quite a few documents on agreed trades were caught, still unsigned, in limbo, and there was considerable uncertainty about which trades would be honored. The effect of this scare has been that when the seller of credit protection sends the documentation to the buyer, it is now usually signed and returned within three days. In the intervening period, there is a gentleman’s agreement (more scope for litigation) between everybody that the deal will be consummated.

3. Can credit derivatives offer protection on a larger universe of names?

If credit derivatives are to become a mainstream risk management tool for commercial banks, their modeling and use will have to appeal to a much wider universe of names. “Most of the activity to date has been in maybe 100 names, since they are the ones that dealers can hedge, rather than the ones that customers want protection for,” notes Don van Deventer, a partner at Kamakura. He points out that while it might be technically possible for a bank with a portfolio of smaller corporate risks to use credit derivatives involving those 100 names to hedge its exposure, the costs in terms of the bid/offer spread would be exorbitant.

A simple example would be a credit derivative based on the 500 corporations in the Standard & Poor’s 500 that paid out a specified amount if any constituent stock defaulted during the contract period. “That is a credit derivative with extremely broad application to portfolio management, and the technology is now available to price and hedge such a position,” says van Deventer.

Dan Curry, a managing director for derivatives at Moody’s Investors Service, mentions an alternative solution. “I think people are starting to consider the idea of using catastrophe bond structures as a way of doing credit derivatives,” he says. “The issue would be tied to an index of defaults parametrically—so as defaults rose above a certain level, payments would start going down on the associated bonds.” The index would attempt to replicate a particular industry or country sector to which the bank was exposed in its loan portfolio. As with cat bonds, these securities could be issued in multiple tranches, which could offer varying mixtures of coupon and principal protection to suit a range of investing appetites. For each default in the reference index, the coupon payments would be reduced by a specified amount. In the case of tranches with only limited principal protection, repayment of principal at the bond’s maturity could also be reduced. Although the level of repayment would be tied to specific events, the objective would be to create an offsetting liability rather than match the risk in the loan portfolio dollar for dollar. “While it’s possible to do that, it would make the structure rather complex and probably harder to sell,” says Curry.

Can credit derivatives offer protection on a larger universe of names?

For the bank seeking protection on a loan portfolio of less highly rated names, this approach has a number of attractions. High on the list is the lack of counterparty exposure—no worrying about whether the seller of default protection will itself default, since the buyer of protection obviously gets the money up front from the investors. In comparison with some other structures that have been sold to investors, the presence of a reference index should make pricing relatively transparent—simply plug in the current default levels from the index into the formula in the bond’s documentation, and away you go.

The cat bond approach has one problem: It doesn’t allow the buyer of protection to fine-tune its exposure. While the particular sector associated with the index could perform relatively well, the specific names to which the bank is exposed could disintegrate.

“From the regulatory capital perspective, I’m also not sure how helpful this sort of structure would be,” says William Margrabe, president of the William Margrabe Group. “If the bank is still guaranteeing the structure, then it won’t benefit in terms of regulatory capital. If the structure is put into an SPV, then the costs of monitoring its quality would be much higher.”

From the potential investors’ point of view, there is also the concern that the bank might try to “lemon pick” credits that it already had concerns about for inclusion in the reference index. Unlike a conventional cat bond, where payment (or lack of it) is tied to damage caused by something beyond the control of the issuer, such as a hurricane, there is scope here for the issuer to tilt the playing field.

4. Can credit derivatives conceal excessive exposure to a single credit name?

With the plethora of banking mergers in the last year or two—and no sign that they are abating—a number of people have begun wondering whether senior managers are sufficiently aware of the off-balance-sheet exposures associated with credit derivatives. “When banks merge, they are relatively sophisticated about looking at the assets on their balance sheet and calculating their potential combined exposure post-merger, but the rigor they bring to their off-balance-sheet portfolios can be more variable,” says Tower Group’s Roby.

The potential risks go beyond the simple aggregated position of two banks that both have off-balance-sheet synthetic long exposure to a particular credit via credit derivatives. What is written into the credit derivatives contract often depends specifically on what is written into the underlying loan contract in terms of the covenants. As a result, there is an increased likelihood that the credit derivatives in the merging banks’ portfolios will have a level of optionality and detail in the structure quite different from a vanilla derivative. “In a merger situation, you need a separate discipline to evaluate accurately your aggregate exposure to these particular instruments,” says Roby. “If you don’t, your combined operation could inadvertently end up with an inordinately heavy exposure to a particular credit.”

Can credit derivatives conceal excessive exposure to a single credit name?

Some see this concentration risk as an overdone concern and take the view that derivatives have been around, off-balance-sheet, for a long time and that credit derivatives are no better or worse in this respect. Their argument is that due diligence will pick up the credit derivatives exposure just like any other derivative. However, another angle on mergers for a buyer of protection is potentially more problematic. Someone buying credit protection from Bank A on Bank B will only lose out if two things happen—Bank B’s credit starts to deteriorate to the level at which exercise of the contract proves necessary, or Bank A goes out of business and cannot honor its end of the deal. In the event of a merger, however, the third party’s protection evaporates in a stroke as Banks A and B cease to exist as separate entities. This concern has become so prevalent that provision for it has started to appear in some documentation as a “seller merger event.” In such circumstances, a selection of dealers is usually polled for a price on the residue of the original trade’s term for the merged entity, which is marked-to-market against the previous rate set on the protection.

Was this information valuable? Subscribe to Derivatives Strategy by clicking here!