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Credit Derivatives and
Synthetic Securitisation

Guide to Commoditisation of Credit Risk

By Vinod Kothari
July 2002 edition

Preface

Soon after the Sept 11 terrorist attack, the anthrax scare gripped large parts of the World – every news despatch of some queer powdery substance found in someone’s mail feared to be anthrax germs promoted the sales of ciproflaxicin or similar antibiotics. The banking world today is in a tighter grip of corporate bankruptcy fears – and the sale of credit derivatives is booming. Financial Times of 5th July reports: "The volatility in the corporate debt markets surrounding high-profile names such as WorldCom, France Telecom and Vivendi has placed banks' credit derivative trading desks at the heart of the action." It goes on to say: "JP Morgan's London default swap desk has been completing 140 trades a day", which is reportedly double the usual deal rate for them.

Credit risk has always been inherent in a system that thrives on credit, but the emergence of the multi-national corporation has multiplied the magnitude of credit risk many times. There are very few today who propound things like "small is beautiful", but increasingly, the World is getting to realise that the failure of an Enron or WorldCom today can have almost the same tragic and long-lasting social impact as a high-rise building crashing. What is even more serious is the backlash - the entire system works on so much of interdependence that a bankruptcy in one part of the World can ignite disaster in a totally unconnected territory.

As risk gets more concentric, there is greater need to diffuse it – and that is where credit derivatives come handy. It would be difficult to establish that credit derivatives reduce the risk of the corporate system we live with, but certainly, as more risk is traded, it becomes better understood, better appreciated, and diversified.

There are reasons to dismiss as too harsh the famous Howard Davies’ comment calling CDOs "the most toxic element of the financial markets today." But few will disagree that a substantial part of credit derivatives market today is motivated by speculative reasons, given a neat name of "arbitrage" activity. When good intents of profit-making are proved wrong by eventual realities, the borderline of distinction between arbitrage and speculation disappears, and we set out in search of the "rogue trader". There is need to tread the sensitive area of credit derivatives with caution.

This is best reflected in the cover design of this book. We show a crashing high-rise being packed into a box, to be put up for sale. The crashing building is a symbol of risk – the risk of a high profile corporate bankruptcy, being packed for trading. Aptly, the box says: Handle with care.

Having said this, I must say – this book is not focused on the risks of credit derivatives. It is a complete treatise on the technique, issues, motivations and structures – structures which seem to be making a lot of sense. This book tries to explain the methodology of synthetic securitisation which has been used to commoditise the risks in funding large corporations as well as small and medium enterprises.

 

This is my third book – and I have taken a long time of some 17 years to add up to this number. The last one on securitisation brought me close to the structured finance community World-over. I have tremendously enjoyed the attention I got; and I do hope this one will also be well received.

 

This is a question which I have faced often – I am not an ex-credit derivatives dealer, or former investment banker, or for that matter, former-anything. So, how do I get the authority to write on credit derivatives. I have found a workable answer to this repeat question. The all-time classic Kamasutra was written by Vatsyayan who was an Indian sage! So, to do it is not necessary to know it.

 

I do remain open and eager to any constructive comments of my readers.

VINOD KOTHARI

Calcutta
9th July 2002