Documente Academic
Documente Profesional
Documente Cultură
Principal
MFAS Investment Advisors
∗
The author would like to thank Marie B Stewart and Douglas J Lucas of J P Morgan, New York
and Linda A Mead of J P Morgan, Sydney for providing information on synthetic credit-linked
structures.
1
This is consistent with the trends in the global credit derivatives market.
Worldwide, the aggregate notional value of credit derivatives outstanding was
US$810 billion (as at 31 December 2000).4 It is estimated that this figure will
reach US$1.97 trillion this year and US$2.55 trillion in 2002.5 Table I sets out a
breakdown of the credit derivatives outstanding worldwide as at the end of 2000,
while Table II provides a breakdown of worldwide credit derivatives transactions
for the calendar year 2000.
Credit derivatives are chiefly used by financial institutions to unbundle and lay-off
the relatively static credit risk on their loan portfolios (including residential
mortgage loans, commercial loans, car loans, credit card receivables, and margin
1
Australian Financial Markets Association, 2000 Australian Financial Markets Report: Overview
(2001), p 28.
2
Ibid, pp 27-28.
3
Id.
4
Sources: Risk Waters Group; British Bankers’ Association.
5
Source: Lehman Brothers. This growth is likely to be assisted by the increase in default rates
due to the present economic slowdown in the United States: “Derivative Trades rise with
Defaults”, CreditRisk, March 2001. See also “The Swaps Emperor’s New Clothes”, Economist, 10
Feb. 2001.
2
6
G R Duffee and C Zhou, “Credit Derivatives in Banking: Useful Tools for Managing Risk? (Haas
School of Business, University of California, Berkeley and Anderson Graduate School of
Management, University of California, Riverside, 1999). Credit derivatives are also used by
monoline insurers to lay-off the static credit risk on credit-wrapped bonds: Standard & Poor’s,
“Bond Insurers and Credit Default Swaps” (Nov. 2000).
7
See further “Credit Derivatives: Vanilla Volumes Challenged”, Risk, Feb. 2001.
8
For a discussion of the different types of credit derivatives (viz, credit default products, credit
spread products, total rate of return swaps, and credit-linked notes) and the regulation of credit
derivatives in Australia, see P U Ali, “Unbundling Credit Risk: The Nature and Regulation of
Credit Derivatives” (2000) 11 JBFLP 73. See also F Iacono, “Credit Derivatives” in R J Schwartz
and C W Smith (eds), Derivatives Handbook: Risk Management and Control (John Wiley & Sons,
1997); PricewaterhouseCoopers, The PricewaterhouseCoopers Credit Derivatives Primer (1998),
pp 6-40; Deutsche Bank, Credit Derivatives and Structured Credit: A Survey of Products,
Applications and Market Issues (1999), pp 9-16 and 19-22; J P Morgan Chase, The J P Morgan
Guide to Credit Derivatives (Risk, 1999), pp 12-23; S Das, “Credit Derivatives – Products” in S
Das (ed), Credit Derivatives and Credit Linked Notes (2nd ed., John Wiley & Sons, 2000), pp 10-
39; Citigroup, “A Banker’s Primer on Credit Derivatives” (June 1999); G Dufey and F Rehm, “An
Introduction to Credit Derivatives” (University of Michigan Business School, 2000); P J
Schonbucher, “Credit Risk Modelling and Credit Derivatives” (University of Bonn, 2000), pp 60-
65; UBS, “Isolated Transfer of Default or Spread Risk” (June 2000).
3
A financial institution or fund manager that holds a credit spread put option is
entitled to sell the spread on a reference credit (eg a loan to the bidder, or debt
securities issued by the bidder) to the writer of the option, for the amount by
which the actual spot spread exceeds the strike price of the option. The amount
9
S K Aggrawal, “Credit Derivatives move beyond Plain Vanilla” The Stern Journal, Spring 2000,
at 51.
4
received from the exercise of the option therefore compensates the holder for
any loss of value on the reference credit, due the ratings downgrade of the
merged entity and the consequent widening (ie deterioration) of the spread on
the reference credit.
As noted above, credit derivatives are mainly used to manage static credit
exposures, exemplified by the credit risk on bank loans. Now, however, financial
10
See further P U Ali, “Cross-Border Finance and Hedging Currency Convertibility Risk” (2001)
29 ABLR 162.
5
market participants have begun to use credit derivatives to manage the dynamic
credit risk on market instruments, primarily other OTC derivatives.11 Market
instruments are marked-to-market on a regular basis, meaning that not only the
level of credit exposure but also which of the counterparties is obligated to the
other may change from valuation to valuation (in contrast to, say, a commercial
loan where the loan balance and the roles of creditor and debtor do not change
as a result of changes in the value of the funded asset).
Credit derivatives, such as total rate of return swaps, can be used to create
leveraged positions.12 In a total rate of return swap, one of the counterparties is
obligated to pay the other amounts equivalent to the return on a reference credit,
in exchange for periodic interest payments referable to the first counterparty’s
cost of funds in respect of the reference credit. The first counterparty is
11
These swaps are known as “credit intermediation swaps”. See further J P Morgan Chase, op cit
n 8, pp 17-19; S Das, “Credit Derivatives – Applications” in Das, op cit n 8, pp 196-200; Prebon
Yamane, “Using Credit Derivatives to manage Dynamic Market Contingent Risk” (Jan. 2000).
12
Ali, op cit n 8, at 77. See also Prebon Yamane, “Using Credit Derivatives to achieve Leverage”
(Jan. 2000).
6
consequently able to lay-off the credit risk on the reference credit via the receipt,
from the second counterparty, of a guaranteed minimum rate of return.
However, the total rate of return swap can also be characterised as a leveraged
financing of the reference credit – the first counterparty has, in effect, funded the
acquisition by the second counterparty of the reference credit. During the term of
this in-substance loan, the second counterparty makes interest payments on the
loan to the first counterparty. The second counterparty also bears all the risks
associated with ownership of the reference credit ie it is entitled to all income and
any upside performance but also bears the full risk of downside performance.
The loan is discharged through the “sale” of the reference credit on maturity, with
the second counterparty retaining any increase in value or absorbing any fall in
value. Indeed, in practice, total rate of return swaps are more often used to
create leveraged exposure to reference credits, rather than to hedge the credit
risk on such credits.
13
Das, op cit n 11, pp 214-215. For a discussion of more complex yield enhancement structures
involving credit spread products and credit exchange swaps, see Prebon Yamane, “Using Credit
Derivatives for Yield Enhancement” (Jan. 2000).
7
redemption payment by either a fixed amount or the fall in the value of the
defaulted security. The attractiveness of these swaps to investors is increased
by the fact that they pay an enhanced coupon, in excess of the coupon on the
underlying basket securities. This enhanced coupon compensates for the fact
that, because of their first-to-default structure, such swaps are of a lesser credit
quality than the individual basket securities.
Credit derivatives can also be used to exploit funding and capital arbitrage
opportunities.14
Funding arbitrage
Lower-rated banks have a higher cost of funds than more highly-rated banks.
This makes it difficult for the former to achieve positive spreads on loans to
highly-rated corporations. Such banks are faced with two unpalatable
alternatives – that is, making sub-economic loans to highly-rated borrowers, or
exiting the highly-rated segment of the corporate market and risking a
deterioration in their loan portfolios through a greater concentration on lower-
rated borrowers.
14
Das, ibid, pp 200-206; Prebon Yamane, “Using Credit Derivatives for Capital and Funding
Arbitrage” (Jan. 2000).
8
swap, in contrast to a loan, does not need to be funded, thus minimising the
impact of the lower-rated bank’s unfavourable cost of funds. Moreover, the
assumption, under the swap, of an exposure to a high quality credit should
enhance that bank’s loan book as well as its risk-return profile. In addition, the
highly-rated bank is able to diversify its portfolio (by reducing its aggregate
exposure to that corporation or to a particular industry or geographic region) and
may also be able to maximise its relative funding advantage where the fee paid
by it for protection under the swap is less than the spread on the loan.
Banks can also use credit derivatives to arbitrage the different risk capital
requirements applicable to their banking and trading books.
15
APRA, APS 110.6; APS 112.3; AGN 112.1.29.
16
APRA, AGN 113.1.1; AGN 113.4.2, 113.4.14 and 113.4.18.
9
Synthetic assets – tailored to meet the needs of fund managers and other
investors – can be created by securitising credit derivatives. These synthetic
assets, called “credit-linked notes”, fall into two categories:
17
Deutsche Bank, op cit n 8, p 15; Moody’s Investors Service, “Understanding the Risks in Credit
Default Swaps” (March 2001), at 1. The Moody’s paper contains a detailed discussion of the risks
associated with credit default swaps embedded in credit default-linked notes and backing
synthetic credit-linked notes. Recent examples of credit default-linked notes include: Enron Credit
Linked Notes Trust; Freddie Mac’s MODERNs (Mortgage Default Recourse Notes); Lehman
Brothers’ RACERS (Restructured Asset Certificate with Enhanced Returns). See also KBC
Derivatives, “Take More Equity for Credit” (Feb. 2001).
18
S Das, “Credit Linked Notes – Structured Notes” in Das, op cit n 8, pp 85-87.
10
Both these types of credit-linked structured notes, like credit default-linked notes,
pay an enhanced coupon. In the case of total return credit-linked notes, the
notes will, on maturity or following the occurrence of a credit event, be redeemed
for the market value of the reference credit. Investors holding such notes thus
participate fully in any upside or downside performance of the reference credit.19
Alternatively, credit default-linked notes and total return credit-linked notes may
be physcially-settled – where the notes are redeemed by the delivery to the
investors of a rateable share of the securities or other assets comprising the
reference credit.
In the case of credit spread-linked notes, the notes will, on maturity or following
the occurrence of a credit event, be redeemed for an amount adjusted to take
account of the then spread on the reference credit. The investor thus gains if the
spread has narrowed (ie improved) but loses if the spread has widened (ie
deteriorated).20
19
Ibid, pp 73-76. The pay-out under a total return credit-linked note may also be leveraged, with
the investor receiving a multiple of the positive or negative change in value of the reference credit
at the time the note is redeemed (called “leveraged total return credit-linked notes”): ibid, pp 76-
78.
20
Ibid, pp 80-83.
11
Alternatively, the terms on which the notes have been issued may provide that
the notes will be redeemed for their face value only on maturity, notwithstanding
the earlier occurrence of a credit event. Such notes will, however, usually also
provide that the investor will, if no credit event has occurred, receive a boosed
principal amount (eg 120% of the face value of the notes) or the face value of the
notes plus an amount reflecting a share of the upside performance of the
reference credit.
21
These credit-linked notes are analogous to capital-protected equity-linked notes: for example,
Solar protected notes where only the coupon is at risk (the coupon is linked to the price
performance of a basket of shares) and Neptune and Rainbow protected notes which do not pay
a coupon but where the investor shares in the upside price performance of a basket of shares.
See further Credit Lyonnais, “New Correlation Structures for Equity-Linked Notes” (Jan. 2001).
22
J M Tavakoli, Credit Derivatives: A Guide to Instruments and Applications (John Wiley & Sons,
1998), pp 206-207; Das, op cit n 18, pp 87-88. See also First Union Securities, “Maximizing
Return and Managing Risk with CLO Principal Protected Notes and Other Synthetics” (July
2000).
12
If no credit event occurs during the term of the notes, the notes will be redeemed,
on maturity, for their face value. If, however, a credit event does occur, the notes
will be immediately redeemed for their face value less the amount referable to
the SPV’s obligations to the financial institution under the above credit derivative.
Such notes pay an enhanced coupon (funded by the fee paid by the financial
institution under the credit derivative and the return of the investment of the
subscription proceeds of the notes).
Synthetic credit-linked notes are usually issued in multiple tranches, with the
above financial institution retaining the most junior tranche (called the “first loss
position” or the “equity piece”). In some structures, the financial institution may
also retain the most senior tranche (called the “super senior position”).24
23
See Ali, op cit n 8, at 77-78; P U Ali and M Tisdell, “Collateralised Debt Obligations, with an
Overview of the CONDOR Securitisation Programme” (2000) 18 C&SLJ 371, at 372. See also
Das, op cit n 11, pp 207-210; Prebon Yamane, “Using Credit Derivatives to create Synthetic
Assets” (Jan. 2000).
24
For a more detailed description of the various synthetic structures, see P U Ali, “The Future of
Loan Portfolio Management: An Overview of Synthetic Collateralised Loan Obligations” (2001) 12
JBFLP 58. See also Basel Committee on Banking Supervision, Consultative Document: Asset
Securitisation (Bank for International Settlements, Jan. 2001), pp 25-28.
13
The vast majority of synthetic credit-linked notes have involved the securitisation
of the static credit risk on loan portfolios25 or debt securities portfolios (including
corporate bonds and asset-backed securities),26 although, in a small number of
25
Recent examples of such programmes include: Amstel (ABN-AMRO Bank); BAC (Bank of
America); Banco Santer Central Hispano; Bankgesellschaft Berlin; BISTRO (J P Morgan Chase);
Blue Stripe (Deutsche Bank); CAST (Deutsche Bank); Castle Harbour (Bank of America); CHLOE
(Credit Agricole Indosuez); Cygnus (KBC Bank); Eurohypo; Euroliberte (BNP Paribas); Europa
(Rheinische Hypothekenbank); Globe (Deutsche Bank); HAT (UBS); HIGHTS (Bank of America);
Hesperic (Banco Santander); HK Synthetic MBS (ABN-AMRO Bank); IGLOO (Natexis Banques
Populaires); IKB Deutsche Industriebank; Leonardo (Banca Commerciale Italiana); Lunar (Bristol
& West); Marylebone (Abbey National); NATIX (Natexis Banques Populaires); Neuschwanstein
(Bayerische Landesbank Girozentrale); Olan (BNP Paribas); Promise (Kreditanstalt fur
Wiederaufbau); Scala (Banca Commerciale Italiana); SERVES (Bank of America); Sherpas
(Provident Bank); Sirius (Credit Lyonnais); Silver Eagle (Dresdner Bank); Sundial (Rabobank).
See further B Masters and K Bryson, “Credit Derivatives and Loan Portfolio Management” in J
Francis, J A Frost and J G Whittaker (eds), The Handbook of Credit Derivatives (McGraw Hill,
1999), pp 77-80; S Das, “Credit Linked Notes – Credit Portfolio Securitization Structures” in Das,
op cit n 8, pp 144-159; Societe Generale, CBO, CLO, CDO: A Practical Guide for Investors
(2000), pp 5-8; S Henke, H P Burghof and B Rudolph, “Credit Securitization and Credit
Derivatives: Financial Instruments and the Credit Risk Management of Middle Market Commercial
Loan Portfolios (Ludwig-Maximilian University, Munich, 1998); O Melennec, “CBO, CLO, CDO: A
Practical Guide for Investors” (2000) 3 Securitization Conduit 21 (No. 3), at 26-29; C Smithson
and G Hayt, “Credit Derivatives: Implications for Bank Portfolio Management” (2000) J of Lending
& Credit Risk Management 42; R D Brown, “Managing Credit Risk with Synthetic Collateralized
Loan Obligations” (Federal Reserve Bank of Philadelphia, 2nd Qtr, 2000); “Synthetic Structures
drive Innovation”, Risk, June 2000; Moody’s Investors Service, “Synthetic CDO’s: European
Credit Risk Transfer ‘A La Carte’” (July 2000); “Squeezing the Balance Sheet from Both Sides”,
Euromoney, Sept. 2000; “CDO Market looks to New Structures”, Risk, Dec. 2000; Fitch IBCA,
Duff & Phelps, “Synthetic CDOs: A Growing Market for Credit Derivatives” (Feb. 2001), at 4-7.
26
Recent examples of such programmes include: Amadeus (Bank Austria); Blue Eagle (Barclays
Bank); Brooklands (UBS); CABRAL (ESAF and Investil); EPOCH (Morgan Stanley Dean Witter);
Equinox (Rabobank); European Dream (Westfalische Hypothekenbank); Fidex (BNP Paribas);
Padova (Banca Antoniana Popolare Veneta); Segesta (Banca 121); TORUS (Toronto-Dominion
Bank); Nerva (Barclays Bank); North Street (UBS); PARIS (Natexis Banques Populaires); Repon
(Deutsche Bank); Rivera (BNP Paribas). These programmes usually have the ability to securitise
14
transactions, such notes have been issued in respect of the dynamic credit risk
on derivatives books.27
the credit risk in respect of both loans and debt securities, although they are heavily tilted towards
the latter.
27
Recent examples of such programmes include: Alpine (UBS); Europower (Morgan Stanley
Dean Witter); HAN (Korea Development Bank); Palmyra (Citigroup); Tagus (Banco Comercial
Portugues, ESAF and AF Investimentos). See further S Das, “Credit Linked Notes – Repackaged
Notes and Repackaging Vehicles” in Das, op cit n 8, pp 118-120; Fitch IBCA, Duff & Phelps, op
cit n 25, at 3-4.
15
Table II: Breakdown of credit derivatives transactions for 2000 (by notional value)