Basics of Credit Derivatives

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Vinod Kothari's
Credit Derivatives and Synthetic Securitisation
A guide to commoditisation of credit risk

with updates upto May 2003



Preface VII

about the author 14

chapter 1: Credit Derivatives: Structure, evolution, motivations and economics 17

Credit risk: the challenge of our times: 18

Derivatives: the building block of credit derivatives 18

Securitisation: The other building block 19

Meaning of credit derivatives 20

What is a credit derivative? 20

A definition of credit derivatives: 21

Quick guide to basic jargon: 22

Synthetic lending: 23

Why do they do it? 24

The elements of a credit derivative: 26

OTC derivatives and capital market deals: 26

Reference asset or portfolio: 26

Basket trades: 27

Index-based derivatives: 28

Protection buyer 28

Protection seller 29

Funded and unfunded credit derivatives: 39

Credit event: 30

Notional value: 30

Premium: 31

Tenure: 31

Loss computation: 31

Threshold risk or loss materiality provisions: 32

Cash and physical settlement: 32

Deliverable asset: 33

ISDA documentation: 33

Quick introduction to the types of credit derivatives: 34

Credit default swap: 34

Total return swap: 34

Credit linked notes: 35

Credit spread options: 35

Credit derivatives and traditional financial guarantee products: 36

Credit derivatives and guarantees: 36

Difference between traditional guarantees and credit derivatives 37

Credit derivatives and securitisation: 39

Evolution of credit derivatives: 39

Credit derivatives and secondary markets in loans: 39

Emergence of credit linked notes: 40

Early period of scepticism: 41

The 1997 crises: credit derivatives get a boost: 45

Current state of the market: 46

Growth out of crises: the 1997 and 1998 crises 48

Enron and Argentina: 48

"We are a credit derivatives company" 49

Synthetic securitisation of retail credit products: 49

Product development: 50

Major centres of credit derivatives activity: 51

Major market players: 51

Banks: 52

Investment banks: 54

Insurance companies: 54

Major products: 55

Reference risks: sovereign versus corporate 56

Motivations: 56

Motivations for the protection buyer: 57

Reducing regulatory capital 57

Economic capital relief: 58

Offers easier alternative to securitisation: 58

Reduction of credit concentration: 60

Better portfolio management: 60

Solves cross border problem: 60

Much higher RARoC returns: 61

Motivations for the protection seller: 61

Synthetic lending: 62

Arbitraging opportunities 62

Yield enhancement: 64

Risk diversification 64

Much less costly: 65

Resolves problems of availability by cloning cash assets: 65

Motivations for the traders and re-packagers: 65

Economic impact of the credit derivative market: 66

The positive side 67

Allows banks to focus on credit asset creation: 67

Effective risk management by diffusion of risk 67

Securitisation results into disintermediation: credit derivatives reinforces the role of commercial banks: 68

Credit derivatives and pricing of credit risks 68

The negative side 69

Lack of transparency in transfer of risks: 69

Cross-sector risk transfers: 70

Transfer of risks to the lesser informed: 70

Increased leverage: 71

Appendix 1 : issues in cross-sector risk transfers (FSA) 72

Appendix 2 : Credit derivatives terminology 76

Chapter 2: Credit default swaps 101

Meaning of credit default swaps: 101

Main terms of the credit default swap: 102

Reference obligation: 102

Premium: 103

Credit events: 105

ISDA's credit events: 106

1. Bankruptcy 106

2. Obligation Acceleration 107

3. Obligation Default 108

4. Failure to Pay 108

5. Repudiation/Moratorium 109

6. Restructuring 109

Notice of credit event: 109

Terms of settlement: 110

Physical settlement: 110

Deliverable obligation: 110

Cash settlement: 110

Valuation of the defaulted obligation: 111

Collateral provisions: 111

Basket trades: 112

Portfolio trades: 113

Structured credit derivatives: 114

Binary swaps: 116

Index-based credit default swaps: 116

The restructuring controversy: 117

Convertible, exchangeable and accreting obligations: 119

chapter 3: Total Rate of Return swaps 121

Meaning of TROR swaps: 121

CDS and TROR swaps: 123

Impact of a TROR swap: 123

Terms of a TROR swap: 125

Reference asset: 125

Credit events: 126

Settlement methods: 126

Index-based total return swaps: 126

chapter 4: Credit linked notes 129

Meaning of a credit linked note: 130

Distinctive features of credit linked notes: 131

Substance of CLNs: a funded avatar of an unfunded derivative: 132

CLNs issued by SPVs: 133

chapter 5: Synthetic Securitisation 137

Cash structure securitisation: 137

Synthetic securitisation: 138

Modus operandi: 139

Structured credit risk transfer: 140

Leveraged risk transfer: 142

Super-senior swap 143

Advantages of synthetic securitisation over cash transfers: 145

Minimizes funding and reinvestment problems: 145

Alleviates transfer-related problems: 146

Does not require artificial separation of origination and servicing functions: 148

Lesser legal costs: 149

No upfront taxation: 149

Avoids double taxation of residual profits: 150

No accounting volatility: 151

Does not reduce book size: 152

Retains flexibility in customer service: 153

Distinction between cash-funded and synthetic securitisation: 153

Elements of synthetic securitisation 155

Originator: 155

Obligor portfolio: 155

Type of Credit derivative: 156

Credit events and loss computation: 156

Special purpose vehicle: 157

Assets of the SPV: 158

Liabilities of the SPV: 159

Non-SPV structures: 160

Sizing of the credit enhancement: 161

Swap calculation agent: 163

Trustees: 163

Super senior swap provider: 164

Other swap counterparties: 164

Arbitrage synthetic CDOs: 164

Difference between arbitrage synthetic CDOs

and balance sheet synthetic CDOs: 167

Collateral manager: 168

Over-collateralisation and interest coverage ratios: 168

Application of OC and IC triggers to synthetic CDOs: 171

Paydown structure: 172

Sequential paydown: 172

Pro-rata paydown: 172

Fast-pay/ slow-pay structure: 173

Evolution and growth of synthetic CDOs 173

Investing in synthetic CDOs: 176

chapter 6: Case studies 179

DBS Bank Singapore's Alco 1: 180

Transaction structure: 180

The SPV 180

The notes: 181

Risk transfer: 182

Reference portfolio: 183

The credit default swap: 184

Investment of the collateral: 186

Interest rate swap and put option: 186

Economics of the transaction to DBS Bank: 186

CAST 1999-1 Non-SPV structure 188

Features of CAST 1999-1 189

Principal protection to subordinate class: 191

Investor interest 192

Cast 2000-1 193

Promise program by KfW Germany 195

Promise A 2002-1 196

Transaction structure: 196

The notes and Schuldscheine: 198

The reference portfolio: 199

Loss structure: 199

Amortization of the notes: 200

Promise-I 2002-1: 201

Jazz synthetic arbitrage CDO 202

Hybrid between cash and synthetic structure: 203

All that Jazz it has: 204

Synthetic versus cash liabilities: 205

The collateral manager 206

Liquidity facility: 207

Over-collateralisation and Interest cover tests: 208

Robeco arbitrage synthetic CDO: 208

Synthetic Credit asset securitisation: SMART from Australia: 211

Synthetic versus cash transfer of lease receivables: 211

Credit protection: 212

Asset structure: 214

White Oak synthetic CDO of structured obligations: 214

The reference portfolio: 215

Credit events: 215

Funding: 215

Regulatory arbitrage? 216

chapter 7: Legal aspects of credit derivatives 217

Legal nature of credit derivatives: 218

Credit derivatives and contingent contracts: 218

Credit derivatives and actionable claims: 218

Contract of guarantee or surety: 219

Contract of indemnity: 224

Credit derivatives and bank letters of credit: 226

Credit derivatives and insurance contracts: 227

Are they gaming, gambling or wager contracts: 228

Are they securities? 228

Are they investment contracts 229

Bilateral contract or transferable: 229

Enforceability of credit derivative contracts: 231

Regulatory enforceability of the derivative contract: 232

Enforceability of the reference obligation: 232

Derivatives-related regulation applicable to credit derivatives: 233

Commodity derivatives laws 233

Commodity futures law in the USA: 234

Exemption to OTC derivatives 234

Commodity Futures Modernization Law: 236

Legal nature of a credit default swap: 238

Legal nature of total return swaps: 238

Legal nature of credit-linked notes: 238

Permissibility for banks: 240

Whether a part of banking business 240

Whether banks can be protection buyers: 241

Whether banks can be protection sellers: 242

Legal position of netting rights: 242

Bankruptcy Code safe harbour to credit derivatives: 243

Early bankruptcy safe harbour in the USA: 243

Financial Contract Netting Improvement law 244

ISDA Documentation for credit derivatives: 245

Master agreement 245

Termination and close-out Netting: 246

Representations: 246

Undertakings: 247

Events of default: 247

Termination events: 248

Consequences of events of default/ termination event: 248

Transferability of the derivative contract: 249

Confirmation: 249

Introducing line of the confirmation: 250

General terms of the Confirmation: 252

Financial terms: 253

Notice requirements: 253

Credit events: 253

Obligations and Obligation Characteristics: 254

Settlement terms: 256

Terms relating to cash settlement: 256

Terms relating to physical settlement: 257

Dispute resolution: 259

Notices etc: 259

The Definitions: 259

Additional documents: 260

chapter 8: Taxation of Credit Derivatives 261

Key issues in taxation: 261

Taxation of the protection buyer 262

Integration with the reference obligation: 262

Option contract treatment: 263

Notional principal contract: 263

Meaning of notional principal contracts: 263

Are credit derivatives notional principal contracts: 264

Hedge tax rules applicable to notional principal contracts: 264

No hedge tax accounting for Notional principal contracts: 265

Taxation of credit linked notes: 266

Taxation of the protection seller: 266

Tax treatment in other countries: 266

chapter 9: Accounting for credit derivatives: 267

Whether derivatives accounting standards applicable? 268

Whether a derivative: 268

Physical settlement deals: 268

Credit default swap and financial guarantees 269

Exchange traded derivatives: 274

Total rate of return swap: 274

Credit linked note: 274

Basics of derivative accounting rules: 275

Basics of accounting for financial instruments 275

Basics of hedge accounting: 276

Why and when hedge accounting? 277

Impact of hedge accounting: 277

Conditions for hedge accounting: 278

Fair value hedge accounting: 278

Cashflow hedge accounting: 279

Accounting for credit default swaps: 280

If the CDS is a financial guarantee contract: 280

If the CDS is not merely a financial guarantee contract: 280

Accounting in the books of the protection buyer: 281

No hedge-accounting: 281

Hedge Accounting: 282

Fair value hedge: 282

Cashflow hedge: 282

Examples: 283

Accounting in the books of the protection seller: 286

Examples: 287

Accounting for total rate of return swap: 288

Books of the protection buyer: 288

Example: 289

Books of the protection seller: 290

Accounting for a credit linked note: 290

Books of the protection buyer: 290

Books of the protection seller: 290

Example 291

Valuation of credit derivatives: 292

What is fair value 292

Sources of exit price information 292

Computation of exit price: 293

Disclosures of credit derivatives: 294

Examples of disclosures: 295

chapter 10 Regulatory and economic capital: impact of credit derivatives 297

Evolution of regulations: 298

The US regulatory guidelines: 299

The 1996 guidelines: 299

Guarantee-like treatment 299

Examiner-determined treatment for the protection buyer: 301

Capital relief to the protection buyer: 301

Funded portion 302

Unfunded portion 302

Senior uncovered position: 302

Capital implications applicable to protection seller: 304

Funded derivatives 304

Unfunded derivatives: 304

The FSA UK's guidelines 304

Stress on risk management issues: need to have proper systems: 305

Legal and reputational risks: 306

Liquidity: 306

Impact of credit derivatives on the remaining assets: 306

Will credit derivatives qualify to be on trading book of banks: 307

Demonstration of trading intent: 307

Marking credit derivatives to market: 308

Where credit derivatives are part of the banking book: 308

In case of funded derivatives: 308

In case of funded derivatives that provide partial risk protection: 308

In case of unfunded derivatives: 309

Where the reference asset and the underlying are not the same: 309

Impact of currency mismatch: 310

Impact of maturity mismatch: 310

Multiple obligors: 311

Capital treatment in the books of the protection seller: 311

In case of funded contracts: 312

In case of unfunded derivatives: 312

In case of multiple obligors: 312

Amount of payout: 313

Conditions for risk transfer by credit derivatives: 313

Conditions to be satisfied by all derivative contracts: 313

Conditions applicable to single-name funded derivatives: 313

Conditions applicable to funded packaged derivatives: 314

BIS-II proposals: 316

Credit risk mitigation: 316

Common conditions for credit derivatives and guarantees: 316

Specific operational requirements for credit derivatives 317

General rules for capital relief: 318

Computation of the risk weightage: 319

W factor 319

Partial protection: 320

Tranched cover: 320

Regulations in other countries 320

Economic capital considerations: 323

Meaning of economic capital: 323

Economic capital models: 324

Credit derivatives and economic capital: 325

chapter 11: Pricing of credit derivatives 327

Approach to pricing of a credit derivative: 328

Nature of a credit derivative contract: 328

Defining the contract: 328

Defining the cash inflows and outflows: 329

Expected value of the protection payment: 329

Expected value of protection payment in case of a credit derivative: 330

Expected value of the CDS premium: 333

Imputing the CDS premium: 334

Estimating default probabilities: 335

Estimating recovery rates: 335

Multiple obligor credit derivatives: 338

Basket trades 338

Pricing of CDOs: 339

Structured risk transfer: 340

Models on credit derivatives pricing: 341

Merton model: 341

The KMV model: 342

Measuring default probability: 343

Asset value and volatility: 344

Computing the distance to default: 344

Computing default probability: 345

The Jarrow Lando Turnbull model 345

Hull and White Model: 349

Pricing of credit derivatives versus cash assets: 350

Fundamental reasons: 351

Funded versus unfunded assets: 351

Deliverable asset: 351

Default definition: 352

Balance sheet/ off-balance sheet transaction: 352

Difference in loss given default due to difference in cost price: 352

Counterparty risk: 353

Encashability of gains: 353

Market reasons: Demand and supply factors: 353

The Hull and White Model: 354

The Jarrow-Lando-Turnbull (JLT) model 357

The Das-Tufano(DT) model 359

The Duffie-Singleton model 360

Merton's Model: 360

chapter 12: Recent Advances in Credit Risk Management: A Comparison of 5 Models (by guest contributor) 363

Abstract 364

The Conceptual Background It all started with Black-Scholes 364

Merton's Model 366

Credit Risk Models Structural versus Reduced Form 368

Key Features of Credit Risk Models 369

Correlation Assumptions: 373

Bottom-up versus Top-down: 374

Economic Data: 375

The Models in Detail 375

KMV's Portfolio Manager 375

JP Morgan's Credit Metrics 377

Kamakura's Risk Manager 378

CSFP's Credit Risk+ 379

McKinsey's Credit Portfolio View 380

So what's the best model? 383

chapter 13: Pricing Multi-name Credit Derivatives (by guest contributor) 387

Introduction 387

Single-name modeling approaches 389

The structural approach 389

The reduced form approach 390

Difficulties in multi-name modeling 391

Multi-name modeling approaches 392

Multivariate structural approach 293

Multivariate reduced form approach 394

The hybrid approach 394

Importance of dependence structure 395

The Normal dependence structure 397

Conclusions 399

References 400


Contents of the Updates May 2003

Current state of the market: 3

Major markets: 4

Major products: 5

Role of insurance companies in the credit derivatives market: 6

Economic impact of credit derivatives: 6

The Greenspan vs Buffet debate: 6

Cross-sector risk transfers: 9

FSA Discussion paper: 9

Insurance regulators' study: 10

Financial Stability Forum: 10

Surety bonds and credit derivatives: 11

ISDA documentation: Master agreement 11

Credit Derivatives Definitions 2003 12

Obligations as guarantor: 13

Restructuring relating changes: 13

Bankruptcy: 14

Revision of IAS 39: 15

FAS 133 developments: 15

Exposure draft of amendments to FAS 133: 15

DIG Issues 16

Regulatory guidelines in Thailand: 19