Basics of Credit Derivatives

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Credit Derivatives news from Feb 2004 to date




News items are indexed chronologically, latest on top


Credit derivatives volumes exceed $ 45 trillion: ISDA survey

The half-yearly credit derivatives data released by ISDA says that credit derivatives volumes, as of end June, 2007, have gone beyond $ 45 trillion, at about $ 45.46 trillion. This scales a growth of 32% from the $ 34 trillion data as of end 2006, and nearly 75% growth over the half year of 2006.

Credit derivatives have been growing at an annual rate of nearly 100% over the past 3-4 years.

During the tremendous credit squeeze that started in the wake of the subprime crisis, credit derivatives volumes are likely to be affected this year. There are several reasons for this - hedge funds who became primary players in credit derivatives in 2004 onwards are likely to stage a retreat, or at least slow their activity this year. CDO activity is completely moribund post July 2007. In general, the market has become risk averse.


Increased role of hedge funds has increased risk of correlated
movements in credit markets: Fitch

Rating agency Fitch recently came up with a special report on the role of hedge funds in the credit markt [Hedge Funds: The Credit Market's New Paradigm, report dated 5 June 2007]. The report states something that anyone having an insight into the credit derivatives market might surely know, but what might look shocking to an outsider. The credit derivatives market is not where banks meet to swap each other's credit risks. It is fast becoming an arena for risk-takers and betters who take leveraged positions on credit risks. Hedge funds occupy nearly 60% of this market today.

Apart from the sheer volume of trade, "(T)he impact of hedge funds on the credit markets can not be measured simply by trading volumes, but also must consider hedge funds’ willingness to be risk takers by investing lower in the capital structure. By investing in instruments that are themselves levered, hedge funds are able to create a multiplier effect by
combining financial leverage with so-called economic leverage. The combination of the two can be thought of as the effective leverage", says Fitch.

There is ample evidence that hedge funds, in search for high returns, take subordinated positions in pools of credit. That apart, they are major players in equity tranches of the indices.

What does this highly leveraged position of hedge funds imply for the credit market? The downgrades for GM and Ford in May 2005 brought sharp MTM losses for several players because of the highly correlated moves by several hedge funds trying to unwind their positions due to their mandates or deleverage triggers. Fitch says that a similar result is almost inevitable. "Credit assets could behave in a more correlated, synchronous fashion if one or a number of hedge funds were forced to liquidate positions following some catalyst event in the markets. Investor redemptions and/or increased margin calls from prime broker banks could exacerbate a larger unwind of credit assets". Hedge funds are far more unstable investors than buy and hold investors of relationship banks.

Besides, hedge funds are typically short-term strategy based. Many of them have short horizons within which they either perform or must wind up. While hedge funds have continued to improve their risk management abilities, there is no way they can eliminate risks, and the next downturn in business cycle may really bring forth this critical situation.


Vinod Kothari teams up with IIT quants to deliver
credit derivatives quantative solutions

Vinod Kothari, a global trainer, author and consultant on structured finance has teamed up with Quantum Phinance (QP) – a financial engineering firm started by IIT alumni at the IIT Bombay incubation centre SINE. Having made his mark in providing consulting services in structured finance, Vinod Kothari by partnering with QP is looking to provide clients with high end quantitative and technological solutions. QP owns a considerable amount of intellectual property on modeling, pricing and risk managing some of the most complex financial structures.

“We wish to compete globally in the high-end financial services market. Towards this end, Mr Kothari’s association with the firm should help us leverage his experience in providing premium services to our Indian and global clients”, said Vaidyanathan Krishnamurthy, a former investment banker with JPMorgan and one of the directors of QP.

"The world of credit derivatives is growing faster than anyone expected. From a naught about 10 years ago, the market has come to a level of USD 34 trillion at this time. The CDS market is today trading almost parallel to market for equities and bonds. In terms of flexibility and trading strategies, the credit derivatives market offers huge potentials of trading on credit, correlation, recoveries and changes in either of these. Structured credit trades require tremendous quantitative skills besides a deep understanding of the way the market operates. Our alliance will be uniquely positioned to offer services to users, hedge funds, traders and other market players. We will also offer tailored services to firms that seek to make investments into credit derivatives trades", said Vinod Kothari.

"We deliver high quality customized solutions to our clients’ problems – and partnering with Mr. Kothari should help us club the vast experience of Mr Kothari with our technological and quantitative expertise to better serve our clients. We are extremely excited about this step", said Sushant Reddy – another director at QP.


India comes up with draft guidelines once again

While the latest credit policy statement promised that India will put in place regulations for credit derivatives by 15th May 2007 (story below), the RBI on 16th May late evening put on its site draft guidelines for public comment for a 30 day period.

The guiidelines, generally at par with similar global regulations, currently permit only single name credit default swaps.

Vinod Kothari's detailed comments, as also the full text of the Guidelines are here.


India to permit single name credit default swaps

India will soon permit single name credit default swaps. The Reserve Bank of India governor Dr Reddy said this in his annual policy statement released 24th June.

Draft guidelines on credit derivatives have been issued almost like 3 years back. In the meantime, several Indian corporates are traded in the international credit default swap markets. Some Indian names are a part of the iTraxx Asia Pacific index. Thus, effectively, the credit derivatives market in India has been exported out due to regulatory inaction.

Finally, the RBI now has thought of allowing the same. The policy statement said guidelines on single name credit default swaps will be issued by 15th May 2007.

Vinod Kothari comments: Single name CDS transactions will fall short of the what the market needs. Synthetic securitisation is badly needed in India due to difficulties in true sale related transactions. Besides, unless single name credit default swaps can be bundled into CDOs, the market will not gain momentum. The policy move may only be seen as a late start.

Links See our page on India.


Credit derivatives volumes rise to USD 34.5 trillion

In credit derivatives business, a 100% growth per year is hardly sensational. ISDA reported its annual derivatives summary for year-end 2006 : the volume of credit derivatives grew in the second half of 2006 from USd 26 trillion to USD 34.5 trillion. The year-on-year growth added to 102%.

The growth in year 2006 over 2005 was 103%. Thus, credit derivatives have established a growth rate of over 100% for at least 2 years now.

The credit derivatives market is still small compared to the total OTC derivatives market adding up to a whopping USD 327.4 trillion. However, credit derivaitves has consistently been the fastest growing among all OT derivatives.

As the base continues to swell, the rate of growth may become difficult to sustain.

Links See also our page on credit derivatives markets.


Subprime worries puncture the ABX.HE prices

While worries about the worsening health of US consumer finance and resulting poor performance of subprime loans have been coming since the beginning of this year (for instance, see the S&P report cited in, the alarm trigger was pressed hard this week with worrying signals from the major subprime lenders such as HSBC and New Century. The ABX.HE index for the BBB- tranche from a price of 92.01 to 85.22. See markit site with ABX.HE quotes here.

HSBC warned on Wednesday that its loss provisions are expected to be higher at USD 1.75bn. HSBC is one of the biggest subprime lenders in the US market. HSBC warned that not only the percentage of loans more than 60 days due is climbing up, even frauds are increasing.

Similarly, a Form 8K filed by New Century, another major home equity lender, said "During the second and third quarters of 2006, the company’s accounting policies incorrectly applied Statement of Financial Accounting Standards No. 140 – Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities. Specifically, the company did not include the expected discount upon disposition of loans when estimating its allowance for loan repurchase losses".

The ABX.HE index is reflective generally of the state of the US economy. In particular, the BBB and BBB- tranches are likely to suffer losses as excess spread levels in the 20 home equity deals are wiped out and the losses are debited to the lowest of the securities.


US Appeal court ruling lends certainty to credit derivatives documentation

The 2nd Circuit Court in the USA recently (5th Feb 2007) gave a ruling on credit derivatives that would go to render more certainty to credit derivatives documentation. In Aon Financial Products v. Societe Generale, the US appeal court rejected the contention taken by a lower court whereby the clear terms of a credit derivatives document could be extended to broaden the definition of "reference entity".

The background of this case is as follows: .

There was an exposure that Bea r Sterns (BSIL)had taken on a Philippino company which was backed by guarnatee of a Philippine govt. body called GSIS. In order to protect itself, BSIL bought protection from Aon. The protection under the BSIL-Aon CDS had actually been triggered when GSIS withdrew its guarantee on the loan. That this withdrawal of guarantee was a credit event was held by the district court in an earlier ruling.

Aon itself had entered into a CDS with Societe Generale, but there, the reference entity was "Republic of Philppines. ISDA's definition of "sovereign" was not used in the documenation.

On the ground that the terms of the Aon/Ursa CDS cannot necessarily be imported into the Aon/SG CDS, and that the reference entity in the latter CDS did not include GSIS, the Court held that SG was not liable to make payment on account of credit event with reference to GSIS.

The case has also discussed some significant features of a "Notice of Credit event", and that the notice must raise an irreovcable demand. Dealing with the fine details of legal language in credit derivatives related correspondence, this case is quite significant.

Links For full text of this and other cases relating to credit derivatives see our page here.


Eurex will start trading in credit futures in March 2007

European exchange Eurex will start futures trading in iTraxx index beginning March 27, 2007. Additionally, trading will start at some date in future on the segments of iTraxx index too.

The Eurex iTraxx® credit futures will closely mimic the risk structure of credit default swaps traded in the over the counter (OTC) market. Trading on Eurex will involve Eurex Clearing as central counterparty thereby reducing the counterparty and systemic risk and adding to the benefits the product will offer to users. The contract will be based on the 5 year series, with a fixed coupon and semi annual maturity dates in March and September. The contract size is EUR 100,000; the tick size is set at 0.005 percent translating into 5 euros per tick. It will be quoted in percent with three decimal places. The product will be cash settled, with reference to the iTraxx® index values of IIC. In the case of a credit event, cash settlement of the single name entity will be made with reference to the ISDA CDS protocol. The Eurex iTraxx® Europe futures contract will be supported by designated market makers, ensuring liquidity from launch.

This is claimed to be the world's first exchange traded credit derivative product.

In the meantime, Chicago Mercantile Exchange has also reported that it will start trading in credit event futures in the 1st quarter of 2007. Regulatory approvals, it seems, are still pending.

Links: A full brochure outlining the trading rules and a simulation guide is here on Eurex site. In case of the CME, the specifications of the futures contracts are here, and a white paper on the trades is here.



Hedge funds institutional demand to grow to $ 1 trillion by 2010

There are those who call them buccaneers and fantasists, but hedge funds are not only here to stay but grow a fascinating pace. A white paper by BoNY and Casey, Quirk and Associates says that the 2010, the institutional demand for hedge funds will grow to $ 1 trillion.

The study, entitled "Institutional Demand for Hedge Funds 2: A Global Perspective," found that by 2010 institutions investing in hedge funds will increase to nearly 25% of all institutions, up from 15% today, representing a more than 60% increase. Retirement plans globally will account for the vast majority of asset flows, with corporate and public pension plans in the United States accounting for the largest percentage increase overall.

This study follows a 2004 study by the Bank and Casey, Quirk that examined U.S. institutional investor appetite for hedge funds. The 2004 study forecast that U.S. institutional investment in hedge funds would increase from $60 billion to $300 billion by 2008, a prediction that thus far is largely in line with actual investments by U.S. institutions.

The study shows that today's hedge fund techniques will be tomorrow's mainstream investing. This paradigm shift will be driven by the need for institutions to generate better overall portfolio returns as well as by their increasing comfort with techniques such as shorting, derivatives and leverage. The study also found that institutional investors' ability to identify and assess quality hedge fund managers will dramatically improve. As a result, hedge fund providers increasingly will be required to demonstrate operational excellence and comprehensive risk oversight, as well as offer fee structures that are more closely linked to value and performance.

While the study found that hedge funds have earned a long-term role in institutional portfolios, the single most important factor that could change growth expectations would be a scenario where hedge fund and fund-of-hedge fund managers meaningfully underperformed the net return expectations of institutional investors. Potential scandals and regulation could also slow predicted growth.


Allegations of insider trading in credit derivatives;
securities regulators plead helplessness

A story on today's [10th October 2006] Bloomberg [Credit default swaps may incite regulators..] mentions several instances of insider trading in the credit derivatives markets: the proposed takeover by Apollo Management and Texas Pacific Group of Harrah's Entertainment, leveraged buyout of HCA Inc., and the buyout by Anadarko Petroleum Corp.of Kerr- McGee Corp. and Western Gas Resources Inc.

It seems the derivatives traders are exploiting the apparent gap in insider trading regulations. Insider trading regulations are applicable on trades in "securities". Credit default swaps, not being securities, are outside the regulatory domain of securities regulators World-over. Hence, even if there is an evidence, existing laws do not allow regulators to interfere.

Links: Bipin Acharya and Timothy Johnson wrote a paper last year on the evidence of insider trading in credit derivatives - may be they come up with more or new findings in light of the developments after their time span of their research. Here is the article.


Credit derivatives: Volumes, and concerns, in a race

The last few months have seen volumes of credit derivatives surge forward; but joining in the race are also the concerns of regulators, investors, economists and the like. While traders and IT companies are enjoying the party like never before, there is a big question - is their something serious in this almost unbridled growth? Growth, when unchecked, always has an underpinning worry, but it is possible that the credit derivatives had always the potential to grow above the level of interest rate derivatives, since, after all, credit is a much bigger risk than interest rates.

ISDA's mid-year survey for 2006 revealed credit derivatives had swelled to a volume of USD 26 trillion, having grown 52% in just 6 months. BBA also released some data predicting the volumes by 2008 will rise to USD 33 trillion, though the BBA data is different from that of ISDA.

Some people used the sharp growth in credit default swaps and compared it with other parameters, to show where the real bubble was. See one such graphic here. . The message is clear - the bubble lay not in property prices or the Nikkei, but in the crdit default swaps market.

In the midst of the frenzied growth, hedge fund Amaranth closed down. The increasing importance that hedge funds have in the credit derivatives market is now no news. Data revealed that hedge funds are taking 55% of credit derivatives trades, particularly for the lower rated tranches.

Among the regulators who have been expressing concerns about credit derivatives is Timothy Geithner. One of his speeches in May 2006 [click here], Geithner's concerns were primarily due to the role of non-banking institutions (read hedge funds) in the market.

The regulators on the other side of the Atlantic are also seemingly worried about the growth in credit derivatives.


FSA's risk outlook for 2006 talks of credit derivatives operational risks

Operational risks in credit derivatives have been the centerpoint of attention, surely among regulators and perceptibly among the industry players as well. While the credit derivatives traders in the US are scheduled to return to the New York Fed by Feb 2006 on steps taken by them to resolve the problem on unconfirmed trades, the FSA UK's risk outlook for 2006 also mentions credit derivatives risks.

The report, dedicated to identifying the risks that pose threats to the financial systems, mentions unconfirmed credit derivatives trades as the first risk facing the banking system. It says:

Credit derivatives provide a valuable mechanism through which financial
market participants can manage their credit risk, bringing together those who
wish to reduce credit exposures with those who are prepared to increase
them. The market has continued to grow at a rapid pace and firms such as
hedge funds have become increasingly important, as both buyers and sellers
of these instruments. Operational and legal risks may arise if the market is
unable to keep up with this growth.

Without confirmation that a trade has taken place, parties to the transaction
are exposed to legal and financial uncertainty. If a credit event occurs while a
credit-derivative transaction remains unconfirmed, doubt as to its legal
validity and contractual responsibilities could prevent the transaction from
being executed. This uncertainty could create liquidity problems and act as
an accelerant in a financial crisis.

In addition, the report also mentions that where an innovative or a complex deal has been sold to a buyer, there is a potential legal risk of claims of mis-selling of the product to the buyer. [Incidentally, there are several such cases already].

The heightened degree of hedge fund presence as equity investors in the credit derivatives market has also been mentioned as one of the risks. As hedge funds react to situations abruptly, the market might have a liquidity crisis, exacerbating a few events into a cyclical change.

Link The full report is here.

ISDA to steer credit derivatives to cash settlement

Having already experimented with auctions-based valuations and cash settlements in case of several major bankruptcies in the recent past, ISDA wants to steer the market to almost completely move towards a cash settlement procedure. This would avoid operational difficulties and complexities of physical settlement, as also would avoid the much-evident scarcity of defaulted bonds at the time of bankruptcy, leading to overpricing.

Credit derivatives are typically settled either on cash or on physical settlement basis. Physical settlement would mean delivery of the defaulted security by the protection buyer to the protection seller, with teh latter paying the par value thereof.. On the other hand, cash settlement is more like a net settlement, with the protection seller paying up the difference between the par value na dthe fair valuation.

In bilateral CDS transactions, physical settlement has been the market norm for quite a while, as the problems of valuation are avoided in physical settlements, and the protection sellers have generally felt that they get a better deal. However, in case of major bankruptcies, there might be thousands of CDS deals to get settled, particularly in case of index trades. This might create scarcity of the defaulted bonds and shoot up the prices. ISDA has lately been using the auction-method and has ushered protocols of traders to agree to cash settlement in case of major bankruptcies, such as that of Delphi reported below.

Now, ISDA proposes a more aggressive use of cash settlements in case of bilateral trades as well. ISDA proposes to circulate a proposal in the week of 13th Feb and expects to have a general standard on this by end June 2006.

Operational issues in credit derivatives have been a major concern of both regulators and market participants. As the market size has been zooming, it is but appropriate that all possible measures are taken to smoothen the processes.

Links On operational problems, the New York Fed had caused a meeting last year - see below. The FSA UK's Financial Risk outlook for 2006 also mentions operational problems as one of the risks for the year.


Delphi's auction passes smoothly,
but worries on credit derivatives settlement continue

ISDA's new-found methodology of having a defaulted entity's bonds valued by auction and therefore, to avoid problems of physical delivery, seemingly worked well in case of Delphi. Delphi was being viewed as a major case of default as Delphi was a reference entity for thousands of index-based contracts besides several single name CDS deals.

With a spate of bankruptcies of some very popular names referenced in hundreds of credit derivatives contracts, ISDA has recently been intervening in the settlement process with an auction platform. This was done earlier in the case of Aikman's bankruptcy. The protocols of ISDA were essentially intended for smoothening the process of settlement under index deals, with single name CDS transactions left to be settled by the parties.

Delphi's debt was valued at 63.375% at the auction on 5th November. Fifteen of the largest derivatives dealers participated in the auction to determine a value at which the contracts could be settled with a cash payment, instead of requiring the transfer of Delphi's bonds. The auction was said to have been quite smooth.

The problems of physical settlement are quite obvious - the group of 14 credit derivatives dealers than met the New York Fed in September are reported to have indicated that they intend to make cash settlements the norm by March next year.

Despite this, the scarcity of cash bonds of a defaulted entity needed for settlement of CDS transactions does cause unwarranted inflation of the price of defaulted bonds. The extent of hoarding in Delphi bonds is evident - Delphi bonds traded up to 72 cents on the dollar , up from 58 cents following the company's bankruptcy filing on October 8. Once it was clear the market was backing the cash settlement process, however, prices fell and bonds traded nearer the auction price - 63.375 cents. Credit derivatives dealers confirm that it might take months to see full settlement of Delphi related CDS contracts.

Links: ISDA's website on the Delphi protocol is here on ISDA website

Delphi causes downgrades of over hundred CDOs

Like a typhoon warning changed into one of a hurricane, the CDO business bore the brunt of a massive downgrade - 127 CDOs were downgraded and an additional 39 were placed on rating watch negative.

The rating action in all covered more than 7% of the CDO universe. Among the downgraded classes, the average downgrade severity was 1.7 notches, with 52% of affected tranches downgraded by a single notch, 33% by two notches, and the remaining 15% by three to five notches.

A total of 794 S&P rated CDOs had Delphi exposure.

Apart from Delphi, S&P says it has also taken into account corporate downgrades. The CDO population commonly references to some 750 global names - there were 22 downgrades in the recent past which are referenced in approximately 30% of all CDOs.

Corporate credit remains on Achilles' heels lately - the disturbance in the aviation and the auto segment might have ripple impact on the rest of the global economy. The fact that a handful of major corporate names are referenced in so many CDS transactions, which together are the driving force of a USD 12 trillion market, is by itself a risk factor.



US bankruptcy law changes to enable close out netting for credit derivatives

Reforms in the US bankruptcy law take effect from the 17th October - among other financial contracts, these amendments will facilitate close out netting for credit derivatives.

The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 was signed into a law recently and will take effect from the 17th October.

Among significant provisions of the law is a provision that permits netting of several financial contracts. In derivatives trades, on the bankruptcy of one of the counterparties to a derivatives trade, the remaining counterparty faces a peculiar problem, in that its own obligations to the bankruptcy counterparty are immediately payable, while its receivables are subjected to bankruptcy administration. Likewise, creditors' rights over the collateral belonging to a bankrupt cannot be exercised except in accordance with the reorganisation plan.

The bankruptcy law has exceptional provisions that permit netting for some financial contracts, including "swaps". The definition of swap agreement in Title IX includes a number of additional types of agreements, such as "spot, same day-tomorrow, tomorrow-next, forward or other foreign exchange agreement[s]," weather derivatives, equity swaps, and debt swaps. In the amended provisions, one of the most significant additions to the category of swap agreements are "total return, credit spread or credit swap, option, future, or forward agreements" in view of the rapid expansion of the credit derivatives market in recent years.

Thus, netting protection will now be available for credit derivatives contracts.

Netting in most common law countries is based on common law principles, as insolvency laws do not contain exceptions for derivatives trades.

Links For more on the bankrupty law changes and impact thereof on the banking system, click here.


Delphi's bankruptcy exposes several synthetic CDOs to rating adversities

As auto parts giant Delphi filed for Chapter 11 on 8th Octber. Delphi., a major components supplier to General Motors, has been facing losses and financial problems for quite some time now, larger part of which is connected with GM.

Delphi was a very common item in several synthetic CDOs. Rating agency Standard and Poor's says that out of Europe, North America, and Japan, 842 of Standard & Poor's publicly and privately rated SCDO transactions had Delphi as a reference entity in their portfolios. These transactions are as under:

Europe 638
North America 156
Japan 48

Relative to the total universe of rated SCDOs, the number of transactions with exposure to Delphi is significant, accounting for approximately 35% of rated SCDO transactions. A review of Standard & Poor's rated SCDO transactions in May 2005 showed that more than half had exposure to Delphi.

Credit default swaps in Delphi weret trading at crazy levels for quite some time. In September, the upfront price of Delphi CDS was 37%, plus another 5% anually. In other words, the market was almost certain of the bankruptcy - they were only betting on the timing.

The sharp rise in US bankruptcies is also attrributed partly to the new bankruptcy law, supposed to take effect this year. This law will apparently make chapter 11 filings and reorganization a bit difficult. Bankruptcy filings jumped 11% in the second quarter in anticipation of the law, according to the Administrative Office of the U.S. Courts in Washington -- those numbers look to rise even more up until the date the rules take effect.

This obviously means synthetic CDOs, particularly CDO squares, will have a serious time in forthcoming months.

Greenspan still hand-holds,
but others express vehement fears on credit derivatives risks

The by-now-well-known approach of Alan Greenspan to credit derivatives volumes was once again evident at one of his recent speeches where he talked of the risk-dispresion in the credit markets leading to the overall health of the global economy. Greenspan, delivering a 27th Sept 2005 address to National Association for Business Economics Annual Meeting, Chicago, Illinois said: "Historically, banks have been at the forefront of financial intermediation, in part because their ability to leverage offers an efficient source of funding. But in periods of severe financial stress, such leverage too often brought down banking institutions and, in some cases, precipitated financial crises that led to recession or worse. But recent regulatory reform, coupled with innovative technologies, has stimulated the development of financial products, such as asset-backed securities, collateral loan obligations, and credit default swaps, that facilitate the dispersion of risk."

He continues: "The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection". "The new instruments of risk dispersal have enabled the largest and most sophisticated banks, in their credit-granting role, to divest themselves of much credit risk by passing it to institutions with far less leverage. Insurance companies, especially those in reinsurance, pension funds, and hedge funds continue to be willing, at a price, to supply credit protection", he added.

However, the fears as to the risk that an overheated derivatives activity creates for the system have continued to arouse vehement critique. For instance, CNN Moneyon 29th Sept titled Wall Street storm may be brewing talks of hedge funds and credit derivatives as two big sources of worry. Not that such apprehensions are highly well-founded or researched, the analysts/reporters seem to have somehow correlated hedge funds and credit derivatives. Hedge funds are a bit obscure and engimatic - like the latest Buttonwood column in the The Economist which talks of a deal-happy hedge fund manager having spent GBP 36000 in a single evening at a London pub. Credit derivatives got clubbed with hedge funds in public perception possibly because of news of credit derivatives related losses to hedge funds after the GM/Ford downgrades.

Links As for financial system risks of credit derivatives, see this page.

Credit derivatives volumes soar in first half 2005 to cross USD 12 trillion

While skepticism as to the potential dangers inherent in heating up of the derivatives market continues to grow, the volume has outgrown skepticism. ISDA recently released the derivatives numbers for first half of 2005 - the credit derivatives market has grown above USD 12 trillion. If the acceleration pace continues, the number might reach USF 20 trillion by the end of the year. This would be well in excess of all expectations.

The growth rate over the previous half year is 47.8% and that over the same period previous year is 128%, which is higher than in case of any other OTC derivative. Even having grown at this rate, credit derivatives are still less than 10% of the total OTC market which is estimated at upwards of USD 200 trillion. However, it is the rate of growth in credit derivaitves which is attracting so much of international attention.

While the ISDA data captures global data based on surveys of members and major dealers, the OCC, which releases quarterly data of credit derivatives of US banks also released the volumes recently which establishes a major surge in volumes of credit derivatives held by US banks.

Links See our global markets page for more stuff


The credit derivatives industry responds to NY Fed with proposals

The meeting of leading credit derivatives dealers with Fed, New York on 15th Sept has been followed with a draft set of proposals by major credit derivatives dealers. The draft has been addressed to the NY Fed. On 5th October, theNY Fed released both the draft of the major dealers' proposals as also its own press release.

The press release of the Fed says that it welcomes the initial commitments made today by fourteen major market participants to improve the infrastructure that supports the credit derivatives markets. Of particular importance are:

  • the commitments to move quickly to a regime of substantially improved controls around assignments, ensuring assignments will have consent of all parties,
  • the targets and deadlines set to reduce confirmation backlogs,
  • the steps to increase substantially the use of electronic matching platforms, and
  • the efforts underway to improve the credit default swap settlement process

The major proposals submitted on behalf of the dealers are as under:

  1. The dealers will provide on a regular basis (10 business days of each month) data about number of unconfirmed trades, backlogs, fails, etc.
  2. The dealers have promised to finalise a guideline to implement ISDA's novation protocol which is to be effective from 24th October. will not accept any novation unless the transferor has signed and adhered to the Protocol or they receive prior written consent from the Remaining Party before firm pricing is given, as per ISDA's proposals.
  3. The dealers have committed that by January 31, 2006, they will each reduce our number of confirmations outstanding more than 30 days by 30% from our number of confirmations outstanding more than 30 days as of September 30, 2005.
  4. DTCC, which does trade matching electronically, assumes a major role in the proposals to reduce number of outstanding confirmations. "All Major Dealers are signed up with DTCC and commit to fully using its existing functionality by October 31, 2005."

Links Full text of the 3-pager proposal by the major credit derivatives dealers is here.


Derivatives dealers agree to self-policing

The meeting of leading credit derivatives dealers with Fed, New York on 15th Sept was one of the leading stories in financial press world over last week. The meeting, attended by 14 leading credit derivatives dealers, and most of the significant regulators, has come up with a promise by the dealers to self-discipline themselves.

The critical issue, highlighted in the Counterparty Risk Management Group report, is the extent of unconfirmed trades in credit derivatives. ISDA's surveys reveal that the number of trades are increasing, and their signed confirmations are quite often pending, creating operational hazards in the business.

The dealers had set a 24th October deadline for abiding by the new ISDA protocol on novation. They also promised to come up with a plan of action soonest.

Recently, Bloomberg quoted an interview with a US OCC official stressing the need for automated confirmation systems. ``Electronic processing should be the standard they're all moving toward,'' said Kathryn Dick, the agency's deputy comptroller for risk evaluation, in an interview from Washington yesterday. ``Dealers need to agree on the system they're going to use and be sure that processing delays aren't occurring because electronic systems aren't compatible,'' Dick said without elaborating.

One of the solutions to avoid problem of pending confirmations is to use automated platforms - for example, the DTCC settlement.

Links For details of DTCC's credit derivatives automated confirmation service, click here


New European CDS Index starts trading

The iTraxx Europe index started trading on 20th Sept 2005. The index has been reconstructed by inclusion of some new names like Kingfisher, Linde, Safeway, TDC, Thomson and Wolters Kluwer.

The composition of the indices is changed every six months to ensure they reflect the most actively traded names and the companies whose credit rating status has changed.

Part of the widening was due to the longer maturities in the new index family, which increased to 5.25 years from 4.75 years for the outgoing indices.

Market reports indicate that while the trading activity was brisk, all the sub indices - HiVol, Xover, etc had increase in spread levels.

Vinod Kothari adds: The composition of all major DJ iTraxx indices was changed effective Sept 20. The names removed are those that are either marked to junk status or have filed for bankruptcy since the last index roll, or, in case of Europe, have been changed for consistency by the index company. . In the DJ CDX.NA.IG Index, the names dropped include: Eastman Kodak Co., Ford Motor Credit Co., General Motors Acceptance Corp.,
Kerr McGee Corp., MBNA Corp., Liberty Media Corp., Lear Corp., Maytag Corp., and Sears Roebuck Acceptance Corp . The names added are The Gap Inc., IAC InterActive Corp., Knight Ridder Inc., Limited Brands Inc.,
Marsh & McLennan Cos. Inc., Radio Shack Corp., Sara Lee Corp., Toll Bros. Inc., and Sabre Holdings Corp.

In the US HiVol sub index, 15 names have been changed.

In the European Index, the 4 names that were replaced are: Allied Domecq PLC, HSBC Bank PLC, Standard Chartered Bank, and Sanofi-Aventis. These have been replaced by Kingfisher PLC, Linde AG, Safeway Ltd, TDC A/S, and Thomson.

The ex-Japan Asia index will also be expanded from 30 names to 50 names.

Links For the trading activity on DJ credit derivatives indices, see here.


No lasting damage to credit derivatives market, but ....

For last few quarters, the BIS quarterly review of banking developments has been devoting space to developments in the credit derivatives markets. The latest quarterly review for the quarter ended Sept 30th 2005 also talks of credit derivatives market developments.

Talking of the May 2005 downgrades, the report says that while there were severe losses on some hedge funds and some were indeed wound up, overall, the hedge fund sector continued to experience net inflows. "Liquidity in the index tranche market was slow to return, and leveraged loans reportedly replaced synthetic instruments as the main source of collateral in new issues of collateralised debt obligations (CDOs). Yet CDO issuance rebounded strongly in June and July from depressed levels in May, suggesting that no lasting damage was done to the functioning of credit derivatives markets."

However, the adverse credit events of May 2005 have sent shock waves as to what might happen if there was persistent and wide spread deterioration in the credit markets, given the levels of leverage that most CDO transactions have and the fact that the losses have been spread to sectors far and wide. The BIS report says: "Nevertheless, the events of May 2005 left unanswered questions about how credit markets might perform if confronted with a widespread deterioration in credit quality. Credit derivatives have undoubtedly enhanced the liquidity of credit markets in general and facilitated the management and monitoring of credit risk exposures. At the same time, the complexity of some products and the associated risk management systems, the growing presence of leveraged players in credit markets and the possibility that investment strategies may be less diverse than anticipated make it difficult to predict how credit markets will function under more stressful conditions."

Links : Full text of the BIS quarterly report is here. We discuss the risks facing the credit derivatives market, including several links on the May 2005 downgrades, here


CDO business has doubled over past 5 years: Bloomberg article

The CDO business has more than doubled over the past 5 years in the USA, far outpacing the 9.6 percent annual growth rate of the $4.7 trillion U.S. corporate bond market. About $290 billion is invested in U.S. CDOs, up from $125 billion at the end of 2000. In the USA, the market is split roughly evenly between cash and synthetic CDOs. An article on Bloomberg 30th August

The spurt in CDO volumes in 2005 has been even more impressive. Cash CDO sales jumped 80 percent in the first seven months of 2005 from a year earlier, according to Merrill research. In July, 26 CDOs valued at $15.8 billion were priced. Of particuar interest is the brilliant pace at which CDO squares have been accepted by the marekt. In July, $1.6 billion of CDO squareds were sold, almost equivalent to all of 2003 and 2004 combined.

CDO has been a major fee-earner for investment banks across the world. The CDO fees usually equal about 1.5 percent to 1.75 percent of the size of a deal, bankers who arrange such sales say. That's more than triple the average 0.4 percent that banks charge to sell investment-grade bonds and about the same as fees on junk bonds, traditionally the most lucrative. Merrill, the No. 2 U.S. securities firm by market value, and Citigroup, the biggest bank, sold a third of this year's $72 billion of U.S. collateralized debt obligations, data compiled by Bloomberg show.

Not all money managers are CDO enthusiasts. Several are turned away by lack of transparency in this market.

The list below ranks the top 10 underwriters of CDOs sold between Jan. 1 and Aug. 14 that are publicly accessible via Bloomberg's mortgage key. Deals backed by commercial paper or sold in non-U.S. currency have been excluded.

Merrill $13.7 Billion
Citigroup $10.5 Billion
Wachovia $7.2 Billion
Goldman Sachs $5.4 Billion
Lehman Brothers $4.6 Billion
Bear Stearns $4.4 Billion
Bank of America $3.9 Billion
CSFB $3.8 Billion
UBS $3.6 Billion
Morgan Stanley $3.5 Billion

Links : for more on CDOs, see our page on CDOs here.



New York financial supervisor calls credit derivatives dealers to discuss risks

According a Bloomberg news of 24th August, the Federal Reserve Bank of New York invited 14 of the ``major participants'' in the credit- derivatives market to a meeting next month amid concern the $8.4 trillion industry is rife with trades lacking key paperwork. Similar concerns have been expressed earlier by UK regulators, as also by the industry body called Counterparty Risk Management group - see news below here, Incidentally, the head of the Counterparty Risk Management Group, Mr Gerald Corrigan, is also a former New York Fed president.

The meeting at the Fed's New York office on Sept. 15 will focus on market practices. , according to an Aug. 12 letter sent to bank chief executives by New York Fed President Timothy Geithner. Fed spokesman Peter Bakstansky confirmed the letter's contents and declined to name the firms invited.

Representatives from the U.S. Securities and Exchange Commission, the Office of the Comptroller of the Currency, the New York State Banking Department, the U.K.'s Financial Services Authority, Germany's Federal Financial Supervisory Authority and the Swiss Federal Banking Commission also will attend the meet.

ISDA has put up a strong face saying that this meeting indicates a welcome regulatory attention.

However, the markets went jittery as Dow finished lower by the end of the trading on 24th August due to combined effect of the above news on credit derivatives and oil prices. Markets in other parts of world that open earlier on 25th also reported losses.


Hedge funds are a major force in credit derivatives market: Fitch

.Hedge funds were known to be trading in derivatives, currencies, and following different strategies to maximise returns, but of late, their presence in the credit derivatives market has become notable. They have quickly and surely risen to a very significant level as providers of equity capital to CDOs, sellers of protection on highly leveraged basket default swaps, etc.

A Fitch special report titled Hedge Funds: An Emerging Force in Global Credit Markets goes into various aspects of hedge fund presence in the credit derivatives markets.

The report estimates that some 30% of the total USD 8.4 trillion credit derivatives market is controlled by alternative investment vehicles, in other words, hedge funds. "fact, the explosive growth in the CDx has been propelled in recent years by hedge funds acting as both buyers and sellers of protection and providing much-needed liquidity", says the report. The typical feature of most hedge fund investments in the credit derivatives markets is that hedge funds are mostly leveraged vehicles, employing 5X or higher leverages. Investrment in junior tranches of CDOs is like investing in a highly leveraged vehicles. Thus, hedge funds investing in credit derivatives markets is like two towers of leverage, standing one over the other. If a hedge fund, with leveraged funding structure, invests in CDO^2, it is 3 towers standing one over the other. More so, several hedge funds work on short term lines of funding with banks and warehousing limits, which may either be quickly drawn back or may have increased margin requirements.

If hedge funds have reliance on short term funding, a marginal credit problem in some segments can blow up into a major problem : "Still, many hedge funds remain reliant on short-term financing to pursue leveraged investment strategies, and the
impact on the credit markets could be fairly broadbased if several credit-oriented hedge funds were forced to deleverage. A far-reaching liquidity squeeze and price dislocation across multiple, interlocking credit markets could ensue simply due to hedge funds’ presence in most, if not all, of the major segments of the credit markets."

The report cautions of the possibilities of a synchronous deveraging of several of these alternative investment vehicles, thereby exacerbating a credit cycle.

Links For a page on hedge funds, see our page here.


Couterparty Risk Management Group
highlights loose ends in credit derivatives trades

.The Couterparty Risk Mnaagement and Policy Group (CRMPG) has come out with its second report on 27th July 2005 wherein it highlights signficant risks facing global financial markets and devotes quite some space to credit derivatives.

The CRMPG is a group of very senior bankers - including some of the most respected US investment banks and law firms. The first report of the CRMPG came out in 1999 - soon after the LTCM crisis.

The Group has talked of several loose ends in current credit derivatives trades. Among the first tasks, it recommends that intermediaries and end-users of credit derivatives understand what the terminology of credit derivatives trades implies. For example, restructuring might be a complex term under the credit derivatives documentation. It also says that market participants should be aware that credit derivatives trades give risk to other risks such as retained credit risk, counterparty credit risk, legal risk, operational risk and concentration/liquidity risk.

Retained credit risk arises because credit risk is not entirely transferred - it is dependent on the definition of "credit event". There might be a severe deterioration of credit not amounting to a default - which is not covered by credit derivatives trades.

Speaking of counterparty risk, the Report says that in cases where the counterparties are leveraged, the counterparty risk becomes critical - "One notable trend in the credit derivatives market is the increased participation by hedge funds and other leveraged counterparties as sellers of credit protection. This increased participation should serve to diversify counterparty credit risk in the credit default market. At the same time, such participation may marginally increase counterparty credit risk due to some hedge funds’ leveraged nature."

Speaking of legal risks, the Report quotes a Fitch report as saying that some 14% of credit derivatives claims there have been legal disputes. "In some instances, the disputes have involved assertions that one of the parties breached fiduciary duties owed to its counterparty, the risks associated with the transaction were not adequately disclosed or the transaction was not suitable for the counterparty". The report cautions market participants to be aware of these risks.

However, the larger issues in credit derivatives trades are operational risks. Some credit defaults might require primary dealers to prepare and serve notices on hundreds of credit derivative transactions, most of which is a manual process and quite resource intensive. The report also notes that in case of physical delivery settlements, in view of the large number of trades, the very availability of bonds of the defaulted entity may be under strain.

The report also talks of certain risks in terms of the impact of credit derivatives on cash markets for credit - the impact of restructuring and workouts, etc., given the fact that where a creditor is already fully or substantially hedged, he has a cash exposure but no real credit exposure which may create anomalies in the way the present system of restructuring and workouts/ liquidations works.

.Links For full text of the CRMPG report, see here. For the 1999 report of the CRMPG, click here.

For our page on financial risks of credit derivatives, see here.


Eurex to start trading in credit derivatives

According to a report in Financial Times, Eurex, Europe's largest derivatives exchange, will start trading in credit derivatives shortly, and in any case, within this year.

According to analysts, this is a clear signal of the coming of age of a rapidly developing credit derivatives market.

Eurex said it had signed an exclusive agreement with International Index Company to license its European iTraxx indices, which are based on 125 CDS contracts – instruments that allow investors to take protection against default by a specific borrower.

The announcement attests to feverish development in the CDS market, given that the iTraxx indices themselves were launched only last year.

Rudolf Ferscha, Eurex chief executive officer, added: “We believe that credit derivatives based on iTraxx indices will meet investor demand for liquidity and transparency in the credit markets and facilitate credit risk management at a low cost.”

The launch of an index-trading platform in credit derivatives is quite a significant development in global credit derivatives and CDO markets. CDOs have also been structured around indices.

CDO landscape has growing seeds of discontent

The CDO landscape seems enticing enough, but it has growing seeds of discontent. Currently, the CDO market, particularly of that for synthetic CDOs is passing through multiple problems - investors exiting with huge mark-to-market or realized losses, legal disputes and claims for liabilities for misrepresentation, and uncertainties surrounding the hedge funds industry which is a major supplier of equity capital to CDOs.

The Financial Times recently carried a story titled CDOs Unwinding with a Whimper wherein it mentions several of the insurance companies that have taken losses on CDO investments. It mentions Royal Sun Alliance, the UK insurance company, which reported a loss of GBP 50 million in 2003. It also talks of Scor, the French insurance group, also revealed in its annual report that it had suffered sizeable losses - and paid Goldman Sachs a hefty €45m to hedge this exposure against as much as $2.5bn losses. Some European banks such as HSH Norbank or Banco Populare di Italia have also admitted to CDO losses, as a result of court cases in which they threatened to sue the vendor banks.

And there have been several suits. The London office of New York-headquartered Weil is facing a claim of up to $100m (£57.4m) from Greenwich Natwest and National Westminister Bank, its founding securitisation clients. This is one of a number of high-profile CDO lawsuits to have been brought this year, prompting questions about the safety of the CDO market.

The claim form for the case alleges that there were problems in the structuring of the disputed transaction, an accusation that has "zero merit", according to the defendants. Whatever the outcome, as the firm assigned to the deal, Weil would have been involved early on with the structuring process.

Once the investment bank acting as bookrunner has carried out the economic modelling for the CDO, the law firm is instructed. Its areas of responsibility include the acquisition and holding of the underlying assets, the management of the debt portfolio and even drawing up documentation for how the CDO is intended to work economically. Firms must also advise on a number of 'what if' scenarios. The 'what if' clauses cover the sorts of problems that could appear over the life of the CDO and how these will be remedied.

Even before the Weil case emerged, CDO public relations had taken a battering. Barclays Capital was taken to court by the German Landesbank HSH Nordbank earlier this year over the alleged mis-selling of CDOs, while Bank of America and Banca Popolare di Intra came to an out-of-court agreement that ended with the Italian bank receiving e15.5m (£10.6m).

The third critical problem for the CDO industry is the shake out in the hedge fund industry. Recently, the turmoil in the credit derivatives market has affected hedge funds. Several hedge funds are reported to have suffered losses. It's not unusual for one out of ten hedge funds to collapse in the course of a year, without fanfare. Almost always these are small or medium-sized funds. But now, suddenly, and for the first time since the LTCM drama in Fall 1998, the large hedge funds are coming onto the radar screen. Three of them have recently acknowledged their dissolution: Bailey Coates Cromwell Fund, London; Marin Capital, California; Aman Capital, Singapore.


ISDA finalises Confirmation for ABS credit default swaps

ISDA has recently [13th June 2005] published the form of confirmation to be used in case of credit default swaps on asset-backed securities. The existing Credit Derivative Definitions 2003 were not squarely applicable in cases where the reference assets were asset-backed securities, because issues like "failure to pay" and "bankruptcy" could not exactly be applied to bankruptcy-remote entities. The new Confirmation sets out a different list of Credit Events in case of asset-backed securities.

The reasons why a new set of definitions and confirmation format was required for ABS trades is quite obvious. Credit events in case of corporate debt are defined on the basis of failure to pay, bankruptcy, etc. In case of asset-backed transactions, most of them do not have any fixed obligation to pay a particular amount, as distributions are based on expected payments. Besides, subordinated tranches allow the issuer the right to write off the principal in the event of a loss allocation. Such principal reduction cannot technically be termed as a default event using standard definitions. Besides, the issuers of asset backed securities are bankruptcy remote entities for whom traditional definitions of bankruptcy do not apply.

The revised definitions apply a 4-event test for asset-backed securities. Failure to pay is defined in relation to scheduled or expected payments. Bankrutpcy definition is amended substantially. In addition, a new definition, that is, rating downgrade, has been brought in whereby the reference security being downgraded to CC or equivalent will be treated as an event of default. Loss Event is also a credit event - this is essentially distribution of principal losses to the securities.

Links Vinod Kothari's narrative on the new Definitions applicable to ABS credit default swap trades is here. Full text of ISDA's Confirmation is here.

Cash settlement valuation under ISDA's Index protocol completed

When Collins and Aikman (Collins), the US auto parts supplier, filed for bankruptcy, one of the tricky issues in credit derivatives tardes was settlement as Collins was a part of the Dow Jones credit derivatives indexes being traded in the market. Physical settlement would have been chaotic due to a limited supply of Collins deliverable securities in the market. To resolve the problem, ISDA developed a new protocol - the 2005 CDS Index Protocol. Full text of the Protocol is here.

Under the Protocol, the reference obligation is to valued by a system of auction, and at the auction-valued price, cash settlement, that is, difference between the par value and the valuation so obtained, will be exchanged. Detailed rules about conducting the auction and the valuation procedure were laid down in the protocol.

The auction of Collins' 10.75% Dec 2011 maturing bonds took place. The auction was conducted by Creditex and Markit - the auction details are here.

Links For links on the ISDA's Protocol, see above. ISDA's site here also answers FAQs on the protocol.

Ripples of May: How GM and Ford downgrades burnt holes in dealers' profits

The massive ripples caused in the credit derivatives market due to downgrades of GM and Ford, and other events that happened more or less the same time, are yet to settle fully. First of all, impact on hedge funds is yet to finally assessed.

Financial press, quoting Financial Times, said Europe’s largest hedge fund manager, GLG Partners, has revealed that flaws in its trading model may have been to blame for the 14.5 percent drop in value of its Credit Fund in May. The fund is down 15.5 per cent in the year to date. CLG's mathematical model failed to foresee market swings in credit derivatives after General Motors and Ford were downgraded. According to the FT, GLG believes conditions will remain difficult as hedge funds and banks try to get out of the same positions.

.A recent BIS report BIS Quarterly Review June 2005 spent a considerable space discussing the woes of the credit derivatives markets in May 2005. "It is easier to take positions – especially short positions – in credit derivatives markets than in corporate bond markets. Therefore, leveraged investors, such as hedge funds and investment banks’ proprietary trading desks, tend to be more active in credit derivatives markets than in their cash counterpart. Leveraged investors play
an important role in promoting market liquidity and improving price discovery. Yet at times their activities can exacerbate price movements. May 2005 seems to have been one such time", explains the BIS report.

"The downgrade of Ford and GM caused relationships between the prices of certain assets to change in unexpected ways. Consequently, some “relative value arbitrage” trades – strategies in which approximately offsetting positions are taken in two securities that have similar but not identical characteristics and trade at different prices – suffered large mark to market losses" - says the BIS report.

The BIS report explains yet another reason why CDO investors suffered losses in the present case. "Another relative value trade on which investors reportedly lost money involved supposed anomalies in the pricing of CDO tranches. Spreads on the equity, ie first loss, tranche of CDOs tend to be much higher than the cost of a (delta) hedged position in the underlying CDO (or alternatively in the mezzanine tranche, which absorbs losses in excess of 3% of the notional amount and up to 10%). In early 2005, an investor who sold protection on the equity tranche of the iTraxx Europe
CDS index and then hedged against market-wide changes in credit spreads by buying protection on the underlying index would have earned a spread of 300 to 400 basis points. Such a trade is exposed to changes in default correlation and so is commonly referred to as a long correlation position. Investors expecting default correlations to remain stable or increase were surprised in May when they instead fell sharply (right-hand panel of the graph). Starting in mid-April, investors
appeared to have become increasingly concerned about idiosyncratic risks. This led to a widening of the spread on equity tranches and losses on long correlation positions (centre panel). The widening accelerated following S&P’s downgrade of GM and Ford. Some correlation traders apparently sought to limit their losses by unwinding their positions. This temporarily put downward pressure on the spread of mezzanine tranches and thus exacerbated mark to market losses.
Whereas normally changes in the spread of the mezzanine tranche are positively correlated with changes in the index, at times in early May the two moved in opposite directions."

Credit derivatives market in tizzy after GM and Ford downgrade

The CDS markets globally went into a tizzy soon after the junk-rating of General Motors and Ford on the 5th of May. While spreads for both the car makers were widening for quite some time in the past, the junk rating meant several hedge funds and institutions, which as per policy are not permitted to play with below-investment-grade clients, were required to either hedge or clear positions on credit derivatives as well. GM bonds were referenced in several CDOs - and that apart, both GM and Ford were regularly traded names in the market.

Several hedge funds have reportedly offloaded their positions - an article in FXstreet named several hedge funds who were reportedly in distress because of positions on credit derivatives of the two. Several banking scrips took a beating on the ground that their hedge funds might be in trouble.

Credit spreads have widened to an extent that the implicit probabilities of default for GM and Ford, respectively, on a cumulative basis over a 5 year term seem to be around 60% to 42%. On the 6th May, GM spreads were about 718 bps and Ford about 625 bps.

If that is the case, what happens to the CDOs' equity tranches? And more significantly, what happens to the CDO^2 ? There have been several highly leveraged products being sold to banks in the Gulf and Far East - the latter understood very little of what is happening except that impressive marketing presentations backed by high-powered mathematics made the high returns on CDO^2 look all like too easy and too much money. S&P has confirmed that most CDOs and CDO^2 have at least one of the two downgraded entities.

Somehow the market always loves to learns lessons the hard way.

The impact of the downgrade on the CDS markets was apparent - the 125-name 5-year DJ CDX.NA.IG index widened from 59.08 bps to 63.49 bps, breaking the 60-bp mark for the first time since moving into a new series.


Greenspan talks of credit derivatives risks

Greenspan seems to have had a slight change of heart, or possibly he has changed his coat - at least that is what seems to be the case with his views on credit derivatives. While Warren Buffet had always looked at credit derivative as weapons of mass destruction, Greenspan was evidently in favour of credit derivatives as having contributed to the stability of global banking. Recently, however, while his overall tone still supported credit derivatives as responsible for the stability of the banking system, he made comprehensive references to observations by others wherein risks of credit derivatives had been highlighted..

On May 5, 2005, while addressing the Federal Reserve Bank of Chicago's Forty-first Annual Conference on
Bank Structure, Chicago, Illinois, Greenspan, while acknowledging that credit derivatives are indeed "the most significant development in financial markets over the past ten years", cited at length the report of the Joint Forum under the aegis of banking and insurance regulators that concluded that the information about risk transferred outside the banking sector by credit derivatives was extremely opaque and in particular, data about the notional values of credit default swaps, particularly CDOs, was not reliable to understand the exact element of risk. CDO tranches being differential in risk allocation, the risk at subordinated tranches could be several times the size of the notional value. Greenspan also cited that the study had found operational risks not properly understood by the investing banks - a point which even the UK FSA report (see below) strongly made.

Greenspan is surely not in favour of either curtailing or regulating the growth of credit derivatives. Countering the case made by some people that since credit derivatives do transfer risks outside the banking system to entities that are not regulated, there is a case for regulation, Greenspa said: "Some observers believe that credit risks will be managed more effectively by banks because they generally are more heavily regulated than the entities to which they are transferring credit risk. But those unregulated and less heavily regulated entities generally are subject to more-effective market discipline than banks. Market participants usually have strong incentives to monitor and control the risks they assume in choosing to deal with particular counterparties. In essence, prudential regulation is supplied by the market through counterparty evaluation and monitoring rather than by authorities."

On the contrary, he feels that the risks being transferred outside the banking are to entities which are lesser leveraged than banks are - "In fact, while many focus on the dangers of risk transfer to highly leveraged entities that might be vulnerable to a sharp widening of credit spreads, a significant portion of the risks that are being transferred outside the banking system are being transferred through private asset managers to institutional investors that have much lower leverage than banks. Indeed, the increasing transfer of systematic risks from banks to entities with lower leverage and longer time horizons may, other things equal, push credit spreads lower. Such investors may naturally have a greater tolerance for risk than banks. "

Those remarks - about risks being transferred to entities which are lesser leveraged, are not necessarily true - if the market developments during this or the past week are a clue. The downgrading of General Motors and Ford Credit to junk status has pushed CDS swaps to crazy levels and hedge funds have turned into big sellers of positions. Some hedge funds are highly leveraged by their very nature.

Greenspan did talk about hedge funds and their role in the credit derivatives market. Once again, he explicitly ruled out capital requirements or regulations for hedge funds, but did caution banks about the impact of sudden widening of credit spreads caused by hedge funds dumping their positions on credit derivatives - "Even with sound credit-risk management, a sudden widening of credit spreads could result in unanticipated losses to investors in some of the newer, more complex structured credit products, and those investors could include some leveraged hedge funds" - he concluded.

Greenspan's remarks could not have come at a more opportune time - the market is alredy bleeding with the impact of downgrade of GM and Ford.

Link Full text of Greenspan's speech here.


UK FSA warns against risks of slack credit derivatives operational risks

You might be sleeping pretty having bought protection against credit risks, but if you haven't done the backroom properly, the so-called protectors might simply wash their hands when the markets turn bad. That, in brief, is the terse warning issued by the UK financial regulator yesterday.

In a letter issued to CEOs of major credit derivatives players, the Capital Markets segment leader said: "..we believe that more can be done to reduce operational and settlement risks. The difficulties of back-office functions keeping pace with the rapidly developing front office trading activity were highlighted during the Joint Forum’s investigation and the FSA's soundings of firms confirmed this. Specifically we are concerned about the level of unsigned confirmations with some transactions remaining unconfirmed for months. Although we recognise that work undertaken in 2004 is helping reduce the backlog, levels of unsigned confirmations and master agreements remain relatively high and raise serious issues for market efficiency and market confidence."

Derivatives dealers pay scant attention to backrooms.

Talking of further operational risks, the FSA says: "One additional operational issue that is creating market inefficiency is firms' communications to paying agents. We are aware that the communication mechanism for disseminating rate-fixing information used for calculating interest and principal payments is not always effective. This is particularly common in financial institutions originating structured debt with a related derivative which accept the role of calculation agent but not of paying agent. The calculation agent should ensure it has in place an effective system for advising paying agents and issuers on a timely basis of all rate or index determinations. This is so custodians and investors may in turn be notified of impending cash movements. Industry participants may wish to consider opening a dialogue on this issue to work on improving communications."


Cash versus synthetics, the basis is only transient : Researcher

A common pursuit for researchers and arbitrageurs is whether and why there is a difference, or gap between the price discovery process in the cash bonds market and the synthetics market. Which of the two is faster to react to developments relating to credit?

Recently, a paper by Haibin Zhu of the Bank for International Settlements went into this question. The author has picked up data of credit default swap deals from 1999 to 2002 for 24 major reference entities in the US and the European market. The author observes that the bond spreads adjusted by swap premia, and credit default swap rates move very closely. The author's significant observation is that "overall, the prices of credit risk in the two markets are very close to each other. This is particularly true when swap rates are used as risk-free rates". However, the difference is substantial if the Treasury rates are used as the reference.

The author does, however, find a strong evidence that, although there seems to be no pricing difference at least 30 days before or 10 days after a rating event, the two markets do behave differently during the short intervals around the rating change. CDS spreads increase (decrease) faster than bond spreads by more than 2 basis points per day within the 30 business days before a rating downgrade (upgrade). The price discrepancies accumulated during this period can be almost fully removed shortly after the rating event (about 6 bp per day in the next 10 days). In other words, the derivatives market seems to have done a better job in incorporating future rating events into the price.

The study seems to suggest that the CDS market leads, and the cash market follows.

It is important to note that the study is limited to observations upto 2002, whereafter the credit derivatives market in width as well as depth has grown tremendously.

Link The complete paper is here.

Wall Street is hiring, and particularly credit derivatives specialists

According to an article in CBS, the securities industry created some 10000 new jobs in June 2004. "The securities industry created about 10,000 jobs in June, bolstering a recovery that to date has recouped nearly half of the jobs lost during the economic downturn", it says.

The workers in greatest demand include compliance officers, credit derivatives specialists and supervisory analysts, along with administrative, technology, operations and accounting staff.

Credit derivatives have tremendously increased in popularity of late in the US markets. While concentration levels still remain high, but there is an increasing awareness and desire to get into action on the part of smaller and even regional banks.

Links If you have a credit derivatives place to put up, you can have it added on our jobs page.


Dow Jones starts trading in standard first-to-default basket

The Dow Jones North American CDX credit derivatives indexes, the main indexes for the market, began including standardized versions of first-to-default (FTD) basket in the New York market, allowing parties to trade in a standardised FTD basket. While basket trades have been there on an OTC basis in the market, the standardised basket option will allow parties to trade with reference to a uniform and standard basket.

Initially, there are standardized FTD baskets for each of five sectors, and two diversified versions. The sectors include basic industries, energy, technology-media-telecom, financials, as well as more diversified baskets. For instance, the basic industry basket has the following names: Ford Motor Co., Bombardier , Delphi Corp. , Dow Chemical Co. and International Paper.

Index trades on standardised terms are becoming increasingly popular in credit derivatives markets, signalling forthcoming explosive growth.

Links For more on what first to default basket swaps are, click here.

iTraxx starts trading in Singapore

The new consolidated Asia-specific CDS indices started trading in Singapore markets this Monday. The early trades revealed there was more interest in selling protection than in buying protection - indicating firm view of underlying Asian names.

The bouquet of iTraxx indices includes the Dow Jones iTraxx CJ50 Japan, the iTraxx Asia Ex-Japan made up of iTraxx Korea, iTraxx Greater China and iTraxx Rest of Asia, and the iTraxx Australia.

The new indexes are administered by International Index Co., the result of a merger between JPMorgan (JPM) and Morgan Stanley's (MWD) TRAC-X and iBoxx Ltd. which ran indexes in Europe and the U.S. The indexes are licensed by Dow Jones Indexes, a part of Dow Jones & Co. (DJ) which also publishes this index.

The rival groups agreed in April to bury their differences and launched a combined set of European indices at the end of last month.

In the US the high-yield indices have been merged into the DJ CDX High Yield Index but work is continuing on the investment grade and emerging market indices.

Merging iBoxx and Trac-x, the competing indices that have made way for iTraxx, has led to a dramatic increase in trading volumes. They have risen three to four-fold in Europe since iTraxx was launched, JP Morgan said.


Federal regulators seek more analytical information on credit default swaps

In a proposed rule, notified on 23rd July 2004, the Federal regulators in the USA are seeking more details about credit defaut swaps. The reason cited is the fast growth of credit default swaps.

The proposal states: "The Federal Reserve proposes to revise the FR 2436 by adding tables to collect data on credit default swaps, effective with the December 31, 2004, report date. Given the very rapid growth of creditderivatives in recent years, the G–10 central banks determined that data on credit default swaps should be collected semiannually. The credit default swaps
data would be collected on new Tables4A through 4D".

The proposed Tables 4A - 4D run as under:

Proposed Table 4A–Credit Default Swaps by Rating Category. Data would be disaggregated into upper investment grade (AA and higher), lower investment grade (A and BBB), non investment grade (BB and lower), and not rated. Information on the credit rating of the reference entity would give central banks and other data users a clearer picture of the nature and amount
of credit risk that is being transferred in the credit default swap market.

Proposed Table 4B–Credit Default Swaps by Sector of the Reference Entity. Data would be disaggregated into
financial firms, nonfinancial firms, sovereigns, and multiple sectors (for multiple–name instruments). Information on the sector of the reference entity would give central banks and other data users a clearer picture of the nature of the credit risk that is being transferred in the credit default swap market.

Proposed Table 4C–Credit Default Swaps by Remaining Contract Maturity. Data would be disaggregated into one
year or less, over one year through five years, and over five years.

Proposed Table 4D–Credit Default Swaps, Gross Positive and Gross Negative Market Values. Data would
show the magnitude of unsettled changes in value of credit default swap contracts outstanding at the time of reporting. Such a time series is a valuable source of information for researchers and market participants in developing an understanding of the role
and function of the credit default swap market in financial systems in various circumstances.


US treasury and IRS seek inputs on credit default swaps

The US treasury and Inland Revenue Service are seeking inputs to assist it in taxation of credit default swaps. A recent press release and a notice dated 19th July 2004 has been issued calling for inputs in the matter.

The press release says: "Taxpayers and industry groups have requested specific guidance regarding the tax treatment of credit default swaps. A large international market for credit default swaps has developed, and the requests for guidance focus on the treatment of payments from U.S. persons to foreign persons in these transactions. Treasury and the IRS believe that credit default swaps deserve careful study so that appropriate guidance can be issued."

The Notice no 2004-52 that has been issued in this regard says that there are various possible tax options for credit default swaps. "Some possible analogies for a CDS include a derivative financial instrument such as a contingent option or notional principal contract, a financial guarantee or standby letter of credit, and an insurance. contract. A variety of theories have been advanced in the existing literature both for and against these analogies. Other commentary recommends an alternative to the analogue approach."

Comments may be submitted either physically or by e-mail to, including: Notice 2004-52 in the subject line of any electronic communications.

Links Vinod Kothari's book on credit derivatives, among other topics, contains a chapter on taxation of credit derivatives as well - see here for contents.

Hedge funds and pension funds increasingly seen in CDS market

The CDS market is fast coming out of its banker-dominated mould, and today, there a variety of participants including the hedge funds and pension funds into it. Essentially, the CDO technology has enabled institutional investors and asset managers to increasingly participate into the credit derivatives arena - stand-alone derivatives are difficult for many to digest, but when the same is embedded into an investment product, it is easy as a lollypop. [Moral - people can afford to lose their investments, but they cannot afford to lose without investing! ]

A recent report by Nomura Research [2004 Mid-year Fixed Income Outlook] says that hedge funds and pension funds are now regularly playing as investors in the CDO market. ".. hedge funds are believed to be driving the rapid growth of the market,
as evidenced by the emergence of new types of funds that are focused on credit and creditderivatives. In recent months, hedge funds were reportedly behind some dramatic movements in CDS spreads."

Not only hedge funds, corporations are also investing into CDOs. US corporates are flush with funds which their way into attractive investment opportunities as CDOs.

More welcome news is the entry of such conservative investors as pension funds. "With hugefunding deficits, some pension funds in search of alternative investments to enhance yields are heading to credit market products. While credit products such as high-yield and structured finance CDOs, as well as CDS index trades and single-tranche CDOs, are gaining popularity among pension
funds, some funds are even moving into more complex structures. For example, the asset management giant Pimco reportedly said earlier this year that it will increase the size of its credit derivatives portfolio to almost 25% of its fixed income holdings. Likewise, General Motor’s pension fund manager was reported to have directed over $10 billion of funds to the structured credit market to boost investment returns", says Nomura Research paper.


Basle II is finally out: restructuring must be a credit event for full hedge

The new capital framework for banks all over the world, that would be effectively implemented by year-end 2006, has been announced by the Bank for International Settlements (BIS). End-June 2004, the BIS announced the new capital proposals on which work has been going on for over 4 years now.

As far as credit derivatives are concerned, the final rules substantially contain the same provisions as in Consultative Paper 3, issued in April last year. However, credit derivative transactions must include restructuring as a credit event to get advantage of the full hedge. If restructuring is not included as an event, the hedge will be limited to 60% - in other words, 40% of the underlying obligation will be deemed to be unhedged.

Links For a quick write on the new Basle proposals, see our page here.


Sporadic liquidity a constraint to
looking at CDS as hedging tool: Fitch report

Rating agency Fitch on 7th June 2004 published a special report looking into the liquidity of the CDS market. The credit derivatives market is almost entirely OTC market and therefore, liquidity is a significant issue in use of credit derivatives as hedging tool. The ability to buy protection at a time when it is needed, that is, when a reference entity's credit is worsening, is the hallmark of liquidity.

Fitch picked case studies of trades done through some well known CDS brokers relating to a dozen of European fallen angels. Fallen angels are corporates that were investment grades, but then they were downgraded to speculative grades.

The study comes out with several observations. Of the 12 names, only 2 were consistently liquit. In 6 cases out of 12, during the period of stress, the market completely crashed with no trades at all, whereas in a deep market it would have been expected that the underlying credit risk would have been priced and protection sellers willing to sell protection at a price. Fitch concludes that the market is mainly investment grade - that is, protection sellers are not prepared to sell protection on credits which have been junked, nor to protection buyers proactively engage in seeking protection for names with worsening credits. The report also shows number of bids for protection bought substantially exceeding actual trades, once again, showing the immaturity of the market. Do protection buyers pre-empt a downgrade - the study should largely reveal, no.

For some of the 12 names that were liquid, what made them liquid? The study generally concludes that the significant common factor was that those names were common reference names in synthetic CDOs. Thus, "An entity’s weighting in the synthetic CDO industry, therefore, was by far the most significant factor in assessing its liquidity in the CDS market."