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Contents

ONE introduction: redefining liquid credit 3 TWO customised tranches: in search of new markets 7

THREE correlation trading: casting cupolas aside 13

FOUR making sense of ratings: fine models and sharp haircuts 19

FIVE documenting portfolio derivatives: a new layer of complexity 27

SIX tracking portfolio performance: tools for analysing portfolio credit risk 33

SEVEN bring on the manager: strategies for adding value 41

Glossary 47

The Creditflux inside guide to portfolio credit swaps

Written by Lisa Cooper, Euan Hagger and Michael Peterson

Edited by Michael Peterson

Published by Creditflux Limited89 Fleet Street, London EC4Y 1DH, UKwww.creditflux.com

© Creditflux 2004

introduction: redefining liquid credit 3

Getting ahead in business – indeed, some might argue, the economic wellbeing of the human species – is mostly about inventing and finding uses for things that people did not realise they had any need for.

Take mobile telephones. e modern world could function perfectly effectively without the ability to make a phone call while crossing a street or to find out the latest sports results while sitting on a train. And if mobile telephony had never been invented, few would have felt deprived by having to find a call box or wait 20 minutes longer for news of the game on the television.

But without doubt this new technology has spurred enormous creation of value in the past 20 years and given consumers much greater choice over the use of their time and income.

In a different way, innovation in the world of credit has created value for finan-cial intermediaries of one sort or another and broadened the choices available to investors and risk managers.

Less than a decade ago credit – the debt of companies and countries – was mostly a buy-and-hold investment, available to very few institutions and offering only a limited range of risk and returns. Outside the US, few companies issued tradable debt and the credit business was largely a bank monopoly. And even in the US, few credits attracted anything like the depth of analysis or the volume of trading that you might see for even a small-cap equity. As an asset class available for investment, credit barely registered on the radar screens.

at has changed. A credit culture has spread beyond North America as banks in Europe and Asia have switched away from bilateral lending. More companies now issue bonds. e loan market is now more liquid. And there is a well devel-oped and global business of repackaging corporate debt into new investments such as collateralised debt obligations (CDOs).

One part of this credit revolution has been the rise of credit derivatives – con-tracts that pay out on the default of a corporate or sovereign borrower. Single-name credit default swaps emerged in the late 1990s as a way of transferring the

Chapter 1introduction:redefining liquid credit

4 portfolio credit swaps introduction: redefining liquid credit 5

risk of a credit instrument without the asset changing hands. ey were typically used to exploit arbitrages created by regulation of one kind

or another – double taxation treaties were a popular early target. e complex le-gal and regulatory environment of Europe turned out to be fertile terrain for the product and London emerged by the beginning of this decade as a major centre for trading credit derivatives.

By 2000 there was an active market in credit default swaps on big corporate or emerging market borrowers such as Ford, British Telecom and Argentina. ere was also trading in first-to-default baskets, where an investor would sell protection on a group of five to 10 names and make a payment if any one of those credits defaulted.

But contrary to some expectations, these original credit default swaps brought few new providers of capital to the credit market. True, a few insurers embraced credit derivatives wholeheartedly. But for the most part, investors distrusted the uncertain legal structure of credit default swaps. And many found it difficult and expensive to amass and manage a portfolio of credit using single-name products because of high dealing costs.

Credit derivatives remained a market dominated by the traditional takers of credit risk: banks. According to a survey of the market by the British Bankers’ Association in 2002, banks not only accounted for most protection bought at that time, they were also the biggest sellers of protection, using the market as a quick and diverse source of additional credit risk.

In addition, banks quickly found credit derivatives useful for offloading large chunks of their corporate loan books synthetically. e first true portfolio credit derivatives were structures such as JP Morgan’s Bistro, which allowed banks to shed the parts of their balance sheet that used up most capital – especially in regulatory terms. ese deals, usually called synthetic securitisations or synthetic CDOs, were often much easier to execute than securitisation, which would have

Originally, credit default swaps brought few new providers of capital to the credit market

Timeline: development of portfolio credit swaps

Late 1980s First CDOs launchedMid-1990s First credit derivatives traded1997 JP Morgan’s Bistro, first balance sheet synthetic CDO1999 Development of single-tranche, investor-driven portfolio swaps2000 First synthetic CDOs of ABSDecember 2000 Alpine Partners, first synthetic securitisation of swap counterparty exposureJuly 2001 Repon 17, first emerging market synthetic CDOJuly 2001 Palmyra Funding, first independently managed portfolio credit swapFebruary 2002 Jazz CDO I, first long–short managed syntheticAugust 2002 Latitude, first synthetic securitisation of shipping loansMay 2003 Index tranches launchedDecember 2003 Odysseus, first portfolio credit swap including equity default obligations

4 portfolio credit swaps introduction: redefining liquid credit 5

achieved the same effect, and had the great advantage that the bank did not even need to tell borrowers that it had sold on their loans.

Although some of these trades gained a reputation as being badly structured for investors, buyers of many of the early balance sheet syn-thetics got a bargain. Banks were will-ing to sell risk for a good price because it freed up capital, and investors got their hands on portfolios of big-cap credit much more quickly than they could by buying individual bonds or loans.

Around 2000, the profile of the typical deal changed. e shift is usu-ally described as being a change from balance sheet-driven trades, where a bank is seeking to reduce its use of regulatory capital, to an arbitrage model, where investors buy into a portfolio designed to produce the greatest possible spread.

In fact, this is a simplification. Any portfolio credit derivative can be seen in two different ways, depending on which side of the trade you talk to. Investors are looking for banks willing to hold assets on their balance sheet while, at the same time, banks are trying to take on and trade risk in a way that gives them a good return on capital.

“For players like ourselves, the role of CDO arranger has been an evolutionary process,” says Walter Gontarek, co-head of global credit products at RBC Capital Markets in London. “In the first phase, many of us executed the risk of the port-folio to a single counterparty synthetically, essentially a balance sheet exercise. e next phase resulted in a tranched execution with junior, senior and super-senior tranches in order to reduce liability costs and customise risk and return profiles for counterparties. e final and more recent phase of this evolutionary process has been more of a principal-finance model, where arrangers may retain risk within the capital structure, on a non-hedged, static delta or rebalancing basis. In this case, you may see the house buying assets when assets are cheap, and at a later time buying liabilities when they are cheap on a relative basis.”

is evolution of the market – especially the shift away from full capital struc-

Portfolio credit swaps: defining a new market

The rapid development of the structured credit derivative market has rather overtaken the terminology used to describe these trades. The term synthetic CDO does not really cover the breadth of ac-tivities involved, and suggests, wrongly, that tranches are always collateralised.

It perhaps makes more sense to use a single term to cover any instrument that transfers slices of credit portfolio risk in synthetic form. These tranched portfolio credit derivatives – or, as this guide refers to them, portfolio credit swaps – range from standardised tradable index tranches, through bespoke portfolios of liquid cred-its such as investment grade corporates, to large granular portfolios of bilateral loans and mortgages.

In this guide, our focus is mainly on the deals that reference more liquid underlying assets such as corporates and some as-set-backed securities. Pools of assets such as residential mortgage loans, which make up a significant part of the market, are a some-what different product. These small loans, which usually only one lender has time to analyse and monitor, are unlikely to become a tradable form of credit risk any time soon.

They lend themselves to an originate-and-securitise banking model, with investors buying on the basis of actuarial rather than fundamental credit analysis and benefiting from the portfolios’ huge diversity. For lenders, the choice of using credit derivatives or true-sale securitisation to lay off the risk comes down to questions of their cost of funding and regulatory environment.

6 portfolio credit swaps

tures towards individually tai-lored tranches – meant that the total notional amount of risk transferred grew at a staggering rate (see chart).

At the same time, the range of assets involved has broadened away from invest-ment-grade corporate debt as banks saw the benefit of using portfolio credit derivatives to transfer other forms of credit risk, including asset-backed securities, residential mort-gage loans and derivative counterparty risk.

Finally, it seems, the credit derivatives market is able to offer investors some-thing more useful than single name risk, and firms have responded by moving into the market in ever greater numbers.

One factor that continues to make portfolio credit attractive to new investors is healthy returns. In spite of continuing defaults, tightening credit spreads since early 2003 have meant that even the least leveraged tranches have tended to per-form very well.

According to Morgan Stanley’s calculations, investing in a 0–3% piece of the Dow Jones North America index – a leveraged, first loss tranche – would have returned a spectacular 113.1% if held throughout 2003 up to mid-December. Over the same period a mezzanine 3–7% tranche would have produced a return of 53.9%, the return on a ‘senior mezzanine’ 7–10% investment would have been 30.4%, and even a senior 10–15% tranche would have returned 15.4%.

Not surprisingly, investors and traders have flocked to this market in the hunt for yield and volatility. But will this influx turn into an outflux next time spreads start to widen and returns for investors turn negative?

Most credit derivative bankers believe that the changes that have been wrought in the credit market in the past few years mean that we will never return to the buy-and-hold bank-only model of credit. “e development of a liquid market for credit is an irreversible process,” says Farid Amellal, global head of credit trading at BNP Paribas in London. “ere will be years when credit does not perform well, and times of shock when the market becomes less liquid. But this new component of the financial market – the ability to trade credit – is something that will not dis-appear. at is no more likely than society abandoning mobile phones and going back to using only fixed line telephones.”

Farid Amellal, BNP Paribas: development of a liquid credit market is an irreversible process

Synthetic CDO volumes by month January 2002–December 2003*

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customised tranches 7

For any investor willing to take a punt on portfolio credit, mid to late 2002 was a good time. Over the previous 12 months or so, a growing number of arrangers had become willing to create single-tranche portfolio swaps. is

meant investors could pick their own portfolios and trade when they liked, rather than waiting for investors across the capital structure to get into line.

Furthermore, new market standards eliminated the risk of having names triggered by such spurious credit events as obligation acceleration. And Isda’s initiatives had also taken some sting out of restructuring as a credit event, by limiting the type and maturity of obligations that could be delivered – at least for North American reference credits.

Admittedly, these products were not a liquid investment. But an investor could take the same structure to a number of credit derivative dealers to get the best price. Worried about some of the high risk names the arranger had suggested, such as the likes of El Paso and Arrow Electronics? No problem. Simply switch them for some solid triple Bs. With average investment-grade corporate spreads in excess of 200 basis points there would still be plenty of juice in the portfolio.

Of course, back in 2002 most investors were too worried about the prospect of an imminent systemic credit meltdown to dabble in any kind of leveraged credit investment. But fast-forward a year or so, through one of the most dramatic periods of credit tightening the market has ever seen – and the picture looks very different. A large number of investors are now interested in buying tranches, but if the same reference assets and structures are used, the economics are no longer as compelling. Riskier credits – even high-yield names – are back in vogue. New structures and techniques are being developed to cram more risk into tranches.

Another change may be that dealers are no longer desperate for your business. Most have about as much demand for double-A risk as they can cope with.

“Customer appetite for single-tranche trades was not the issue last year [2003],” says Mitch Janowski, head of correlation trading at Citigroup in London. “e limitation on this market was the capacity of the dealer community to process

Chapter 2customised tranches:in search of new markets

8 portfolio credit swaps customised tranches 9

and manage these trades, for example, putting on and adjusting all the single-name hedges.”

In early 2004, after three years of phenomenal growth, the market for tranches based on unique portfolios seems to be pausing for breath. Trades referencing pure corporate portfolios have become a rarity as a result of low spreads on individual credit names.

Some of the most popular trades of the past year have been those referencing pools which themselves consist of corporate portfolio tranches – also known as synthetic CDOs squared – along with a pool of highly rated asset-backed securities. ese deals are structured to produce tranches with a good yield for their rating (see Chapter 4). However, bankers stress that price is not the only consideration for investors in these structures. “Because they include many more names than a typical corporate CDO, deals backed by other CDOs are always likely to make sense from a diversification point of view,” says Andre Van Damme from BNP Paribas’ structured credit solutions group.

Besides greater diversity, single-tranche investors have increasingly demanded other features designed to protect their investments against credit deterioration. One increasingly popular option is for the investor to gain the right to make a small number of substitutions in the portfolio during the life of the deal. “It is inevitable that self-managed deals will come to supersede static deals,” says Antoine Chausson, regional head of structuring at BNP Paribas in London. “e right to make substitutions is a valuable option which more and more investors will come to demand.”

Self-managed tranches are said to be popular among bank loan portfolio managers, who tend to have a lot of credit expertise in-house and want an efficient way to source additional credit. But this style of deal is not suitable for all investors. “A hundred names is a lot to monitor on an ongoing basis,” points out Tina Rydberg, regional head of structuring at BNP Paribas in London. “Many investors may not have the capability to analyse so many credits on an ongoing basis and would prefer to employ a manager to manage the portfolio.”

As a result, there have been some examples of single-tranche deals with a third-party manager. ese deals differ from full-blown managed synthetics (see Chapter 7) in that they are managed on a defensive and highly selective basis. Transactions tend to be private, and the dealer typically signs up a manager or panel of managers in advance so that the investor can complete the trade quickly.

“ird-party management can make a lot of sense for single-tranche deals,” says Manish Chandra, regional head of structuring at BNP Paribas. “ese deals are generally much faster to execute than full-capital structure transactions. Clearly, however, the manager needs to be comfortable working closely with the dealer, since all trading decisions have an impact on how the tranche is hedged.”

But as market-implied default risk has declined, investors have become a little less worried about portfolio deterioration and more concerned about finding ways to increase the returns from their assets. As a result, structurers and investors are

Tina Rydberg, BNP Paribas: 100 names is a lot to monitor on an ongoing basis


now exploring a range of different portfolio investment ideas, some of which may become mainstream features of the market in future.

One avenue is more actively managed structures, including an ability for the vehicle to benefit from taking short credit positions – something a few independently managed deals can already do. “In a low-spread environment, a CDO that is able to make greater use of short positions makes increasing sense,” says Alberto Matta, from BNP Paribas’ structured credit sales group in London. “For investors who are not able to go out and short individual names themselves, it could provide a means to put on relative value trades between different credits.”

Another idea is to set up synthetic versions of market value CDOs. ese vehicles are a close relative of cashflow CDOs, but are more actively managed and tend to include a broader range of assets. e key difference from a cashflow CDO, where assets are valued at par, is that in a market value deal, managers mark the collateral to market on a daily basis.

“We can expect to see more market value structures in future,” says Perry Inglis, managing director at Standard & Poor’s in London, “and this may include synthetic market value CDOs. In fact, synthetic deals already have some market value-like elements, such as the ability to liquidate collateral in a credit event.”

For single-tranche portfolio investments, one structure that could be valuable to investors worried about rising spreads is a floating-premium deal, also known as a constant maturity credit default swap. In early 2004 a number of credit derivative dealers were putting together deals of this kind referencing linear portfolios of credit. ere are, however, a number of obstacles to applying the same approach to a tranched portfolio.

As well as trying to devise new structures, arrangers of portfolio credit swaps are putting a lot of effort into broadening the range of investors in these products. is is not simply a matter of increasing the absolute number

of trades. It is also because the preponderance of investors who buy at the senior mezzanine level – usually defined as somewhere from single A to triple A – makes it harder for dealers to balance the correlation of their books (something which has also triggered the development of the index tranche market – see Chapter 3).

“One key to success in the structured credit business that we feel will become increasingly important is distribution capacity across the capital structure,” believes Walter Gontarek, co-head of global credit products at RBC Capital Markets in London. “Organisations that are able to distribute across the whole risk spectrum will fare better than those that focus on the same narrow part of the capital struc-ture - the key benefit to the arranger being the ability to pro-actively mitigate cor-relation and sudden-default risks which become embedded in a non-linear credit book. In addition, there may be accounting and valuation benefits for some houses sensitive to these issues.”

e hunt for new investors has already driven structured credit marketers to many new parts of the world in 2003. Although bankers are usually coy about who

Manish Chandra, BNP Paribas: third-party management makes senses for single-tranche deals


buys their deals, it is thought that non-Japanese Asian investors have been among the most receptive to tranched credit in 2003. China, in particular, seems to be one of the fastest-growing sources of demand for the product.

Meanwhile Australia has become a key market for many credit derivative deal-ers, as demonstrated by the large number of trades priced in Australian dollars.

Australia and New Zealand are almost unique in that retail investors in these two countries have bought into tranches of portfolio credit swaps. Deutsche Bank’s Nexus transaction, which was sold to Australian retail investors in December 2002, was the first deal anywhere to be structured as a public retail bond offering. Deutsche and ABN Amro have since issued a number of other deals to individual investors in the region.

e emergence of a retail market for portfolio tranches in other parts of the world is one of the great hopes of most structured credit marketers. However, for now Australia and New Zealand seem to have a uniquely favourable regulatory environment for retail structured credit.

In other countries, there is evidence that the authorities are becoming more wary of the concept rather than more tolerant. In Italy, for example, some dealers had a healthy business selling portfolio credit exposures to Italian insurance

companies, which then repackaged the risk as structured insurance policies and sold it to retail investors. However, the Italian insurance regulator clamped down on this practice in mid 2003. And in the wake of defaults by Italian companies Cirio and Parmalat, the Italian authorities seem likely to remain sceptical of the benefits of individuals buying leveraged credit investments in the near future.

Nevertheless, as many bankers point out, structured credit can be a much more suitable product for retail than many other structured investments that they routinely buy. “If regulators can be convinced that structured credit is a suitable product for retail investors, retail will become one of the largest markets for this product – and certainly a very interesting one,” says BNP Paribas’ Matta.

In the absence of a real mass market for credit portfolio swaps, many deal-ers are targeting the next best thing: smaller institutions and private banks. “A true retail market for portfolio credit tranches may be some way off,” says BNP Paribas’ Chausson. “But we are seeing the emergence of a non-institutional client base. is is an intermediate sector consisting of investors such as high-net-worth individuals that have shown an appetite for other structured risk such as foreign exchange, equity or interest rates.”

Some bankers believe that a highly standardised and transparent form of portfolio credit – such as an investment based on credit indices – will be the best way to broaden the investor base. An alternative view is that the rise of retail or quasi-retail demand will go hand-in-hand with the emergence of more hybrid structures, such as those mixing credit and equity risk (see box).

“As the investor community widens to include more individual investors and small institutions there will be an increasing need for products that can achieve several different components of risk exposure,” says Farid Amellal, global head

Antoine Chausson, BNP Paribas: a true retail market may be some way off


of credit trading at BNP Paribas. “Increasingly, we can expect to see products with payoff linked to a wide variety of asset classes, including not only credit, but also risks such as interest rates, inflation, foreign exchange and equity.”

As well as developing structures that combine credit with other risks, dealers are working hard to create a market for portfolio credit swaps linked to assets other than investment grade corporates.

e most promising area to date has been ABS, an asset class that BNP Paribas began incorporating in trades as long ago as 2001. However, only a handful of asset-backed securities are liquid enough for dealers to delta hedge – and these tend to be highly rated securities which do not produce much yield. As a result, asset-backed securities are usually referenced only in deals that also include bespoke portfolio tranches as reference obligations.

Even so, bankers report some signs of growing demand for portfolio credit beyond the established asset classes of investment grade corporates and ABS. “e number of names that are liquid enough to include in portfolio tranches has increased substantially,” says Chausson. “ere are perhaps 700 or 800 investment-grade corporates now compared to no more than 200 a few years ago. Moving beyond the universe of investment-grade corporates and liquid asset-backed securities, the uni-verse is extending – albeit at a slower pace than for non-investment grade reference entities: fallen angels, high-yield and emerging market names are getting more attention amongst credit investors.”

Mixing credit and equity

One idea that has gained a lot of recent interest, at least among credit derivative dealers, is creating portfolios of so-called equity default swaps. These are equity derivatives documented in a way similar to credit default swaps. However, instead of being triggered by a credit event such as failure to pay or bankruptcy, the key trig-ger is a fall in the reference entity’s share price below a certain threshold. The product was devised by JP Morgan, but several other dealers have also traded the product.

Dealers have also persuaded rating agencies to rate portfolios of these swaps. “Equity default swaps use very well known tech-nology,” says Marc Freydefont, senior credit officer at Moody’s in London. “Equity put options with a digital payment – known as barrier options – have existed in the equity derivatives market for a long time. What is new here is that the barriers are set very low. This gives the product characteristics closer to that of a credit de-fault swap.”

Typically, equity default swaps are structured with binary recov-ery rates. “One of the interest drivers of this type of transaction is that people like unambiguous trigger events that are not subject to different legal interpretations,” says Paul Mazataud, managing di-rector at Moody’s in Paris. “For the same reason, there is a desire for simple recovery rate definitions, such as a fixed recovery rates.”

Like Moody’s, Standard & Poor’s produced a methodology for rating portfolios of equity default swaps in early 2004. “We have been asked to look at a wide range of different types of portfolio,” says Kai Gilkes, head of analytics at S&P in London.

Significantly, one of the first public deals using a portfolio of equity default swaps references a portfolio of Japanese companies in a deal being put together by Daiwa Securities in early 2004. The key driver of the equity default swap product is low credit spreads – a particular feature of Japanese names.

Equity default swaps have higher premiums than credit deriva-tives and so portfolios of these swaps provide a higher yield than a comparable credit portfolio. But the higher spreads are the result of higher risk: equity default swaps are much more likely to trigger than credit default swaps. Therefore, the challenge for dealers is to find investors willing to buy into the structure.

“Traditional CDO investors are not the most obvious base for equity default swap portfolios,” says Tina Rydberg, regional head of structuring at BNP Paribas. “However, in a tight credit environment, there may be opportunities and a new client group who would find this risk very appealing.”


CASE STUDY

An Overture to the mass market?

“The big vision,” as one structured credit marketer puts it, “is to bring structured credit to the masses, as a core asset class in its own right.” One barrier preventing this vision from becoming reality is the lack of transparent pricing for synthetic CDOs. A 3 billion transaction called Overture, which was arranged by JP Morgan at the end of 2003, stands out as one of the more interest-ing experiments in trying to remove that barrier.

The hybrid cash and synthetic CDO, which is man-aged by Axa Investment Managers, is not only one of the largest CDOs issued to date, but also the first trans-action to be distributed on a syndicated basis.

“We wanted to move to a liquid, transparent product that is open to a large class of investors,” says Laurent Gueunier, head of investment grade CDOs at Axa Investment Managers in Paris. “A large number of first time buyers of CDOs came into the deal. This was an ambitious but successful exercise that introduces transparency and offers a benchmark.”

In Overture’s case, seven regional co-lead manag-ers were brought into the deal: Wachovia Bank in the US; CDC-IXIS, ABN Amro and Bayerische Landesbank in Europe; Standard Chartered Bank in the Middle East; Mizuho Securities in Japan; and the Develop-ment Bank of Singapore in Asia ex-Japan.

Roughly 150 investors around the world placed or-ders for the deal, and 96 were allocated investments. By the standards of the synthetic CDO business, where distribution to more than a handful of buyers is a rarity, that represents an enormous number.

Axa IM’s Gueunier says that roughly a third of the investors in the CDO were first time buyers of struc-tured credit. High net worth individuals were well represented among these new buyers.

Oldrich Masek, co-head of CDO origination, structuring and execution at JP Morgan, says the trans-action is analogous with landmark deals that have been executed in the asset-backed securities market,

which have expanded the investor base for ABS distri-bution by using multi-managed, multi-currency, fixed and floating rate tranches sold globally.

In fact, compared with the ABS market, Overture represents a much more ambitious attempt at primary and secondary market development. “Overture shows that there is another model to sole-managed transac-tions that offer limited liquidity, and that we can move towards a more mature market with broader product identity,” says Masek. “The key difference with Over-ture is the transparency that the syndicated approach provided. Extending the ability to disaggregate the deal beyond a single dealer is good for pricing trans-parency, and the more that people can model a deal up, the more they can trade it.”

Using a syndicate group introduced some good pricing tension, adds Masek. “Some of the debt tranches were six to seven times oversubscribed, so that helped to drive the price in. It was a classic syndi-cated mechanism.”

Oldrich Masek, JP Morgan: the difference is transparency

correlation trading 13

Default correlation – the extent to which defaults cluster together – is hardly a new concept. Correlation is one of the first risks any credit investor starts to think about when building up a portfolio of credit. So it

may come as a surprise to some credit veterans to hear that correlation became the great buzzword of the credit derivatives market during 2003.

What has made correlation such a hot topic is the development of a new kind of portfolio credit derivative market in mid-2003. is has, for the first time, made it possible to infer the market’s view of the correlation of credit portfolios as well as its view of individual default risk.

From around June 2003, dealers began to trade tranches with each other using standard portfolios and standardised terms such as attachment and detachment points. e trades were done using so-called credit derivative indices – pre-agreed portfolios whose composition remains fixed for a period of six months – such as the North American and European Dow Jones Trac-x indices, and later the iBoxx indices.

What is so exciting about index tranches is that they allow traders to make market-based assumptions about the risk of default correlation in the portfolio as well as the overall default risk. at has brought new firms – notably hedge funds – to the structured credit market.

“e development of a market for credit derivative index tranches has allowed more sophisticated investors to look at correlation as a tradable risk feature for the first time and to arbitrage differences in pricing of correlation between differ-ent tranches,” says Farid Amellal, global head of credit trading at BNP Paribas in London.

e big driver for the growth of this market was the need by credit derivative dealers for observable market prices that would validate their strategies for hedg-ing the portfolio tranches they were selling to investors.

Some time around 2001, dealers realised that they did not need to sell entire capital structures of portfolio credit risk. ey could issue investors with a tranche

Chapter 3correlation trading:casting cupolas aside

14 portfolio credit swaps correlation trading 15

of their chosen seniority and hedge the individual names in the portfolio dynami-cally.

For example, if a credit derivatives desk trades a tranche of a portfolio including Ford, the value of the tranche will go up and down as Ford’s credit spread moves. e dealer can hedge the tranche without having to construct an entire capital structure by simply buying and selling Ford and all the other names in the portfo-lio in the right amount. is proportion is known as the hedge ratio or delta and it depends on the seniority of the tranche as well as the spread of the individual credit.

is delta-hedging strategy takes care of the spread risk of the individual names. But for the dealer to book a profit from this arbitrage, it needs to be sure that it sold the tranche for more than the cost of the hedge.

at requires the trading desk to make an assumption about default correlation, since correlation is the only factor that determines the risk of a tranche other than the credit risk of the individual names. High correlation is positive for investors in the most junior tranches of risk, since they stand a better chance of sustaining no losses at all, while low correlation is a good thing for senior protection sellers, since it implies less chance of catastrophic losses across the portfolio.

True, the bank could simply calculate a theoretical value for correlation based on mathematical models. But the whole thrust of accounting standards for finan-cial institutions recently has been away from mark-to-model and towards mark-to-market. A specific trigger was the release of a new GAAP accounting require-ment at the end of 2002, known as EITF 02-03, which called for profits from complex derivatives to be calculated using “observable” market parameters.

The widely held view that this new accounting standard gave birth directly to the index tranche market is something of a simplification. Traders – and their product controllers – almost always prefer to make money by

arbitraging different markets rather than by trading against a theoretical model. “P&L recognition is an issue that cuts across the industry,” says Alan Shaffran, head of credit derivatives at Citigroup in London. “Even in banks that are not subject to EITF 02-03, risk managers like price verification and have similar ground rules on the quality of P&L.”

e index tranche market uses terms that are as standardised as possible, including identical documentation and settlement mechanisms. is is to boost liquidity by ensuring that all dealers are trading correlation in the same way. Cru-cially, the attachment and detachment points of the tranches are standard.

A 0–3% tranche, representing an equity position in the portfolio, is one of the most heavily traded tranches. en there is a junior mezzanine tranche which is 3–6% for European indices but 3–7% in North America. A senior mezzanine tranche of 7–10% or 6–9% is also among the most liquid.

At the beginning of the market, synthetic CDO arrangers sought to offload some of the correlation imbalances they had built up through their customer trades. at led to an initial flurry of interdealer trading, but also created an op-

‘Even in banks that are not subject to EITF 02-03, risk managers like price verification’


portunity for new traders such as prop desks and hedge funds to buy the pieces that they saw being of-floaded cheaply. “By the end of 2003 the Street had got very long correla-tion, so many active trading accounts have seen this is an opportunity to buy correlation cheaply,” says Eric Lepage, global head of exotic credit derivatives trading at BNP Paribas in London.

Hedge funds and other ac-tive traders that buy and sell index tranches follow a number of different strategies. e classic play, at least in the first few months of the market, has been to take on a long correla-tion position, such as selling equity

protection, and delta-hedging the position using the broad Trac-x or iBoxx index. Others are directional traders, who simply welcome the chance to get long or short the credit market with leverage using a liquid product.

“e fact that you now see hedge funds involved in the structured credit market shows how far this market has developed,” says Shaffran at Citigroup. “e two things hedge funds need are effective pricing and liquidity. Both have been signifi-cantly enhanced by the introduction of index tranche trading.”

A different long correlation trade, but one that takes a bearish view of the credit market, is to buy senior protection, such as a 6–9% position. is is a welcome trade for dealers that have sold a lot of senior mezzanine risk – as most have – since it exactly counteracts the credit and correlation risk of their bespoke customer trades, leaving only a mismatch between the names in the index and the ones in the customised portfolio trades.

“Unlike leveraged mezzanine investors, who tend to be correlation sellers and hence put the Street long correlation, hedge funds are volunteering as correla-tion buyers by putting on a range of different trades, using index tranches,” says Emmanuel Rousseau, European head of correlation trading at Bear Stearns in London. “For example, some funds have realised that buying senior protection could be an efficient way to protect their credit exposure, and other traditional CDO equity buyers have tried to benefit from the temporary shortage of equity protection sellers.”

As a liquid market for correlation has developed, the price has changed to reflect the balance of buyers and sellers. A key feature of the market is that supply and demand for different tranches creates different implied correlations at differ-ent points in the risk spectrum.

e most marked trend since the inception of the market has been for the cor-

Emmanuel Rousseau, Bear Stearns: hedge funds are buying correlation


relation implied by junior mez-zanine tranches to fall, as more and more sellers of protection at that level come into the market (see chart). At the same time, the correlation implied by senior and equity positions has remained high, giving rise to a correlation ‘smile’ when plotted as a graph.

Partly this is a function of the direction of credit spreads. “When using a basic Guassian copula model, the presence of a correlation ‘smile’ means that you have to change the correlation

level you use to price a tranche when the level of spreads in the portfolio – along with many other factors – changes,” says Bear’s Rousseau. “For example, when spreads decrease, senior mezzanine tranches become relatively more senior and their implied correlation tends to increase.”

In the same way, the correlation exposure of a tranche also changes with time. “A tranche that is fairly junior on day one will become very senior towards the end of the deal if no defaults have taken place,” points out Martin St Pierre, global head of correlation trading at Bear Stearns. “As the tranche matures and becomes longer correlation for the protection buyer we have go out and hedge that correla-tion position.”

One of the biggest questions for the correlation market is how a major change in spreads will affect correlation assumptions at the mezzanine level. “Correlation numbers are largely a function of technical factors

such as the demand for different tranches,” says Sivan Mahadevan, structured credit strategist at Morgan Stanley in New York. “But the general assumption is that if we see a stress scenario with a big spread widening, we will see a rise in correlation.”

In early 2004, most dealers still have a lot of customer trades on their books in the 3–6% area – where the dealers bought protection. is mezzanine risk can be long or short correlation depending on the level of spreads. With spreads low, the mezzanine protection on the books gives the Street a long correlation exposure since the mezzanine is relatively senior. However, rising spreads makes mezzanine more junior, and that might reverse the dealers’ correlation exposure.

“Since these tranches are close to the inflection point for correlation, a big rise in spreads to the levels of late 2002 could flip everyone’s correlation position around,” says St Pierre. “en the street would be rethinking their correlation hedging strategies.”

In spite of falling implied correlation at the mezzanine level – where the banks

DJ Trac-x North America implied correlation by tranche

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have lost money on a mark-to-market basis, running a correlation book has be-come a highly profitable business for credit derivative dealers.

In part, this is because not all banks have to run a completely flat book and so some have been able to benefit from directional changes in correlation. “e name of the game is to run a correlation position while managing individual default risk,” says Raj Amin, European head of exotic credit derivatives trading at BNP Pari-bas. “A controlled risk appetite, properly managed, can add value at a time when spreads are tight and firms are long correlation.”

The development of an observable market in credit correlation has created one problem for credit derivatives houses: it almost completely contradicts what their models tell them should happen. Quants have spent the past couple

of years competing to produce rigorous models for transforming individual default probabilities into patterns of default across portfolios. But none of the current models comes close to explaining the way correlation is currently priced in the market.

e industry standard model is a copula, a calculation designed to turn a series of individual probabilities into a joint probability. ere are two big problems with copulas. One is practical: they require huge amounts of computation to come up with an answer. In a fast-moving trading environ-ment, that is often not a great deal of use.

e second problem is that they rely on as-sumptions about the distribution of credit events. e industry standard model assumes that defaults exhibit a bell shaped or normal (Gaussian) pattern of distribution. But the market treats that assump-tion with scepticism.

“Using a single matrix of correlation numbers in a basic Gaussian copula model will not explain all the prices you observe on the tranches,” says Rousseau. “For example, the higher correlation used for the more senior part of the capital structure will reflect that a fat-tail event – a meltdown scenario – is more likely than this model says it should be.”

Several competitors to the Gaussian standard have been proposed. e best known alternative is a student-T copula, which does make greater allowance for extreme events, but which correlation traders say has limitations in other respects.

“e debate about the pros and cons of different correlation models is much more open than was the case for other new derivative markets,” says Mitch Janowski, head of correlation trading at Citigroup in London. “e Gaussian copula – which is the industry standard model – has its flaws, and many people are working on refinements to that approach. But the basic limitation of any model is

Martin St Pierre, Bear Stearns: correlation could flip around


that it assumes we have an arbitrage-free market, whereas in fact this is an imperfect market.”

e cutting edge of modelling seems to have shifted away from the search for copulas that bet-ter explain the real world towards techniques de-signed to speed up calculation of tranche risk using something like the Gaussian copula.

But even then, say traders, nobody should be-lieve that a position is safe just because their mod-els tell them so. “You need to use a huge degree of common sense when working with the models,” says St Pierre at Bear Stearns. “You can’t just trust the black box, you should look at what the market is telling you about risk.”

Another pressing need is to understand how correlation relates to other risks. “e development of the exotic credit derivatives market has been ex-tremely quick, so it is hardly surprising that the modelling has partially lagged the market,” says Rousseau. “With the emergence of longer term structures and the development of volatility prod-ucts, the market needs to think through or rethink a whole range of issues, such as the true impact of the inter-relation between spread volatility, default

correlation and recovery levels.”BNP Paribas’ Amin agrees: “We are still in the early days of modelling credit

correlation,” he says. “Sophistication in modelling allows you to be one step ahead. e goal is to unite concepts of volatility with the current firm value models and to truly extend the hybrid universe.”

Meanwhile, outside the dealer community, the whole emphasis on correlation as a tradable asset class may be misplaced. For many firms, the great benefit that the market for index tranches has brought is the ability to trade in and out of lever-aged long and short credit positions efficiently.

“e spread sensitivity in these tranches can be a very big number depending on tranche seniority,” says Morgan Stanley’s Mahadevan. “For most people spreads, not correlation, will dominate their P&L. Correlation is only your main concern if you are delta-neutral, which is not the case for most investors in tranches.”

Raj Amin, BNP Paribas: goal is to extend the hybrid universe

making sense of ratings 19

Not all portfolio credit derivatives are rated. Tranches of credit derivative indices, for example, do not generally carry a credit rating. But credit ratings are essential to the structured credit market, since most of the

ultimate providers of risk capital depend on them to a large extent.Of course, ratings are integral to the entire credit market. But what makes

them especially crucial for structured finance is that deals are often structured to achieve a specific rating. As a result, the rating agency analysts are closely involved in the process of structuring new deals.

at may be true to some extent across the securitisation market, but it is especially true for investments linked to portfolios of corporate credit – such as cashflow CDOs and portfolio credit swaps, since these depend on the complex relationship between credit ratings on individual assets and credit ratings on tranches of portfolios of those assets. In most cases, for a deal to make sense, the income paid out on the liabilities – something largely determined by the rating – has to be less than the income from the individual assets.

As Standard & Poor’s puts it in its CDO rating criteria report: “In CDOs the goal of the structure is to allow an assignment of a rating higher than those of the sponsors ... and higher than the average rating of the underlying assets.”

As the report goes on to say, this is not alchemy. In fact, this arbitrage – which lies at the heart of the structured credit market – arises for several reasons. First, slicing a portfolio into different tranches of risk should in itself create some value. Investors should be willing to pay a premium for diversified credit risk that has the precise risk profile they require – whether it is a triple-A note or a highly leveraged equity position.

Second, and perhaps more important, there is always some divergence between the way the market sees credit risk and the rating agencies’ view of the world. For example, during the bear market of 2002, rating agencies often seemed to be lag-ging the market in downgrading troubled credits, and, as a result, many names traded wide for their ratings.

Chapter 4making sense of ratings:fine models and sharp haircuts

20 portfolio credit swaps making sense of ratings 21

at created opportunities for credit derivatives bankers to put together high-yielding portfolios with a favourable rating. At the time, this was regarded by many observers as a case of bankers arbitraging the rating agencies. But with hindsight, now that spreads and default rates have fallen, it looks rather as if it was the short-term overreaction of the market that was providing the arbitrage opportunity and not the caution of the agencies.

And then there is another kind of arbitrage: structural com-plexity. New structured products always introduce new risks that are sometimes far from obvious – even to rating agency analysts. is is why they worry constantly about bankers slipping hidden risks into the deals they are asked to rate. Rating agencies try to

stay one step ahead in this game of cat and mouse by penalising new or dubious structural features, and by regularly refining their methodologies.

Although it is early days, there is not yet any convincing evidence that synthet-ic CDO ratings have been too generous. True, there have been many downgrades. But that is not surprising given the stressful credit environment of recent years. To date, only junior investors in synthetic CDOs have suffered losses – and even then only for the most distressed deals.

“If you look at how rated tranches have performed in the past few years, you would have to say that the ratings for synthetic CDOs have been about right,” says one structurer at a major credit derivatives dealer.

Rating agencies face the unenviable task of having constantly to adapt their methodologies and evolve with the market as their workload increases. e shift away from full-capital-structure synthetic CDOs towards single-tranche deals has produced a big increase in the number of different portfolios the agencies have been asked to rate.

At the same time, the marked deterioration in the quality of many CDO pools in recent years has prompted investors to demand ever greater transparency on their deals. Rating agencies have responded by devoting

greater resources to deal surveillance.Nevertheless, the increasing structural standardisation of portfolio credit swaps

means that deals can often be rated much more quickly than in the past. “e process of rating deals has become quicker as the market has evolved,” says Perry Inglis, managing director at Standard & Poor’s in London. “For repeat deals using standard documentation we can give a rating in as little as one day.”

All ratings reflect an agency’s opinion about credit risk, but each of the agencies approaches the task of giving an opinion in a different way. ey also use confus-ingly different terminology to describe the same concepts.

In fact, the different agencies’ ratings do not actually describe the same kind of risk (see What CDO ratings mean). e big difference is that Moody’s ratings include an assessment of the severity of losses on a particular note or credit default

Perry Inglis, Standard & Poor’s: repeat deals can be rated in only a day


swap, while S&P and Fitch look only at the prob-ability that the instrument will suffer some kind of loss. In other words, S&P and Fitch rate to the first dollar of loss, while Moody’s rates to the expected loss. is distinction often does not matter, but is important for CDOs of CDOs (see below).

e rating agencies each have their different methodologies for rating portfolio credit swap tranches. But fundamentally, there are more simi-larities than differences. In the case of all three ma-jor rating agencies, the fundamental starting point is the credit ratings of the individual assets in the pool. (e three agencies also follow basically the same approach for rating cash-flow CDOs as they do for synthetic deals, although each type of deal requires a few tweaks to the basic methodology.)

In each case, the rating agencies look at the default risk of each individual asset in the pool, the similarity between them and their expected recovery rates.

S&P calculates the expected default rate of the portfolio at each rating level us-ing CDO Evaluator, a proprietary model which it also makes available to investors and structurers. CDO Evaluator uses Monte Carlo simulation – that is, it gener-ates thousands of different random scenarios – to calculate the likely level of de-faults. e inputs for the model are individual default probabilities based on their ratings and the industry of the reference entities, to take account of correlation.

To work out the amount of credit enhancement needed to achieve a particular rating, Standard & Poor’s takes the expected default rate, as calculated by CDO Evaluator, and deducts expected recovery rates. e rating also needs to take ac-count of the positive effects of excess spread and various qualitative factors.

Moody’s approach to rating portfolio credit derivatives is in a state of some flux.

What CDO ratings mean

“The probability of a tranche performing in accord-ance with the terms of the notes” – Fitch Ratings“Our opinion of the expected loss on the note, which is the difference between the present value of the ex-pected payments on the note and the present value of the promised payments under the note, expressed as a percentage of the present value of the promise” – Moody’s Investors Services“The likelihood of full payment of interest either on a timely or ultimate basis” – Standard & Poor’s

Main factors taken into account in calculating tranche ratings

Type of risk Fitch Moody’s S&P

Portfolio default probability

Rating of individual assets + correlation

Rating of individual assets + diversity score

Rating of individual assets + correlation

Correlation Industry sector and region of individual assets

Dealt with through diversity score based on industry sector of individual assets

Industry sector of individual assets

Recovery rates (expected loss)

Seniority and jurisdiction of assets

Rating of individual assets Seniority and jurisdiction of assets


It has traditionally used a method that avoids the need for Monte Carlo simula-tion, the binomial expansion technique. Under this methodology, Moody’s assigns a diversity score to the portfolio based on the type and sector of the assets.

e portfolio is then modelled as if it consisted of a series of identical assets: the greater the diversity score, the greater the number of assets. e assets are as-sumed to have an identical default probability, which is the weighted average of the original portfolio. e expected loss – the mirror image of the recovery rate – is calculated based on the ratings of the assets.

For more diverse portfolios, Moody’s has shifted away from the binomial method. One refinement is to use a dual or multiple binomial expansion tech-nique. is is the same as normal binomial expansion except that Moody’s breaks the portfolio down into different sub pools. However, for an increasing number of synthetic CDOs, Moody’s now uses Monte Carlo simulation to calculate expected losses across the portfolio. At the time of writing, the agency is in the process of releasing its synthetic CDO rating models to the market.

In 2003 Fitch Ratings switched from an approach based on various probability matrices to one using a simulation-based model, known as Fitch Default Vector. As with S&P’s CDO Evaluator, Fitch makes Vector available for structurers and arrangers who use it as a guide to what rating the agency would give to a particular CDO tranche.

“In conjunction with a good understanding of our criteria, Vector should give you a good approximation of the credit enhancement levels we require for a par-ticular deal,” says Richard Gambel, head of credit derivatives at Fitch in London. “But there are always areas that require qualitative analysis. For example, we need to make allowances for deals that include restructuring language, reference entities where the cheapest-to-deliver option is particularly valuable and non-standard valuation procedures.”

Fitch’s Vector model calculates potential portfolio default and loss distributions based on the default probability of the individual assets – usually inferred from their rating. e other inputs are recovery rate assumptions and the

correlation of the assets in the pool. Correlation is implied from a study of equity price correlation which acts as a proxy for asset correlation. Asset correlation is widely used as a proxy for the far less observable default correlation since, as the Merton model explains, companies default when the value of their assets fall below the value of their liabilities.

Whatever the precise methodology for turning individual ratings into portfolio tranche ratings, it is clearly vital that the assumptions about default probability, recovery rates and correlation used in the calculations are reliable.

One area that has attracted a lot of attention in the past couple of years is re-covery rates. Some recent credit events affecting portfolio credit derivatives, such as WorldCom and Enron, have produced spectacularly low recovery rates. On one widely referenced credit, Teleglobe, debt investors lost as much as 99 cents in the dollar.

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Deepali Advani, Moody’s: Isda reforms addressed long-standing concerns


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But the range of losses has been very wide, with other names such as Railtrack producing recovery rates of more than 80%. Recovery rates are something rating agencies are constantly monitoring. For example, S&P recently calculated that the cumulative average recovery rate in synthetic CDOs from 2000 to 2003 is just under 36%. However, the range of recoveries was large, with a standard deviation from the mean of 27%.

Based on that data, S&P sees no need to revisit its basic corporate recovery rate assumptions. “Although we are still talking about a relatively small number of credit events, with a large standard deviation, we are now getting close to data that is statistically meaningful for recovery rates affecting synthetic CDOs,” says Nik Khakee, director at Standard & Poor’s in New York. “And what the data shows is that recovery rates are in line with our rating assumptions for pools of credit. For example, the cumulative average recovery rate for North American credits of 32.4% is close to our assumed recovery rate of 33.3% for these credits.”

One factor that has been widely blamed for low recovery rates in portfolio credit swaps is the way credit events are settled. Most deals are cash-settled credit derivatives. As such, the amount of loss allocated to investors from each credit event is determined by an estimate of the price of the asset after default.

at valuation is usually done by the arranger of the deal who, as the buyer of protection, has an incentive to obtain as low a price as possible to the detriment of investors. is is an example of an area subject to many subtle forms of bad practice which the rating agencies try to discourage by haircutting their ratings for individ-ual deals. If the rating agencies see valuation mechanisms they think will produce bad results, they reduce their recovery rate assumptions for that portfolio.

One thing that affects valuations is how soon after default the dealer should seek bids. “We generally believe recovery rates follow an inverted J-curve,” says Khakee. “ere is a period of price discovery that takes

certain amount of time, then after around 45 business days the price is resolved at a level that is consistent with our expectations. However, there are clearly some credit events that do not follow this pattern.”

In S&P’s view, dealers that do not wait 45 days before doing a valuation could end up getting suboptimal bids. But Katrien Van Acoleyen, director at Standard & Poor’s in London, says that the rating agency is assessing what cut-off point makes best sense, as more data becomes available as the market matures.

e agency already requires a somewhat longer wait period than its rivals. “For corporate portfolios, we prefer to see a lag of between 30 and 60 days before valu-ation,” says Fitch’s Gambel. “We could consider an earlier start to the valuation process but that would have to be coupled with a minimum recovery rate.”

Moody’s also likes to see at least 30 days between a credit event and valuation, says analyst Rudolph Bunja. “We want the valuation process to be as objective and transparent as possible in order to mitigate the option to value the cheapest assets.”

Something else the rating agencies like to see is a reasonably large number of

Katrien Van Acoleyen, Standard & Poor’s: valuation cut-off points are being reassessed


dealers on the poll. Moody’s prefers to see five bids solicited from dealers not affiliated with the calculation agent or one another, says Deepali Advani, senior analyst with the firm in New York.

Moody’s also stipulates that bids must be from market mak-ers in the assets being valued. “In the early days we saw some bids solicited from entities that we had never heard of, or who were not in a position to make a bid,” says William May, managing director at Moody’s in New York.

But there is some disagreement about whether a specified minimum wait period really helps to avoid low bids. Fitch has put together research which appears to indicate that valuations are lowest at the time most dealers are going out to the market to get bids. It may be that pushing back the required wait time would simply delay the improvement in the recovery rate.

And then there are defaults that do not seem to follow the J-curve pattern of post-default recovery at all. For example, for a good year after Enron’s bankruptcy, its bonds continued on a downward path. A more recent defaulter, Parmalat, seems to be following a similar pattern.

But rating agency analysts believe these cases are exceptional. “We have ob-served from the historical numbers that prices tend to vacillate in the early days and then settle out,” says May at Moody’s. “One exception is cases where fraud is discovered and the amount of money involved keeps rising. However, that is not typical of a normal default scenario.”

e uncertainty of cash settlement is one thing that can make portfolio credit derivatives riskier than the basic rating agency models assume. Another problem-atic area is the language of default.

Investors in a credit derivatives incur losses when a reference entity suffers a credit event, as defined in the deal’s documentation. e problem for rating agen-cies is that the standard credit default swap triggers for a credit event are rather broader than the concept of default they use in their historical default statistics.

Moody’s, in particular, pushed hard in the early days of the market to exclude so-called soft credit events, which might expose deals to a much higher rate of default than had typically been seen in the past. “For us, the biggest shift in align-ing credit event definitions with our own concept of default were the November 2001 supplements to the Isda credit derivative definitions,” says Moody’s Advani. “rough these, obligation acceleration was removed as a standard credit event and the scope of restructuring was reduced. e supplements addressed some of the concerns we had been expressing for years.”

All the rating agencies continue to make adjustments for credit event defi-nitions that might lead to bigger losses than their models assume. For example Moody’s applies a 10% haircut to its assumed recovery rates for investment-grade credits referenced using old restructuring and 5% if one of the two new modified forms of the restructuring credit event is used.

One way in which synthetic CDOs tend to be more straightforward for rating

William May, Moody’s: fraud cases are not typical defaults


agencies to deal with than cashflow transactions is that they are still mostly static. But there are a large minority of portfolio credit swaps that are managed – either by a third party asset manager or by the investor. Where names in the portfolio can be substituted, the rating agency needs to assess the motivation and capability of the manager to maintain the credit quality of the reference pool.

Typically, the agencies might also impose limits on the type of assets that can be added to the pool. S&P’s approach, however, is to require the manager to rerun the CDO Evaluator model each time a substitution is made. In addition, there are limits on the amount of trading the agency is prepared to allow. “We never allow managers to do discretionary trades on more than 20% of the deal a year,” says S&P’s Van Acoleyen, “although managers can always do credit impaired trades.”

Perhaps the most controversial area of the synthetic CDO business for rating agencies has been the recent emergence of synthetic CDOs of CDOs – or CDOs squared. ese deals typically reference a portfolio of highly rated

asset-backed securities with a small bucket for CDOs, although some recent deals have been structured as pure CDOs of CDOs. In both cases, the CDOs are almost always portfolio credit tranches created with the specific purpose of serving as reference obligations in the transaction.

Although CDOs of CDOs are typically more diverse than a straight corporate portfolio – because of the greater number of names – they may not be quite as diverse as investors think. “ere is a finite universe of corporate names out there,” points out Gambel at Fitch. “A 30% overlap of names between the different underlying CDOs is not unusual. So one default might damage a lot of the reference CDOs. In addition, small changes to assumptions about correlation between the ultimate underlying corporates lead to large increases in correlation between the reference CDOs, which can be detrimental to the peformance of the master CDO.”

All three agencies now rate synthetic CDO squared transactions by “looking through” or “drilling down” to the ultimate reference entities in the deal. But this does not address perhaps the most interesting feature of these deals, the peculiar risk profile of an investment covering a small tranche of the capital structure refer-encing assets that are themselves thin tranches of a subportfolio.

Part of the enormous appeal of credit derivatives is their flexibility as a struc-turing tool, and synthetic CDOs of CDOs are structured to exploit the low prob-ability–high risk credit scenarios that are hardest to model. Most recent synthetic CDOs of CDOs are designed to produce a tranche that has a very low risk of suffering a loss – typically double A or better. However, if losses do hit the tranche, there is a very high chance that the entire tranche will be wiped out immediately.

Under the approach used by two of the three main rating agencies, such a tranche is rated purely on the likelihood of any kind of loss being suffered. e fact that the tranche has negligible recovery expectations is the investor’s problem. As ever, the message investors should draw from this is not to rely blindly on agency ratings, and need to be sure that they understand exactly what the ratings really mean.

But, of course, investors already know that. Don’t they?

‘There is a finite universe of corporate names out there. A 30% overlap between underlying CDOs is not unusual’

documenting portfolio credit derivatives 27

Documentation is critical to any financial contract. What makes language particularly contentious for credit derivatives is that the whole purpose of these contracts is to pay out money if a described occurrence – default

– takes place. In that respect, credit derivatives are unlike most derivatives, whose economics

are tied to quantifiable occurrences, such as movements in share prices. ey are more like insurance contracts, another area of finance in which there are frequent disputes about wording of contracts and intentions. Of course, credit derivatives are not insurance contracts, as any lawyer will tell you – particularly if his client is an institution that is not permitted to write insurance business.

Efforts to standardise and streamline credit default swap documentation have been an important feature of the market since it evolved in the late 1990s. ese initiatives have been pushed forward by the big credit derivative dealers, who are anxious to ensure that they can cope with a high volume of plain-vanilla trades. is has resulted in the use of pre-agreed master confirmations, streamlined procedures for physical settlement, standardised maturity dates and other developments driven by the single-name credit default swap business.

But not all changes to documentation and market practice have been geared to the single-name business. Portfolio credit investors have played an important role in shaping the documentation used for all trades today. For example, senior sellers of protection were among the loudest voices calling for the abolition, or at least reform, of one credit event: restructuring. is steady pressure has kept the question of restructuring at the top of the market’s agenda in the early years of this decade.

e outcome of the great restructuring debate is that different forms of the credit event are now used for different reference credits (see box on next page). at adds to the complexity of documenting portfolio credit derivatives, since most pools contain credits from a variety of different regions. Contracts need to spell out, for example, the requirement that North American credits are triggered

Chapter 5documenting portfolio credit derivatives:a new layer of complexity

28 portfolio credit swaps documenting portfolio credit derivatives 29

by “modified” restructuring, while European names follow the “modified modified” version.

Bankruptcy is another credit event that has been altered following pressure from portfolio credit investors. ey succeeded in tightening up the definition of bankruptcy included in the 2003 standard contract. e market agreed to exclude a clause that allowed protection buyers to trigger a credit event if the reference entity takes action “in furtherance of ” bankruptcy.

e “in furtherance of ” issue first came under the spotlight in March 2001 after rating agency Moody’s Investors Service argued that the definition was too broad and would encourage protection buyers to call credit events in a wide range of circumstances short of an actual bankruptcy.

ose fears seem to have been justified. Several contracts are thought to have been triggered under “in furtherance of bankruptcy” in recent years. In cases such as Marconi, British Energy and Parmalat, some contracts are understood to have been called on this basis well before the rest of the market delivered credit event notices. In the first two cases, the reference companies did not go on to file for bankruptcy.

But although issues such as restructuring, bankruptcy, and the definition of a successor

reference entity are highly relevant to portfolio credit derivatives, many legal specialists believe that standardisation of portfolio trades has taken a back seat to the needs of the single-name flow business. “ere is a desire to standardise documentation between dealers but less interest in creating a standard for the market at large,” says one derivatives lawyer. “To some extent there is recognition that this should be on the agenda, but there is also reticence because it would make it easier to join the market. Standardisation would lower the barriers to entry.”

Some of the most contentious remaining areas of documentation are precisely the ones common in bespoke portfolio trades. e definition of valuation methods, for example, remains a grey area. is is an issue for any cash-settled credit derivative, but whereas most portfolio deals are cash settled, it is rarely a problem for single-name trades, which are normally physically settled.

Defining credit events for credit derivatives referencing asset-backed securities is also a legal quagmire. Again, it is rarely a problem in the single-name world, where ABS-backed trades are rare, but is becoming increasingly common for portfolio credit swaps.

Flavours of restructuring

Common name: old RProper name: restructuringKey features: no limit on the maturity of obligations that can be delivered; both bonds and bilateral loans can be deliveredMarkets where used: Asia, emerging market sovereigns

Common name: mod RProper name: restructuring maturity limitation and fully transferable obligationKey features: long-dated debt cannot be delivered following a default: bilateral loans cannot be delivered (obligations must be fully transferable)Markets where used: North America, Australia

Common name: mod mod RProper name: modified restructuring maturity limitation and conditionally transferable obligationKey features: long-dated debt cannot be delivered (but longer than for mod R); only transferable obligations can be delivered (but consent-required loans can be delivered in certain circumstances)Markets where used: Europe


Still, some lawyers believe the market is making progress on these issues. “A number of factors are converging in the default swaps market to bring about standardisation in relation to non-single-name default swaps,” says Neil Weidner, capital markets partner at law firm Cadwalader, Wickersham & Taft. “From the investor standpoint there is certainly a desire for more uniformity. We are a little ways away but not that far away from having very standardised documents.”

So just how standardised are portfolio credit swap contracts likely to become? Some derivatives lawyers see scope for relatively far-reaching standardisation, including, for example, creating a common approach for valuation and cash settlement mechanisms following a credit event.

A wide variety of valuation methods have been used for cash settlement of defaulted reference entities within credit default swaps, and this has contributed to the enormous range of different recovery values after

recent credit events. Careful appraisal of valuation and settlement mechanisms is therefore vital at the documentation stage, since they can have a huge impact on the economics of a trade.

In the investment-grade corporate universe, the market is converging on multiple valuation dates lasting from 60 to 90 days after the credit event, according to structured finance lawyers. However, a study by Fitch Ratings, Credit Events in Global Synthetic CDOs: 2000-2003, concluded that valuations completed between 50 and 90 days after the credit event produced below-average recoveries.

“e decline in the recoveries experienced by credit events that settled between 50 and 90 days may be caused by supply and demand,” the report notes. “Since many credit events were settled between 50 and 90 days, the bidding process of the CDOs may have caused an oversupply of bid requests into the market, thereby depressing prices and recoveries on the reference credits.”

e Fitch study was based on 112 credit events called on 115 investment-grade corporate synthetic securitisations between 2000 and the end of January 2003.

Investors worry about ending up with an artificially low recovery rate if the post-default market for the reference credit’s debt proves to be illiquid or opaque. Structurers and lawyers are experimenting with a number of ways to avoid this happening.

“It is more common now to see valuations trying to hit a specific floor,” says Chris Georgiou, partner at law firm Ashurst. “Valuation can start immediately and if you hit the recovery floor you take that value.”

Alternatively, the floor may be the starting point for the valuation process. “We have seen a number of transactions where the prescribed valuation process does not allow you to have a valuation date if you have not received on that date bids that are at least a certain percentage – agreed in advance – of the original price,” adds Assia Damianova, associate at law firm Sidley Austin Brown & Wood. “In that case, you will have to go to the next valuation date and attempt to obtain bids at – or above – that reserved price. at longer procedure may guard off against too low bids when the asset is not very liquid.”

‘We are not that far away from having very standardised documents for portfolio default swaps’


ere has been some disagreement between the three main rating agencies over what period constitutes the optimal recovery window. Standard & Poor’s for instance, penalises deals where the valuation date is less than 60 calendar days. Fitch has recommended that the valuation date is at least 30 days after a default to increase the probability of higher recoveries. Moody’s also prefers a waiting period of at least 30 days.

One thing that has an obvious bearing on recovery values is the number of bids the calculation agent (usually the protection buyer) has to get to determine the price of the defaulted bonds or loans. Most investors in the portfolio credit swaps market can recount horror stories of early deals in which the issuer was able to calculate the recovery rate after seeking only two or three bids – including one from its own trading desk.

In response to these problems, market practice is converging on a minimum of five firm bids from an approved list of dealers. “at is the general approach,” says David Geen, senior counsel at Goldman Sachs in London. “If you cannot get five, the approach is usually to find three, and failing that you move to weighted averages and indicative quotes. ree indicative quotes is typically the cut-off point.”

at still leaves the problem of valuations falling to zero after this process has been exhausted. But some deals have used additional mechanisms to prevent this from happening. “ere is a sliding scale where you move from five firm quotes down to weighted averages and indicative quotes, and then any other valuations, including equity or even property valuations,” says Georgiou.

Other aspects of the valuation process that may require negotiation include the size of the quotations that are being sought to arrive at the recovery value. “e protection seller wants round quotations, while the protection buyer does not want quotation sizes to be too restrictive. ey want to be able to quickly check the market,” says Damianova, “and, in certain cases, to be able to value ‘odd lots’ corresponding to bonds physically delivered to that buyer in a [front end] transaction that has now been hedged.”

Geen adds: “How much of a bond you seek a quote for is an important question. at can affect the price people will give. If it is an illiquid bond and you are seeking a large quotation amount, prices may be much lower.”

Another important issue to define is whether or not the parties involved in the transaction should be able to participate in the bidding process. “You can have situations where parties to deals that pay out are given a ‘last look option’ recognising their interest in submitting a bid if they feel that the valuation is low,” notes Damianova. “at can work if the institution that sells protection is set up to react quickly with respect to the bidding process and submit a firm bid within the short time-frame allowed to dealers.”

In the case of inter-dealer trades, it is now fairly normal for the protection seller to be allowed to bid, adds Geen. “ere is an acceptance that the protection seller can bid,” he says, “but it has to be a firm bid that it can get hit on. Without that requirement people can start gaming the system.”

Assia Damianova, Sidley Austin Brown and Wood: protection seller given a ‘last look’


Despite some continuing variation, standardising the basic approach to cash settlement is achievable, says Georgiou. “Commoditisation is where the market is going,” he says. “We see lots of variations but many are on the same theme and it should be possible to boil the process down to a limited range of mechanisms per asset class.”

Defaults referencing non-corporate reference obligations often require their own unique approach. “Valuation issues can be especially important when you have an interesting asset such as aircraft,” says Damianova. “How long do you allow yourself to value the loss, and after what period do you go to a desktop valuation? What approach do you use for involving expert assessors? ose sorts of questions can result in a lot of negotiation.”

By far the most important asset type for portfolio credit swaps other than investment-grade corporate debt is asset-backed securities. Deals referencing asset-backed securities – including other synthetic CDOs

– accounted for just under 13% of the market in 2003 according to Creditflux’s calculations.

Although valuation is an important consideration for these assets, the really thorny issue is the definition of a credit event. Special features such as interest payment deferral, write-downs and loss make-up mechanisms can all result in differing interpretations of whether or not a genuine credit event has occurred. Unless the triggers are defined carefully, the deal can incur losses much more easily than the investor expected.

For this reason, rating agencies are keen to ensure that documentation on deals referencing portfolios of ABS includes only narrowly defined credit events. Moody’s, in a November 2003 report, stated its preference for “clean credit events”. “A ‘clean’ credit event is one in which the [ABS] reference obligation will experience an economic loss due to credit-related reasons,” the report noted. “Our goal is to prevent spurious credit events that do not give rise to permanent losses and to minimize the potential for moral hazard.”

Securities that are allowed to defer interest – or pay in kind (PIK) – are a particular grey area, and many mezzanine CDO notes fall into this category. Moody’s recommends that a credit event on a PIKable security should be defined as when the bond defers interest consecutively over two or more payment periods in an amount equivalent to at least two payments under the terms of the obligation, and if the rating of the tranche has been downgraded to double-C or lower. “We believe that once this point has been reached there is a very high probability that the tranche will experience a loss,” says the report’s author, Yuri Yoshizawa.

ere are already signs of documentation moving towards this kind of definition, although recent synthetic CDOs of ABS have typically opted for a downgrade to triple C or lower as the appropriate ratings measure of an economic loss.

In the case of write-downs – a common feature of synthetic CDOs – Moody’s

Chris Georgiou, Ashurst: standardised cash settlement is achievable


says that the cleanest approach would be to restrict credit events to situations where there is no mechanism for potentially making up the loss.

Yoshizawa says that a reversible write-down could be accepted as a loss event by Moody’s provided the write-down results in an “inevitable and permanent loss”. Ideally, an independent third party would be used to establish that it is mathematically impossible to recoup the loss. is practice has been adopted by some but not all recent portfolio credit swaps referencing ABS. But even if a transaction has a third party in place, the verifier may prove to be reluctant to sign off on a credit event.

“Ideally an accountancy firm would stick out their necks and say that their examination of the deal suggests that there has been a credit event,” notes one market participant. “But whether a firm would be willing to do that, particularly if the determination was a pretty close thing, remains to be seen. Accountancy firms would be putting their reputation on the line. ey could also be proved wrong and risk being sued.”

Most lawyers, rating agency analysts and investors would like to see issues such as ABS credit events and cash settlement at the top of the agenda of future Isda meetings on credit derivatives market practice. If these areas become more standardised it will undoubtedly be positive for the portfolio credit swaps market.

But there is little sign at present that credit derivative dealers have much appetite to discuss these issues. Instead, one of the few recent industry-wide initiatives concerning portfolio credit derivative documentation has centred

on the largely inter-dealer business of trading tranches of credit derivative indices such as Dow Jones Trac-x and iBoxx.

In 2003 leading dealers devised a way to settle index tranches that avoided many of the conflicts of interests inherent in most settlement of portfolio credit derivatives. Rather than seeking a reference price for the defaulted entity’s bonds, the protection buyer in a tranched index trade is required to physically deliver assets to the protection seller. What is new in this approach, however, is that the amount of assets that are delivered is determined by the hedge ratio (or delta) of the name in the protection buyer’s position.

Dealers argue that this approach is suitable only for portfolio swaps where both counterparties run delta-hedged correlation books. is development suggests that if anything the gulf between market practice in the flow credit derivatives market and documentation for bespoke portfolio trades is likely to widen rather than narrow.

In the early years of this decade, the portfolio credit swaps market was dominated by a relatively small number of investors. ose who wrote protection on super-senior tranches were particularly influential. Now, with the investor base apparently becoming wider and more fragmented, there may be less chance of investors lobbying for standardised and transparent documentation.

Investors may need to pay close attention to the details in portfolio credit swap contracts for a long time to come.

‘Ideally an accountancy firm would stick out their necks and say there has been a credit event’

tracking portfolio performance 33

The portfolio credit market can be likened to the options market in the early 1970s before Fischer Black and Myron Scholes developed their famous pricing model. Without a common method for valuing tranches, investors

have no sure-fire way of tracking their portfolios or monitoring their risk. Of course, the investment banks that arrange most synthetic deals have developed sophisticated systems for pricing and monitoring CDOs. For the average investor, though, the easiest way to find out the value of its CDO tranche is simply to call the bank that made the sale.

But as investors have become more aware of the risks inherent in structured products, they have started to demand more tools to help them monitor their investments. And the industry is responding. A plethora of new initiatives from software developers, investment banks, rating agencies and other organisations has emerged in recent years, making it easier for investors to track their credit exposure and do something about problems before it is too late.

ese developments are essential to the continued progress of the structured credit market. To attract a wider investor base, greater transparency and secondary market liquidity are prerequisites and several moves are afoot that aim to help bring these goals closer, by making comparisons between deals easier. So far these have been aimed predominantly at the cashflow CDO market, but schemes for synthetic deals will follow.

e Bond Market Association has provided much of the stimulus for the current wave of openness. Its transaction library of CDO documentation – which investors will be able to access free of charge – is due to be up and running by the end of March 2004. e library will contain both cashflow and synthetic deals and almost all the major dealers have agreed to take part.

Rating agency Moody’s Investors Service has contributed to the transparency movement by making its analysis on individual cashflow CDOs available to all institutional investors from the start of this year. Previously, only those who invested in a particular deal could access this information through its enhanced

Chapter 6tracking portfolio performance:tools for analysing portfolio credit risk

34 portfolio credit swaps tracking portfolio performance 35

monitoring service. Later this year Moody’s will formulate a way to incorporate synthetic CDOs into the enhanced monitoring service.

Another fillip for portfolio credit investors has been the widening of access to data. Mark-it Partners has been instrumental in this, with its feed for credit default swap prices and its Red database of reference entity data. One area that is yet to be addressed, however, is data on recovery rates, which are essential to accurate pricing for both single-name and portfolio credit investments. “In the US there is a statutory requirement post default to file recovery rates,” says Krishna Biltoo, managing director,

securities services at Standard & Poor’s. “In Europe it is universally agreed that the market needs a reliable set of recovery rates, and even ratings on recovery rates, to make CDOs more transparent and attractive to investors.”

Although the industry welcomes these changes, investors still need more regular and detailed information than these transparency-related initiatives can offer. Today some smaller investors only receive news of downgrades or defaults post-event from issuers, making it difficult to manage their investments. Many use spreadsheets and databases linked to data feeds to calculate credit curves and prices, and to news wires or rating agencies for alerts relating to the names in the portfolio. Others have adapted their bond systems for use with credit portfolios.

But, warns Clive Castle, chief executive officer of software consultancy Credit Instruments: “If you use an interest rate swap or bond trading system to manage CDOs, you can construct a reference portfolio by putting together a basket of credit default swaps. You can get quite a long way doing this, but you may not get the reference data right, you won’t have a complete history of the reference portfolio, which you need for reporting purposes, and you can’t simulate the significance of events on your portfolio.”

Only a dedicated system enables investors to monitor changes in the credit risk of a portfolio credit swap and, where possible, make portfolio substitutions. “Most small-scale investors don’t have these tools,” says Castle. “Even investment banks often only have rudimentary systems for doing this.” Larger investors should be able to value their portfolios in a transparent way, to see which names are adding the most risk and to look at the sensitivity of their investments to events using scenario analysis.

Krishna Biltoo, S&P: Europe needs recovery rate transparency


In the field of structured credit pricing and revaluation, one of the newest software offerings is from broker and software house GFI, which is expanding its Fenics Credit product to cover synthetic and cashflow CDOs. Fenics Credit was launched last year and is aimed at front- and middle-office users, predominantly at second-tier banks and hedge funds. To date, it covers credit default swaps, forward-starting default swaps, options on default swaps and, recently, basket products. e next version, due for release at the end of the first quarter, will introduce portfolio tranches.

Whereas most basket trades consist of up to a dozen names, CDO portfolios can have 10 times that number, and for each name a default probability curve and correlation matrix must be calculated, in addition to inputting recovery rates. “ere are so many data relationships that calculations are often very slow,” says Matt Woodhams, global product manager, analytics at GFI. “No closed-form-style solution – like a mathematical formula – exists for this, so the problem has typically been solved using simulation, which in itself implies slowness of calculation.”

GFI has implemented a non-simulation-based approach, developed by John Hull and Alan White of the University of Toronto, which can cut calculation times down from several minutes to just a few seconds. “Now that these instruments are being traded a lot more, this speed is great for front- or middle-office pricing, where you need a quick turnaround time to get the calculations out,” says Woodhams.

Clearly, accurate data is crucial to meaningful valuations, and GFI’s strength is that, as a credit derivatives broker, it can imply default probability curves directly from market prices for credit default swaps, rather than

from bond or equity prices. No additional data feeds are necessary. But even at a busy brokerage, not every data point is available every day, so GFI uses a series of algorithms to fill in any missing data points.

Wall Street Analytics has chosen a different route to GFI’s, introducing Monte Carlo simulation to its CDO valuation package, CDOnet, at the end of last year. It runs thousands of individual scenarios involving default probabilities, recovery rates, recovery delays, prepayment propensity, sensitivity to interest rates and exchange rates, deal structure, and correlation. Jacob Grotta, vice-president of Wall Street Analytics, says that using Monte Carlo simulation to value CDOs greatly increases accuracy. CDOnet links into the firm’s database of 450 CDOs – about 40 of which are synthetic – that are modelled and updated every month.

One of Wall Street Analytics’ main competitors is Intex Solutions, probably the most widely used CDO system in the US, which took the lead in the cashflow CDO business by providing deal information and analytics to all users, not just those that invested in a specific deal. Intex currently has over 700 CDOs in its system, but only a small minority of these are synthetic deals. “We are just beginning to do modelling and monthly updates on synthetics as well as cashflow CDOs,” says Jim Wilner, vice-president of marketing at Intex. “Last year we were learning about this asset class and what makes synthetics different from cashflow deals. Now we’re beginning to ramp up our coverage.”

‘Front and middle office pricing needs a quick turnaround time’


Wilner says no bank has refused to let its deals be posted on the Intex system. “In the past, even if a deal was in our system, the banks controlled access. But more and more they are willing to grant permission to any qualifying investor or other dealer,” he says. Intex enables users to model waterfalls and apply different types of analytics and stress tests under various default and recovery scenarios. Investors can also monitor the assets underlying the deals and access information in the trustee reports of each deal.

Another player in this field is Numerix, which offers an analytics toolkit that institutions can use to build their own customised applications, with numerical methods and financial models provided by Numerix.

is combines with an off-the-shelf application engine for pricing and risk management. It works on a standalone spreadsheet basis, or can be integrated into the trading system. e firm has also developed a static CDO model that can be used for tranches of the Dow Jones Trac-x and iBoxx credit derivative indices, which eliminates the need for Monte Carlo simulation for synthetic CDO tranches without waterfalls.

Michael Iver, sales director at Numerix, says flexibility is one of the key advantages the system provides. “We offer users different ways of looking at their risk. ese include sensitivity to credit default swap spreads, to survival probability, recovery rates, correlation and hedge ratios. Within each of these we offer different ways of looking at and measuring risk, using analytic and Monte Carlo approaches.”

Credit Instruments offers another type of monitoring system for portfolio credit swaps: an automated post-trade management system that is geared to middle- and back-office users, rather than trading desks. It is based on imputed credit ratings calculated from the debt issued by the names in the portfolio, and alerts investors to changes in the risk associated with those credits. e imputed ratings are likely to move before the rating agencies downgrade the debt. “e idea for the investor or investment bank is to try to outguess what the rating agencies do and be ahead of the game,” says Castle.

“For a portfolio of 200 reference entities, you need to run about 30,000 securities issued into the market to calculate the imputed credit rating for the portfolio, which is way beyond what you can meaningfully do with a spreadsheet,” says Castle. e system is tailored to the investments of a particular institution and can be run on a standard compact-style server, meaning set-up costs are low. e system links into the Red database to cut down operational risk and improve the accuracy of pricing.

Some synthetic CDO investors may find that the investment bank they routinely deal with can offer them pricing and analytics as part of their sales service at no extra cost. “Many investment banks have similar products, but some are marketing their models a bit harder than others, with the aim of ensuring clients use theirs rather than anyone else’s. For example, if an investor adopts Bear Stearns’ model, it is more likely to buy Bear Stearns’ deals in the future because it

‘If an investor adopts Bear Stearns’ model it is more likely to buy Bear Stearns’ deals in future’

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Market Data - as an interdealer broker GFI acts as an intermediary and therefore does not takeproprietary positions in the markets in which it operates - our data is therefore independent and reflectsmarket conditions on more than 2,000 reference entities, conveniently delivered as a download or via aweb based subscription service.

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CreditFlux guide_credit_mar2004.qxd 09/02/2004 18:10 Page 1


Voted No.1 in credit derivativesfor the 6th year running*

GFI combines brokerages services, with market data and FENICS analytical pricing tools to support oneof the fastest growing derivative markets.

Brokerage services - Credit Default Swaps, Options on Credit Default Swaps, �Nth� to DefaultBaskets, Cancellable / Extendable Credit Protection, CDOs / Synthentic CDO tranches.

Market Data - as an interdealer broker GFI acts as an intermediary and therefore does not takeproprietary positions in the markets in which it operates - our data is therefore independent and reflectsmarket conditions on more than 2,000 reference entities, conveniently delivered as a download or via aweb based subscription service.

FENICS Analytics - advanced pricing and position keeping for CDS, Forward CDS, Credit Swaptions,Cancellable CDS, Baskets and CDOs developed in partnership with independent academics ProfessorsJohn Hull and Alan White.

Find out more at www.GFIgroup.com/Credit

brokerage data analytics

[email protected] www.GFIgroup.com/CreditThis advertisement has been approved by GFInet UK Ltd. which is regulated by the FSA in the United Kingdom.

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CreditFlux guide_credit_mar2004.qxd 09/02/2004 18:10 Page 1


will become used to the way that model analyses the deal,” says Alex Veroude, head of structured products at Gulf International Bank (GIB).

ese models can help investors to decide which structures to buy into in the first place and build optimal portfolios for bespoke deals, as well as monitor the risk of tranches and individual names post-trade. Around half a dozen banks are offering analysis to clients using this type of product. “We use several models that we’ve been offered by banks,” says John Weiss, portfolio manager at fund management group Cheyne Capital. “ey all give interesting information, but in a different form. Each takes a slightly different angle.”

Chris Cloke Browne, head of the portfolio advisory group at Dresdner Kleinwort Wasserstein, says of his bank’s model, CreditHorizons: “Our system

brings CDO tranches into a VAR [value at risk]-type framework so you can measure the risk between tranches on a consistent basis. You know the return on each tranche, and by measuring the risk on each tranche on the same basis, you can then enter into the tranche with the best return on risk.” A web-based risk-reporting system monitors daily changes in the risk profile of the entire CDO portfolio and of individual tranches.

Dresdner’s own loan portfolio management team is the biggest user of CreditHorizons. “Buying credit protection against your peak risks in a loan portfolio using single-name default swaps is expensive – we have protection

on $2.7 billion of notional so you can imagine the cost,” says Cloke Browne. “is cost has to be funded, and one way to do this is to sell protection on a reasonably senior CDO tranche and use this to diversify the loan portfolio.”

CreditHorizons indicates the transactions it is most cost-effective to hedge and those with the best return on risk. “We have a large CDO book, which has 15 tranches in it now – both long and short – from very low subordination up to super senior level,” says Cloke Browne. “We generate a risk profile on a name-by-name basis and use this to derive where the risk concentrations lie. is drives the next transaction decision.”

As well as being used in-house, CreditHorizons has 30 external users, largely other loan portfolio managers, but also insurance companies and asset managers. Rather than charging them a fee, the bank sources risk from these institutions that

Matt Woodhams, GFI: simulation implies slow calculation


can help diversify its own loan portfolio, thereby generating transaction fees and releasing capital that can be redeployed elsewhere.

Bank of America’s portfolio credit product, Lighthouse, is also available free of charge to the bank’s clients. “Our objective is not to get a fee, but to help set a standard to make the process of pricing credit more liquid and transparent,” says Raja Visweswaran, head of European and international strategy in Bank of America’s credit research team. But unlike at Dresdner, the product is independent of the bank’s own loan or credit portfolio management.

Lighthouse is based on the credit option adjusted spread (COAS) model, a credit risk measurement model developed by Bank of America, which incorporates information from the equity, options and credit markets as well as balance-sheet fundamentals. Lighthouse brings the results of the COAS model into a portfolio environment, enabling the user to compare all the credits in a portfolio on the basis of their relative efficiency in terms of risk contribution and spread.

Both CreditHorizons and Lighthouse have their origins in PortfolioRisk+, a model developed by Credit Suisse First Boston, which was launched about two years ago. It currently has over 50 users worldwide, and although so

far only about a fifth of them of are using it for portfolio credit, the proportion is increasing steadily as the bank has started to focus on structured credit clients in particular.

“We don’t use it with every client,” says Recai Günesdogdu, European head of the fixed-income portfolio strategy group at Credit Suisse First Boston. “We need to work with clients to train them and ensure that they understand the techniques involved. And they have to be comfortable with the Merton-type approach for pricing credit securities.” PortfolioRisk+ is currently offered as part of the bank’s advisory service, but in the latter part of 2004 it will be available to selected clients – those that understand the model and are comfortable with the technology – over the internet.

e bank claims that the latest version of PortfolioRisk+, released last September, is more advanced than the models offered by other banks. It introduces expected shortfall as a more accurate measure of risk and improves the methodology for dealing with “tail-end” (high impact, low probability) risk to better approximate risk across the entire credit distribution.

Raja Visweswaran, Bank of America: seeking transparency not fees


Rating agencies also offer a range of monitoring tools, which can be used for cashflow or synthetic CDOs. “e rating agencies are becoming much more helpful in their analysis of these deals,” says GIB’s Veroude. He points in particular to S&P’s new rated over-collateralisation measure, which indicates the potential total cashflow available to support a rated CDO tranche. It overcomes many of the shortcomings of traditional methods of measuring over-collateralization by taking into account the credit quality of the collateral portfolio and allowing a direct comparison of the rated liabilities across different transactions.

Some argue that investors prefer the transparency of a market-based approach to analytics based on credit ratings – which can be regarded as subjective and backward-looking. “e inputs [of Lighthouse] are all market based – equity

prices, option prices and credit spreads,” says Bank of America’s Visweswaran. “Investor confidence in the product is higher because the entire process is transparent, and that’s the unique selling point of this approach.”

But not everyone agrees. “For managing a synthetic CDO, you can’t say ratings aren’t important, as the manager has to adhere to numerous rating agency constraints,” says Cheyne Capital’s Weiss. “Markets do move on rating agency actions, and if you don’t monitor them, you’re not doing the job properly.” Cheyne – itself a manager of synthetic CDOs – tracks Moody’s KMV scores and results from S&P’s CDO Evaluator, as well as market-based and fundamental information, in its credit screening system.

S&P’s Biltoo warns against models focusing too heavily on market factors, particularly the widening of credit spreads. “All kinds of things can move credit spreads, and these are not necessarily precursors to a default,” he says.

No market: no modelAll the portfolio credit systems, whether commercial or bank-owned, can be applied to credit derivatives backed by pools of corporate credit risk. However, for deals referencing assets that are not widely traded, for example, asset-backed securities, loans or mortgages, such models don’t help. “It’s a non-standardised market, so you can’t develop a model that works perfectly for these deals. It’s more about knowing the portfolio that you invest in than applying a model,” says Alex Veroude, head of structured products at Gulf International Bank.

GIB uses a model that calculates the market value of the securities underlying the synthetic pool. “We have a very large database of European ABS products. If we’re offered a portfolio with 100 asset-backed names, chances are we will have 90 of them modelled up anyway. For the remainder, we will research them, and once we’re comfortable that we understand all 100 assets, we can then analyse the capital structure and are able to value intrinsically the particular tranche of the synthetic deal,” says Veroude.

bring on the manager 41

The benefits of managed synthetic CDOs over static transactions have been a lively debating point since the early days of the portfolio credit derivatives market. Some of the first synthetic CDOs were managed, in the sense that

the issuer could make substitutions. But investors soon discovered that giving protection buyers the right to introduce new names did not necessarily work in their favour.

However, in 2001 a new type of portfolio credit instrument appeared. is is a deal where an asset manager is paid to trade the portfolio for the benefit of inves-tors. ese independent managers can point to a range of advantages associated with active collateral management, although not all investors are convinced that managers add value.

But there is no doubt that managed synthetic CDOs are today an established part of the market – though still a small one. Less than 10% of synthetic CDOs in 2003 were in the form of independently managed transactions, according to Creditflux’s database of transactions.

One of the arguments put forward for choosing a managed over a static ap-proach is that static deals are more vulnerable at the portfolio selection stage to the inclusion of bad credits. In the absence of a credit manager, independent manag-ers argue, the dynamics of a transaction can become biased towards including the highest yielding assets possible, at the expense of fundamental credit analysis.

“e initial selection does determine 80% of the outcome,” says Maryam Mues-sel, chief operating officer at New York-based American Capital Access (ACA), which closed its first managed investment-grade corporate synthetic deal in 2001. “at initial decision has to be very carefully done and we really slow down the credit selection process. You cannot respond to a 24-hour pricing determination. ere are even instances of managers pre-committing to transactions. How can you commit before pricing when you do not have all the information on the names that are to be included?”

At first glance an ability to hedge deteriorating credits, trade out of positions,

Chapter 7bring on the manager:strategies for adding value

42 portfolio credit swaps bring on the manager 43

and cover hedging costs by executing relative value trades seems to provide an obvious advantage over static portfolio credit swaps.

As well as arguing that a managed approach provides an edge during initial portfolio selection, independent managers say that the ability to physically settle a reference entity after a default is a key advantage over static deals, which are cash settled.

“Using a managed approach with physical settlement means you are not at risk of taking a loss realised in cash at the worst moment,” says Laurent Gueunier, head of investment-grade CDOs at French asset manager Axa Investment Managers. “WorldCom, for example, was 11% of par when delivered, but is now 30% so you have made part of the money back. You do not have that ability with static [cash-settled] deals.”

Within the larger argument about the pros and cons of managed transactions is a debate over how actively a manager should trade the underlying collateral. Axa Investment Managers, which has built a reputation as one of the most innovative CDO managers in the European market, falls firmly into the hands-on category.

e firm has dealt approximately €10 billion in credit default swaps since closing its first managed deal, Jazz CDO 1, in February 2002. Today, it manages synthetic CDOs totalling €6 billion.

Biggest managed synthetic CDOs 2003

Date Vehicle/issuer Notional (m) Protection buyer Arranger Exposure type

29 Apr Robeco CDO VII 2,800 Robeco Robeco, Rabobank

IG corporate

5 Dec Overture CDO I $3,385 Axa Investment Managers

JP Morgan IG corporate

29 Oct Cheyne Single Tranche Managed 1 & 2

2,000 Cheyne Capital Management

Morgan Stanley

IG corporate

13 May United Global Investment Grade CDO III

$1,700 UOB Asset Management

Goldman Sachs

IG corporate

21 Feb Pintas $1,620 Cheyne Capital Management

JP Morgan IG corporate

26 Feb Full Moon ¥140,000 Dai-Ichi Life IBJ Asset Management

BNP Paribas

IG corporate

4 Nov Tempo CDO I 1,000 Axa Investment Managers

Citigroup asset-backed

30 Jul Anchor I CDO 1,000 Harbourmaster Capital Management

Bank of America

asset-backed

42 portfolio credit swaps bring on the manager 43

“We think it is important to have an active trading strategy,” says Gueunier. “at way you can store trading gains to pay future pool trading losses. It provides stability for the mezzanine holders but also ensures healthy returns for equity.”

Axa IM has applied this philosophy through an innovative series of hybrid synthetic deals that combine debt securities and synthetic assets in the collateral portfolios. is approach, which was applied most recently to the firm’s €3 billion Overture transaction, allows Axa IM to take advantage of trading opportunities in the cash as well as the credit derivatives market.

“We found a lot of value in longer-dated cash bonds when putting the Over-ture deal together,” recalls Gueunier. “at allowed us to create a portfolio with a spread of 112bp and an average rating in the triple-B area. At the time, the average market spread was around 75bp in five-year credit default swaps. But now that the market has reversed we have found more value in credit default swaps. at is a good illustration of why we believe that playing every aspect of the credit market is important.”

Not all collateral managers, however, subscribe to a high turnover style of management. ACA, for example, which is the market’s only single-A-rated financial insurance company, prefers to take advantage of relative value

opportunities on a selective basis, but not to trade the portfolio too actively.“CDOs are not vehicles that lend themselves well to trading,” says Muessel. “ese are highly regulated vehicles with definite rules of engagement.”

Muessel says that ACA’s approach to collateral management involves placing a strong emphasis on the separation of trading from credit fundamentals analysis – a point that Gueunier says is also central to Axa IM’s management style.

“e traders are second to the analysts,” says Muessel. “We bifurcate credit from trading so that there is a check-and-balance. ere can be residual loyalty to the Street so that takes a lot of heat away from the trader. e trader can say, ‘It is not my call, I need to make sure my analyst is comfortable.’ ”

Muessel adds that an active trading style risks diluting a credit fundamentals- driven approach to CDO collateral management. “You cannot make credit deci-sions in a few seconds,” she says. “When the trader is the portfolio manager the impression sometimes is that it becomes more of a rates-driven strategy. But you can have losses that when they hit can cut right through you. We are putting credit people in charge of the overall process and traders in control of the information flow and giving us market colour.”

ACA, which is one of the very few managers of synthetic CDOs to have an unblemished track record in terms of avoidance of a default, has three investment grade corporate synthetic CDOs under management. e firm has also built a track record in managing cash flow CDOs of asset-backed securities, having three transactions under its belt. e firm has $6 billion notional amount of CDOs under management, split evenly between synthetic corporate deals and cash flow ABS transactions.

Even managers with top reputations are not immune to experiencing collateral

Maryam Muessel, ACA: CDOs do not lend themselves well to active trading


defaults. In the case of Axa IM, WorldCom is the one instance of a default within its CDOs, in Jazz CDO 1.

London-based Cheyne Capital, which also has a zero default record across its deals, is one of the most active proponents of a high-turnover approach. “Our trading style is different from other houses,” says David Peacock, who co-heads in-vestment-grade credit at Cheyne with John Weiss. “It feels like a hedge fund style because we are quite proactive; we are always looking for the next trade.”

e result, says Peacock, is high incremental returns. “If you break out the re-turns attributable to the locked in cashflow arbitrage from the returns from trad-ing, half the return is from alpha generating trading and half is from the locked in arbitrage,” he says.

Cheyne, which was founded in 1999, has the largest notional amount of syn-thetic CDOs under management in the market. e firm has closed six deals in total since 2002, bringing its CDO assets under management to over $13 billion. Overall trades including ramp-ups total $18 billion.

Peacock contrasts this active trading style with what he says are the drawbacks associated with a typical defensive approach to capital preservation. “A lot of CDO managers are content simply to defend the cashflow in the deal, but that means your returns are capped at the initial level. So that is a loss-making business in my view. If you think that all you have to do is defend the portfolio, the deal will pay 20% a year if you are lucky, or 10% if there are a couple of defaults.”

Adds Cheyne’s John Weiss: “ere is always the risk of something negative happening in the portfolio, which is why we think it is so important to lay on a long–short strategy. We are not looking for a return beyond the zero default return that you have at the outset, but an active trading strategy allows you to build up a pool of additional cash so that if the time comes, you can use that to protect the portfolio. It is a strategy that has enabled us to fulfil our promised returns to the equity.” Like most CDO managers, Cheyne is reluctant to disclose actual figures for its deals’ equity returns.

Cheyne’s trading style, adds Weiss, goes hand-in-hand with a particular type of team set-up. “ere are a number of factors which mean we are set up to be good at spotting relative value opportunities,” he asserts. “First, we are very well structured for credit market information flow. We are a relatively small sized firm, so we are talking every day to our colleagues trading equity, convertible bonds and special situations. Second, we are different from houses that have a large number of analysts covering a certain number of credits each. at can result in compartmen-talisation. People start owning the credits and can be less willing to sell or admit to mistakes. At Cheyne we make use of a smaller number of analysts and focus their attention on a floating list of the more interesting credits. However, if we have a very critical situation, or an immediate buy/sell, we will concentrate resources and have two to three analysts looking at that.”

Peacock believes the performance of Cheyne CDO 1, which of the firm’s three deals has had to contend with the most volatility, validates Cheyne’s CDO man-agement approach. “e first CDO has been an interesting litmus test of how we

‘A lot of CDO managers are content simply to defend the cashflow. But that is a loss-making business’


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are able to perform in a stressed environment,” he says. Not surprisingly, the credit market meltdown in 2002 was a period of increased

trading activity for other CDO managers as well. e ramp-up of ACA’s inaugural synthetic deal took place in February of that year. “We thought we would trade 5% a year,” recalls Muessel. “In fact, we hedged 20% of the portfolio in six months, so that was 20 deals. It was a time of extreme stress in the credit market.” e trades included unwinding exposure to WorldCom in advance of the telecom group’s default in July 2002.

Axa IM, meanwhile, responded to WorldCom’s default with an all-out trading strategy to boost Jazz CDO 1’s performance. “We have had 100% turnover on Jazz CDO 1,” says Gueunier. “We went through one of the most difficult markets in a very long time. e performance of Khaleej, our second CDO which was closed in December 2002 has been exceptional. But with Jazz CDO 1 we have been obliged to do a lot of trades to keep the performance at the right level.”

One thing that all three managers have in common was their avoidance of any exposure to failed Italian dairy company Parmalat.

“We didn’t have Parmalat,” says Gueunier. “We didn’t like it from day one. Why would you want a company that had issued €150 million of bonds very expensively when it was supposed to have €4.2 billion of cash on the balance sheet?”

Different managers take different views on the need to invest in their own deals. For example, Cheyne Capital does not invest in the equity of its transactions. On the other hand, Axa IM has invested in a portion of the equity in its CDOs, and has also bought mezzanine debt. Meanwhile ACA has taken 100% of the equity in all of its transactions so far.

“We are in the credit risk taking business and accessing CDO technology is an attractive way to take on credit risk,” says ACA’s Muessel. “It opens up better spread arbitrage by giving us a blended double-A cost of funds.”

Muessel says that ACA’s operating strategy in the CDO business mitigates any potential conflict of interest between ACA – as equity investor and asset manager – and noteholders. “e more equity the manager takes the more aligned is the manager’s interests with the remaining investors in the CDO,” she says.

ACA is paid a portion of the structuring fees as a joint underwriter of its CDO deals, she notes, along with a risk premium to reflect its participation as a value-added investor, and asset management fees.

e decision to trade out of WorldCom is a good illustration of the balance of interests at work in the CDOs, Muessel says. “What did we want; a principal hit or a reduction in the equity return? We wanted to protect from a worse mistake, or in other words, a principal loss. Partly it goes back to who we are. As an insurance company we are very conservative in not taking principal write-down.”

Muessel says that CDO managers who do not invest in the equity in their deals can sometimes use that fact as a marketing proposition. But, she adds: “It stretches belief a little if a manager is pretending that they are not managing for the equity in addition to the remaining investors in the CDO.

glossary 47

attachment point the minimum level of losses in a portfolio to which a tranche is exposed. See also subordinationasset correlation the degree to which asset values move in tandem. Equity prices are widely taken as a proxy for asset correlationbasket see nth-to-default basketbinary settlement also know as digital, a pay-out following a credit event that is a fixed amount rather than par less a recovery ratecalculation agent see cash settlementcash settlement a payout following a credit event in which the protection seller pays the protection buyer an amount calculated as equivalent to the par value of a deliverable obligation less a recovery rate. is amount is determined by the calculation agent, usually by a dealer poll to determine the price of an obligationcheapest-to-deliver option the protection buyer’s right to choose the eligible obligation with the lowest value following a credit eventCDO squared a CDO of CDOscollateralised debt obligation (CDO) an investment collateralised by or referenced to a diverse portfolio of debt in which the investor is exposed to losses above and below certain thresholdscopula a statistical tool describing how the distribution of single risks join together to form joint risk distribution. In the case of portfolio credit risk, copulas describe how patterns of individual default risk join together to form the distribution of loss on a portfoliocorrelation see asset correlation, spread correlation, default correlation. Correlation is usually measured as a percentage, with 100% representing perfect correlation, 0% no relationship and –100% perfectly negative correlationcorrelation smile a phenomenon whereby junior and senior tranches imply high correlation and mezzanine tranches imply low correlationcredit default swap an over-the-counter contract to transfer credit risk, in which the buyer of protection pays a premium and the seller of protection makes a payment in the event of default. See also single-name credit default swapcredit or trigger event in a standard credit default swap, one of failure to pay, bankruptcy and restructuring default correlation the degree to which the default probability of different credits moves in tandemdeliverable obligation an asset that is eligible to be delivered to the protection seller in the event of default or that can be used as the basis for cash settlementdelta the sensitivity of a derivative to changes in the reference price. In portfolio credit swaps, the sensitivity of the tranche to changes in the price of the underlying namesdetachment point also known as exhaustion point, the maximum level of losses

Glossary


in the portfolio to which a tranche is exposeddigital credit default swap see binary credit default swapequity default swap a barrier equity option which uses terminology similar to a credit default swap. e trigger or equity event is a fall in the reference share price below a certain level at any point during the life of the tradeequity default obligation a portfolio of equity default swapsexhaustion point see detachment pointfirst-loss tranche the most junior tranche in a portfoliofirst-to-default basket see nth-to-default basketMerton model also known as firm-value or latent variable model, the Merton model says default occurs when the value of a company’s assets falls below the value of its debt, it therefore establishes a link between credit and equity pricesMonte Carlo simulation generation of thousands of random scenarios to establish the probability of an event ocurringnth-to-default basket a credit derivative in which the payout is linked to one in a series of defaults (such as first-, second- or third-to-default), with the contract terminating at that pointphysical settlement a payout following a credit event in which the protection buyer delivers an eligible obligation to the protection seller in exchange for the par value of the assetprotection buyer the counterparty that hedges credit risk in a credit derivativeprotection seller the counterparty that assumes credit risk in a credit derivativePV01 a measure of price sensitivity to spread for portfolio risk similar to DV01 (the change in the dollar value of an individual bond or credit default swap with spread movement). PV01 is the mark-to-market change in the value of the tranche expressed in dollars if spreads on the individual names in the portfolio move by one basis pointramp-up the process of assembling a portfolio of assets in a CDOrecovery rate the value of the debt of an entity after it defaultsreference entity the borrower whose default triggers a payout in a credit derivativesingle-name credit default swap a credit default swap referencing a single borrowerspread correlation the tendency for the spreads of different credits to move in tandemsubordination the amount of losses a portfolio has to experience before a tranche suffers any losssynthetic CDO a portfolio credit derivative super senior a tranche that benefits from subordination that is implicitly or explicitly rated triple-Atrigger see credit event

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