Greg N. Gregoriou is Professor of Finance in the School of Business and Economics at the State University of New York, Plattsburgh. He holds a Ph.D. in finance from the University of Quebec in Montreal. Gregoriou specializes in hedge funds, funds of hedge funds, and managed futures. He has published 26 books and over 50 journal articles. He is also hedge fund editor for the peer-reviewed publication Journal of Derivatives and Hedge Funds and editorial board member of the Journal of Wealth Management and the Journal of Risk Management in Financial Institutions.

Paul U. Ali is an Associate Professor in the Faculty of Law at the University of Melbourne, Australia, and a member of its Centre for Corporate Law and Securities Regulation. Previously, he practiced law in Sydney. Ali has published numerous books and articles on banking and finance law, corporate governance and institutional investment law, securitization law, and structured finance law.

THE CREDIT DERIVATIVES HANDBOOK

Global Perspectives, Innovations, and Market Drivers

The McGraw-Hill Companies, Inc.

Copyright © 2008 The McGraw-Hill Companies, Inc.
All right reserved.
ISBN: 978-0-07-154952-3

Contents

Chapter One

The Changing Face of Credit Default Swaps

Paul U. Ali and Jan Job de Vries Robbé

ABSTRACT

Trading in credit default swaps, the most common type of credit risk transfer derivative, has grown explosively over the last decade. Much of this growth is attributable to the development of standardized market documentation for both "vanilla" and exotic variants of credit default swaps, the new source of liquidity provided by hedge funds, the inherent flexibility of credit default swaps, which allows for highly customized trades in credit risk geared to match the risk appetites of market participants, and rapid product innovation. This is well illustrated by three new types of credit default swaps, which form the subject of this chapter.

INTRODUCTION

The global market for credit derivatives and securitized products incorporating credit derivatives has grown explosively over the last decade. This rapid growth has been accompanied by an equally rapid level of innovation in that market, which has seen credit derivatives evolve beyond their original vanilla structures to reference complex financial assets, including securitized and other structured finance products, and also be incorporated into increasingly complex securitization structures to deliver highly customized credit exposure to investors. Both the high levels of transaction volumes and the high degree of product innovation have benefited considerably from the standardization of documentation for credit derivatives under the supervision of the International Swaps and Derivatives Association (ISDA) and the continuing efforts of market participants to address operational risks.

However, the single most important factor for this expansion in transaction volumes—which has also enabled product innovation—is the inherent flexibility of credit derivatives, which has made it possible to customize the trading of credit risk to match the risk appetites of market participants. This is well illustrated by three new types of credit derivatives that form the subject of this chapter: credit default swaps on asset-backed securities, credit index derivatives, and loan-only credit default swaps. These credit derivatives are discussed on a stand-alone basis as distinct from their use in synthetic securitizations, for instance, in single-tranche structures (de Vries Robbé and Ali, 2005a; ibid., 2005b; ibid., 2006; Ali, 2007).

CREDIT DEFAULT SWAPS

Credit derivatives, in common with other over-the-counter derivatives, are privately negotiated bilateral contracts for shifting risk. In the case of credit derivatives, the risk being transferred under the derivative is credit risk, principally, the risk of nonperformance due to default or bankruptcy (de Vries Robbé and Ali, 2005a).

The credit default swap, particularly in its vanilla single-name and more recent credit index forms, is by far the most common type of credit derivative. It enables the parties to trade the credit risk of one or more entities—whether corporations or sovereign states—in isolation to the other risks associated with those entities. Basically, one party (known as the protection seller) agrees, in exchange for the payment to it of a fee by the other party (known as the protection buyer) to the credit default swap, to sell credit risk protection to the protection buyer in relation to certain debt instruments (known as reference obligations) of a third party (known as the reference entity) (de Vries Robbé and Ali, 2005a). In this manner, the protection buyer is able to transfer the credit risk, the subject of the credit default swap, to the protection seller.

The protection seller is obligated to make a payment to the protection buyer if a credit event occurs in relation to the reference entity during the term of the credit default swap. The credit events most commonly encountered in credit default swaps are the bankruptcy of the reference entity and the failure of the reference entity to make principal and interest payments on the reference obligations when due (de Vries Robbé and Ali, 2005a).

A credit default swap envisages two mutually exclusive possibilities. If no credit event occurs during the term of the credit default swap, the protection buyer will continue to pay the fee to the protection seller until the maturity of the credit default swap. If, however, a credit event does occur during the term of the credit default swap, the swap will terminate, with the protection buyer's obligation to pay the fee ceasing and the protection seller becoming obligated to make a payment to the protection buyer. The quantum of that payment will depend upon how the settlement of the credit default swap has been structured. In the case of a physically settled credit default swap, the protection seller will be obligated to purchase the reference obligations or other eligible substitute debt instruments of the reference entity for their full face value from the protection buyer (de Vries Robbé and Ali, 2005a). In contrast, in the case of a cash-settled credit default swap, the protection seller will be obligated to pay either an amount calculated by reference to the fall in value of the reference obligations or a fixed proportion of the face value of the reference obligations (de Vries Robbé and Ali, 2005a).

Stand-alone credit default swaps are typically physically settled, while the credit default swaps used in synthetic securitizations are normally cash settled (de Vries Robbé and Ali, 2005a). There is, however, now a trend in the case of stand-alone credit default swaps away from physical settlement. A key reason is that the difficulty with sourcing illiquid debt instruments for delivery under the swap may impact negatively upon the transfer of credit risk. Once a credit event occurs, the protection buyer—in the case of a physically settled credit default swap—must deliver the requisite debt instruments to the protection seller within the time period provided for in the contract terms. Failure to do so will cause the protection buyer to lose its right to obtain payment from the protection seller and, consequently, the benefit of credit risk protection under the credit default swap (Deutsche Bank v. Ambac Credit Products, 2006). Cash settlement also avoids the risk of there being a run on the debt instruments of a popular reference entity following a credit event.

In their simplest and, until recently, most common form, credit default swaps transfer the credit risk relating to single reference entities (these swaps are known as single-name credit default swaps). It is, however, eminently possible to structure credit default swaps to transfer the credit risk of multiple reference entities (multiname or portfolio credit default swaps) (de Vries Robbé and Ali, 2005a). In the case of a multiname credit default swap, the swap can be structured to terminate upon the first or any subsequent credit event with respect to any one of the reference entities (de Vries Robbé and Ali, 2005a). However, as with single-name credit default swaps, the majority of multiname credit default swaps are first-to-default swaps (de Vries Robbé and Ali, 2005a). It is also possible to structure credit default swaps to transfer the credit risk of all reference entities in a particular geographic region or market sector; these credit index derivatives are discussed below.

Credit Default Swaps on Asset-Backed Securities

The debt instruments referenced by credit default swaps have, to date, mainly comprised loans made to and debt securities issued by corporate and sovereign reference entities (de Vries Robbé and Ali, 2005a; Fitch Ratings, 2007). The last three years, in particular, have witnessed the extension of credit default swaps to more exotic reference obligations, including debt securities issued in structured finance transactions such as securitizations. This can be viewed as simply an incident of the increasing maturation of the global market for credit derivatives, with market participants designing products to permit the trading of credit risk in relation to an ever-wider range of debt instruments. It is also a consequence of the equally explosive growth in the global securitization market over the last decade.

The so-called asset-backed securities referenced by this new form of credit default swap are typically debt securities issued in cash securitizations. These cash securitizations are the most common form of securitization transaction and involve the issue of debt securities to fund the acquisition of diversified pools of income-generating assets where the cash flows generated by those assets are utilized to make principal and interest payments on the debt securities. The assets are isolated in an orphan entity, thus enabling the originator of the assets to transfer the credit risk (together with all other risks) of the assets to the orphan entity and permitting the originator to remove the assets from its balance sheet as well as, in the case of banks and other financial institutions, release the risk capital held against those assets. The assets involved in these cash securitizations are predominantly mortgage loans, credit card receivables, auto loans, and corporate loans.

Credit default swaps on asset-backed securities are, however, not only used to transfer the credit risk of the debt securities issued in cash securitizations but are also being employed increasingly to effect transfers of credit risk in relation to debt securities incorporating other credit default swaps or, in other words, in relation to funded credit default swaps. In a synthetic securitization, the proceeds of the debt securities issued by an orphan entity are used by that entity to collateralize the entity's sale of credit risk protection to, typically, a bank or other financial institution (again, the transfer of the credit risk of the reference obligations to the orphan entity permits the bank or other financial institution to release the risk capital held against those obligations) (de Vries Robbé and Ali, 2005a). The fees received by the orphan entity from its role as protection seller are used, in combination with the returns generated from the entity's investment of the proceeds from the issue of debt securities, to make interest payments on the debt securities (de Vries Robbé and Ali, 2005a). If during the term of the securities, a credit event occurs in respect of one or more of the credit derivatives entered into by the orphan entity, the payment obligations of the entity will be met out of the invested proceeds (de Vries Robbé and Ali, 2005a). The orphan entity's obligation to repay the principal amount of the debt securities to the investors is conditional upon no credit event occurring during the term of the debt securities, and accordingly, the issue of the debt securities by the orphan entity to the investors can be said to fund the orphan entity's obligations under its credit derivatives (de Vries Robbé and Ali, 2005a).

The credit default swap on asset-backed securities thus performs an important role in enabling the participants in securitizations to trade the credit risk of the debt securities issued in securitizations and also the credit risk of the underlying assets, whether these are the assets backing the securities or assets whose credit risk has been incorporated in those securities by credit derivatives (de Vries Robbé and Ali, 2005a; ibid., 2005b; de Vries Robbé, 2006; Parker, 2007). In particular, this swap enables market participants to synthesize credit exposure to debt securities that, due to those securities being illiquid, may be in short supply.

The development of credit default swaps on asset-backed securities has been greatly assisted by the publication by ISDA of contract templates dealing with the most common types of asset-backed securities referenced by those swaps (de Vries Robbé, 2006; Parker, 2007).

Among the key issues addressed in these templates is settlement. The debt securities issued in securitizations are illiquid, unlike the corporate and sovereign debt securities referenced by single-name credit default swaps. Physical settlement may be impracticable if the protection buyer cannot source sufficient reference obligations or eligible substitute obligations in the secondary market, and this lack of liquidity also makes cash settlement difficult as it will impede valuation (de Vries Robbé and Ali, 2005b; de Vries Robbé, 2006; Parker, 2007).

The first ISDA template (the so-called non-PAUG [pay-as-you-go] template) addresses this by allowing the protection buyer to elect physical settlement or synthetic delivery (where a total return swap synthesizing the total returns on the reference obligations is entered into by the parties on the termination of the credit default swap) in place of cash settlement (de Vries Robbé, 2006; Parker, 2007). This template is used mainly in the European credit derivatives market (de Vries Robbé, 2006; Parker, 2007).

The other ISDA templates (the "pay as you go" or PAUG templates) provide for an ongoing process of settlement during the term of the credit default swap with the protection seller being required to compensate the protection buyer for shortfalls suffered by the latter in relation to cash flows from the reference obligations until the termination of the swap (de Vries Robbé, 2006; Parker, 2007). PAUG settlement or physical settlement can be elected by the protection buyer in place of cash settlement for the Form I and CDO PAUG templates, while the Form II PAUG template provides only for PAUG settlement (de Vries Robbé, 2006; Parker, 2007). These three templates are mainly used in the U.S. credit derivatives market (de Vries Robbé, 2006; Parker, 2007).

Credit Index Derivatives

The second, major innovation in the global market for credit derivatives with which this chapter is concerned relates to credit index derivatives. This has involved the extension of the template for single-name credit default swaps first to multiple reference entities (as in the case of multiname credit default swaps) and then to reference entities in a geographic region or market sector as represented by a credit index (de Vries Robbé and Ali, 2005b). These credit indexes comprise the most liquid reference entities in a particular market (as determined by the extent to which such entities are referenced by single-name credit default swaps). The most important—and liquid—indexes are the CDS CDX and iTraxx credit indexes. The iTraxx credit indexes cover reference entities in Europe and Asia, while the CDX credit indexes cover reference entities in North America as well as in Africa, Asia, Eastern Europe, and the Middle East (Parker, 2007). Credit index derivatives have now surpassed single-name credit default swaps as the most widely traded form of credit derivative (Fitch Ratings, 2007).

Credit index derivatives are similar to multiname credit default swaps in that both involve the transfer of the credit risk of multiple reference entities. In the case of the latter, the credit risk transferred relates to the entities in a reference portfolio, while in the case of the former, credit risk is transferred in relation to all of the reference entities in a particular index. There is, however, a critical structural difference between these two types of credit derivatives. A multiname credit default swap involves only a single swap, while a credit index derivative is not a single swap but, instead, comprises a set of individual single- name credit default swaps referencing each of the entities that make up the relevant credit index (de Vries Robbé and Ali, 2005a; ibid., 2005b).

Even though a credit index derivative is a series of individual swaps, the parties cannot deal with one of those swaps in isolation from the other swaps (de Vries Robbé and Ali, 2005a; ibid., 2005b).

A single credit default swap can only be transferred or terminated together with an equal part of each other credit default swap forming part of the index transaction, as permitting the parties to deal with an individual credit default swap without also dealing with the other swaps would affect the weighting of the reference entities in the credit index derivative relative to their weightings in the relevant credit index (de Vries Robbé and Ali, 2005a; ibid., 2005b). That would lead to a mismatch between the credit index derivative and the credit index, meaning that the former would no longer transfer credit risk in respect of the market or region measured by the latter (de Vries Robbé and Ali, 2005a; ibid., 2005b).

(Continues...)

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