Credit Derivativesand StructuredCredit Trading

(Revised Edition)

Vinod Kothari

John Wiley & Sons (Asia) Pte. Ltd.

C O N T E N T S

Foreword xxv

Preface xxvii

PART 1 MARKET, INSTRUMENTS AND MOTIVATIONS

Chapter 1: Credit derivatives: Structure, evolution, motivations, and economics 3

Credit risk: The challenge of our times . ,. 4Derivatives: The building block of credit derivatives 5Securitization: The other building block 5Instruments of credit risk transfer 6Meaning of credit derivatives 6

What is a credit derivative? 6A definition of credit derivatives 7A quick guide to basic jargon 7A quick example 9Synthetic lending 10Reasons for trade in credit risk 10

The elements of a credit derivative 11Bilateral deals and capital market deals 11Reference asset or portfolio 12Structured portfolio trade 12Basket trades 13Index-based credit derivative trades 13Credit default swaps (CDS) on asset-backed securities 13Loan-only CDS 14Protection buyer 14Protection seller 14Funded and unfunded credit derivatives 15Credit event 15Notional value 16Premium 16Tenure 16Loss computation 17Threshold risk or loss materiality provisions 17Cash and physical settlement 17Deliverable asset 18ISDA documentation 18

v i i i Contents

Quick introduction to the types of credit derivatives 19Credit default swap , 19Total return swap ~" 19Credit linked notes 20Credit spread options 20Portfolio default swaps 21Index trades 21

Credit derivatives and traditional financial guarantee products 21Credit derivatives and guarantees 22

Credit derivatives and credit insurance 22Credit derivatives and loan assignments 22Credit derivatives and securitization 24Motivations 24

Motivations for the protection buyer 24Reducing regulatory capital 24Economic capital relief 25Offers easier alternative to securitization 25Reduction of credit concentration 26Better portfolio management 26Solving cross-border_problem 27Enhancing RARoC 27Trading motive 27

Motivations for the protection seller 27Synthetic lending 28Arbitraging opportunities 29Yield enhancement 30Risk diversification 30Balancing the risk balance sheet 30Far fewer expenses 31Resolves problems of availability by cloning cash assets 31

Motivations for the traders and re-packagers 31Economic impact of the credit derivative market 32

The positive side 32Financial stability 32Banks to focus on credit asset creation 33Reducing the cost of credit 33The supply of bank credit increases 34Effective risk management by diffusion of risk 34Securitization results into disintermediation: Credit derivatives

reinforces the role of commercial banks 36Credit derivatives and pricing of credit risks 37

The negative side 37Lack of transparency in transfer of risks 37Cross-sector risk transfers 38

Contents

Transfer of risks to the lesser informed 39Increased leverage 39Credit derivatives promote riskier lending 39Insider trading 40Unconfirmed trades and operational problems 41Credit derivatives have not been tested in adverse market conditions 41

Chapter 2: Credit derivatives: Market, evolution, and current status 47

Evolution of credit derivatives 47Credit derivatives and secondary markets in loans 48The emergence of credit-linked notes (CLNs) 49Four stages of development 49Pre-1997: Early period of skepticism 50The 1997 and 1998-cfises: Credit derivatives get a boost 51Enron, WorldCom, Argentina 53Standardization of CDS 53Advent of index trading 54Advent of credit derivative product companies . 54Synthetic balance sheet securitization 55

Current state of the market 55Growth in credit derivatives relative to other OTC market segments 55

Major centers of credit derivatives activity 58Major market players 58

Protection buyers 58Protection sellers 58Banks 60

Concentric nature of the credit derivatives market 61Trading versus hedging motive 63

Insurance companies 64Financial guarantors 64Hedge funds 64

Dealers 65Hedge funds and credit derivatives 65

Growth of the hedge fund industry 66The advent of credit strategies hedge funds 66Role of hedge funds and credit derivatives 68

Hedge funds as suppliers of equity to credit derivatives 69Credit derivatives losses and hedge funds 69Implications of the intensive hedge funds role 71

Major products 72Reference risks: sovereign versus corporate 72Credit quality of reference entities 74Physical versus cash settlement 76

Contents

PART 2 SINGLE-NAME INSRTUMENTS

Chapter 3: Credit default swaps 81

Meaning of CDS '-- — 81Summary of terms 81

Numerical illustration 83Main terms of the CDS 83

Reference obligation 83Notional value 84Premium 84Credit events 85ISDA's credit events 85

1 Bankruptcy 852 Obligation acceleration 863 Obligation default 864 Failure to pay 875 Repudiation/Moratorium 876 Restructuring 87

Common credit events 87Notice of credit event 88Terms of settlement , 89

Physical settlement 89Deliverable obligation 89Cash settlement 89Valuation of the defaulted obligation 89Threshold amount 89

Collateral provisions 90Funded CDS 90How do the parties to a CDS encash value 91

Impact of time decay on mark-to-market valuation 92CDS on sovereign names 92Basket default swap 92Portfolio CDS 94Structured portfolio default swap 96Binary swaps 98

Chapter 4: Total rate of return swaps 99

Meaning of TROR swaps 99CDS and TROR swaps 100Impact of a TROR swap 101Terms of a TROR swap 101

Reference asset 101Credit events 102Settlement methods 102

Examples of applications of TRSs 102

Contents x i

Advantages of a TRS 103Creates off-balance sheet synthetic assets 103.Avoids problems" of availability 103Avoids regulatory barriers in owning the target asset 103Provides very high leverage 103Avoids regulatory barriers in giving a traditional loan 103Provides better security interest for the synthetic lender 103

Index-based TRSs 104Structured TRS 104TROR swaps and equity swaps 104TROR swaps and property derivatives 104TRSs and camouflaged lending transactions 105

Chapter 5: Credit-linked notes ' 107

Meaning of a CLN 107Distinctive features of CLNs 108Structured risk transfer through CLNs 109CLNs issued by SPVs 109Self-referenced CLNs ••• .. I l l

Chapter 6: Credit default swaps on asset-backedsecurities and derivatives exposures 113

Need for CDSs on asset-backed securities 113Development of CDS on ABS 113Major differences between CDS of ABS and corporate debt 114Documentation templates for different structured finance products 115Special features in the documentation templates 115Notional value of the swap 116Credit events in the case of ABS 117

Credit events in the case of MBS—physical or cash settlement terms 117Meaning of Failure to Pay 117

Failure to Pay during the term of the transaction 117Failure to Pay upon final maturity 118

Meaning of loss event 118Bankruptcy as a credit event in case of CDS of ABS 118Rating downgrade to distressed level 119Restructuring 119Credit events under the PAUG terms 119

Physical delivery option under PAUG 119Two modes of settlement: PAUG and traditional 120

Payments by the protection buyer 120Payments made by the protection seller 121

Write-down 121Principal shortfall 121Interest shortfall 121

x i i Contents

CDS of CDOsCredit events in case of CDS of CDOs

Contingent CDSNotional amount of the transactionMark-to-market valueInterim payments

Credit events

Chapter 7: Loan-only CDS ,—-

Meaning of leveraged loansMarket for leveraged loans

The LCDS marketMotivations of parties

Motivations of the protection buyerMotivations of the protection seller

Distinctive features of LCDS as compared to vanilla CDSEuropean and US LCDSSecured loansPhysical settlementRelevant secured listAuction protocolCancellability when no deliverables of required seniority exist

ISDA documentation for LCDSLCDS basis

Reasons for basis spreads (LCDS: leveraged loans)Reasons for basis spreads (LCDS: CDS)

LCDXiTraxx LevX

Chapter 8: Credit derivatives options and volatility trades

Credit spread tradesCredit default swaptionsPayer optionReceiver options

Out of money swaptionsCombination trades

StraddleStrangleButterflySwaptions on indicesKnock out feature

Constant-to-maturity CDSDistinctive Features of CMCDSGenesis of CMCDSUses of CMCDSCapped CMCDSIndex CMCDS

122122122123123124124

125

125125126127127127128128128128129129129130130130130131131

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133133134136140140140141143145145145147147147148148

Contents x i i i

Chapter 9: Equity default swaps, recovery swaps and other exotic products 151

Equity default swaps 151Synthetic position on various elements in the capital structure 151The intuitive idea behind equity defauh^swaps 152Emergence of equity default swaps 153

Preferred default swap 153Recovery swaps 153

Combining a plain vanilla CDS with a digital CDS 154Recovery swaps 154

Market in recovery swaps 155

PART 3 PORTFOLIO PRODUCTS

Chapter 10: Portfolio credit derivatives and introduction tostructured credit trading 159

Portfolio credit derivatives vs. single-name credit derivatives 159Nature of the tranches 160

Subordination and credit enhancement . 160Attachment and detachment points 161Leverage 161

Tranching: the essence of structured credit trading 161Why a portfolio for tranches 161

Key features of portfolio formulation 161Managed versus index/ index- tracking transactions 162Quality of credits 162Diversification 162Number of credits 162

Number and sizing of the tranches 163Range of structured credit products 163Funded and unfunded transactions 164Special purpose vehicles (SPVs) 164

Chapter 11: Introduction to collateralized debt obligations 167

Terminology: CDO, CBO, and CLO 167Types of CDOs 168

Cash and synthetic CDOs 168Balance sheet and arbitrage CDOs 169CDO types based on collateral 170Par value and market value-based structures 170Managed and static pool structures 171Fully ramped, and to-be-ramped-up structure 171

Typical structure of a CDO 171Basic economic drivers of CDOs 172

CDO Market and the Health of Banking 175Growth of the CDO market 175

The spurt and spike in CDO activity in 2006 and 2007 176CDO market trends 177

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Balance sheet CDOs 177Traditional, cash CDOs 178

The creation of a balance sheet CDO 178Underlying assets , 179Diversity V " ' 179Reinvestment period 179Credit enhancement structure 180Structural tests -'lifO

Synthetic CDOs 180The creation of a synthetic CDO 180Advantages of synthetic CDOs over cash CDOs 182Alleviates problems related to true sale 183

Arbitrage CDOs 186Arbitrage cash CDOs . 187

Legal structure 188Underlying assets 188Reinvestment period 188Credit-enhancement structure 189Illustration of potential returns from arbitrage CDOs 189,

Arbitrage synthetic CDOs 189Creating an arbitrage synthetic CDO 190

Measures of pool quality 190Asset quality tests 191

Weighted average rating factor 191Minimum and maximum weighted average coupon 191

Diversity tests 191Concentration limits 191Diversity score 192

Asset and income coverage 192Over-collateralization test 192Interest coverage test 194

Ramp-up period 195The CDO manager 195

Qualities of the CDO manager 195Balancing between equity investors and debt investors 197

The CDO manager's fees 198Resecuritization or structured finance CDOs 198

Growth of structured product CDOs 198Assets of structured finance CDOs 199Collateral and structural risks in CDO investing 199Correlation risk 199

Interest rate and basis mismatch 200Cross-currency risk 200Liquidity risk 200Ramp-up risks 201

Contents x v

Reinvestment risks during the revolving periodLack of granularityAsset risks

Chapter 12: Indextrades

Reasons for popularity of index tradesDevelopment of the index tradesTranche tradingIndex options and tranche optionsiTraxx Europe

iTraxx Europe Investment gradeiTraxx HiVoliTraxx CrossoverPrice fixings in iTraxx

iTraxx AsiaiTraxx total return indicesLevXEurex iTraxx credit futures

Advantages of index-traded futures over OTC index tradesManner of computing iTraxx futures pricesTreatment of default

CDXABX

TranchesComposition of the index and settlements

CMBXLCDXTABXOther indicesIndex spreads and intrinsic spreads

201201202

203

203205206206207207207207208209209209209209210210210211212212212213213214214

Chapter 13: Single-tranche synthetic CDOs, CPDOs, andother CDO innovations 217

Single-tranche synthetic CDOs 217Delta hedging 219

The concept of PV01 220Why would structurers prefer single-tranche structures 220Distinction between a traditional CDO and STCDO 220Credit CPPI CDO 220

Constant proportion portfolio insurance 221Basic idea of principal protection 221Portfolio insurance 222

Illustration of constant proportion portfolio insurance 222Enter credit CPPI 224

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CPDOs , 225The structure of CPDOs 225

Impact of leverage : . 227CPDOs: from boom to bust V "" 227Leveraged super senior CDOs 227

The transaction structure of an LSS CDO 227Performance of leveraged super senior CDOs 228Case study: STARTS leveraged super senior CDO 228

Long/short CDO 229Collateralized commodity obligations 230

Case study: Barclays CCO transaction 230

Chapter 14: CDO case studies 233

Balance sheet synthetic transactions 233DBS Bank's Alco 1 233

Transaction structure 234The SPV 234The notes 234Risk transfer 235Reference portfolio 236.The CDS 236

Investment of the collateral 237Interest rate swap and put option 237Economics of the transaction to DBS Bank 238Economic capital relief 239Basle II and the Alco 1 transaction 239

CAST 1999-1 Non-SPV structure 239Features of CAST 1999-1 240Principal protection to subordinate class 241Investor interest \ • 241CAST 2000-1 242

Promise program by KfW Germany 243Promise A 2002-1 244Transaction structure 244The notes and Schuldscheine 245The reference portfolio 246Loss structure 246Amortization of the notes: 246Promise-12002-1 247Later Promise transactions 248

Standard Chartered Bank's START series and Sealane(Trade Finance) transaction 249Notes 249Portfolio 249Trade Finance CLO 249

Contents x v i i

The notes 249The portfolio 250

Synthetic credit asset securitization: SMART from Australia 250Synthetic versus-cash transfer of lease receivables 250Credit protection 251Asset structure 252

ANZ's Resonance Funding 252Jazz synthetic arbitrage CDO 253

Hybrid between cash and synthetic structure 253All that Jazz it has 254Synthetic versus cash liabilities 254The collateral manager 255Liquidity facility 255Over-collateralization and interest cover tests 256

Robeco arbitrage synthetic CDO 257White Oak synthetic CDO of structured obligations 258

The reference portfolio 259Credit events 259Funding 259Regulatory arbitrage? 259

Chapter 15: Credit derivative product companies 263

Development of rating-oriented vehicles 263Derivative product companies: A general introduction 264

Market risk 264Credit risk 264Workout risk 265Case study of DPCs: Lehman's subsidiaries 265

Lehman Brothers Derivative Products 265Lehman Brothers Financial Products 266

Credit derivative product companies: Development 266Typical structure of CDPCs 267Rating agencies' conditions for CDPCs 268Constitutional and legal structure 269Operating modes 270Case study: Primus Financial 270

Portfolio 270Financials of Primus 271

Quadrant Structured Credit Products 271Asset Portfolio 272Operating modes 272

Suspension mode 272Winding-up mode 273

Capital model 273Cash flow waterfall 273

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PART 4 PRICING AND VALUATION OF CREDIT DERIVATIVES

Chapter 16: Approaches to quantification of credit risk 279

Credit risk: semi analytic approaches " 280Financial statement analysis 280Multivariate models 280

Altman's Z-score 280Probit and Logit models 281

Option-theoretic models 282Merton model 282

Foundation of the Merton model 283Critical factors in bankruptcy risk 283Value of assets 284The Merton formula for probability of default 286Implementing the Merton formula 286Adding simulation with the Merton formula 287

The KMV model 287Measuring default probability 288

Asset value and volatility 288Computing the distance to default 289Computing default probability 290

Intensity or hazard rate models 290Back-computing implied probability of default from the market 290

Pricing of credit risk in a defaultable bond 290Computing probability of default from the market spreads 292

Chapter 17: Pricing of a single name credit derivative 293

Establishing multi-period probabilities of default 293Working with probability of default 293Getting the probabilities of default from credit spread curve 294

Pricing of a credit default swap 295Approach to pricing 295

Defining the cash inflows and outflows 295Expected value of the inflow 296Expected value of the outflow 297CDS Price 297

Introducing details 297Pricing of a derivative vs. pricing of a bond 298Relevance of recovery rate 299Valuation of a credit default swap 299Value of upfront payment in a CDS 302

Chapter 18: Pricing of a portfolio credit default swap 303

Basic principles of pricing of portfolio default swaps 303Meaning of a portfolio 303

A portfolio without correlation 304

Contents x i x

Binomial distribution 305Tranching of the risk 306Pricing of the tranches 307

Simulation method to derive probability distribution 308Comparing the results of binomial and simulation approaches 309Introducing different exposures and different recovery rates 310

Introducing correlation 311Incorporating correlation in simulation approach 311Impact of correlation on the shape of the probability distribution 313

Correlation and tranche pricing 313Market implied correlation and correlation trading 315

PART 5 LEGAL, REGULATIORY, OPERATIONAL, TAX ANDACCOUNTING ASPECTS

Chapter 19: Legal aspects of credit derivatives 319

Legal nature of credit derivatives 319Credit derivatives and contingent contracts 320Credit derivatives and actionable claims 320Contract of guarantee or surety 320Contract of indemnity 324Credit derivatives and bank letters of credit 325Credit derivatives and credit insurance contracts 325

Robin Pott's opinion on credit derivatives and insurance 327Are they gaming, gambling or wager contracts? 327Are they securities? 328Are they investment contracts? 328Bilateral contract or transferable 329Credit derivatives and commodities 330

Enforceability of credit derivative contracts ' 331Regulatory enforceability of the derivative contract 331Enforceability of the reference obligation 331

Whether credit event? 332Meaning of different credit events 332

Bankruptcy 333(a) Dissolution 333(b) Insolvency 333(c) Arrangement or composition with creditors 334(d) Institution of bankruptcy or winding up proceedings 334(e) Winding-up resolution 335(f) Administration, receivership, and so on 335(g) Foreclosure action by creditors 335(h) Analogous proceedings 336

Obligaton acceleration 336Obligation default 336Failure to pay 337

XX Contents

Repudiation/moratorium 337Restructuring 338More than one credit event 339

Legal disputes on credit derivatives j 339Deliverable obligations ~" 339Service of notices and physical delivery 340Demerger and the meaning of the successor entity 340Fraud allegations 341Significance of writing proper legal names of reference entities 341

Derivatives-related regulation applicable to credit derivatives 342General bar on derivatives 342Commodity futures law in the United States 343

Exemption to OTC derivatives 343Commodity Futures Modernization Law 344

/ Permission for trading in credit futures on exchanges 345Legal nature of total return swaps 346Legal nature of credit-linked notes 346Credit derivatives: Legal authority for banks 347

Whether a part of banking business 347Whether banks can be protection buyers 348Whether banks can be protection sellers 348

Legal authority of a party to enter into a derivative 348Legal position of netting rights 349

Derivatives trades and need for netting 350Bankruptcy laws and derivative contracts: . 350

Bankruptcy Code: a safe harbor to credit derivatives 351Early bankruptcy safe harbor in the United States 351Financial Contract Netting Improvement law 352The Bankruptcy Reform Act 2005 353

Revised definition of "swap agreements" 353Definition of "financial participant" 354Definition of "master netting agreement" 354Power to terminate under section 561 355Amendment of automatic stay provisions 355

Collateral rights 356General provisions relating to collateral 356Collateral rights in bankruptcy 357

UK insolvency law and netting 357EU law on collateral and netting 358Netting in other countries 358Assignment and novation 358Choice of law 359Restructuring credit event 360

Conseco restructuring event: 360Argentina 361Xerox 361Goodyear 361Marconi 361

Contents x x i

Modified restructuring definition 362Modified Modified Restructuring 363

Restructuring practices 364

Chapter 20: Documentation for credit derivatives 365

Overview of derivatives documentation 365Legal impact of master agreements 366Key features of ISDA Master Agreement 366

Conditions precedent 367Netting 367Grossing up for withholding taxes 367Representations and warranties of both the parties 367Mutual covenants on compliances 368Events of default 368

Failure to pay 368Breach of agreement 368Credit support default 368Misrepresentation 368Default under specified transactions and cross default 368Bankruptcy 368Merger without assumption ' • 369

Termination events 369Illegality 369Tax event and tax event upon merger 369Credit event upon merger 369

Consequences of events of default 369Consequences of termination events 369Early termination 370Early termination payments 370Choice of jurisdiction 370

ISDA documentation for credit derivatives 371Confirmation 371Stand-alone confirmation 371

Opening paragraphs of the Confirmation 371General terms of the Confirmation 372Financial terms 373Notice requirements 373Credit events 374Obligations and obligation characteristics 374Settlement terms 375

Master Confirmation format 378Physical settlement matrix 378

Documents in case of specific credit derivatives 378Novation protocol 378Credit support agreement 379

x x i i Contents

Chapter 21: Taxation of credit derivatives 381

The tax basis of credit derivatives 381Nature of credit derivatives from tax viewpoint 382

Guarantee 382Insurance 382

y

Notional principal contracts 383Option contracts 383

Key issues in taxation of CDSs 383Taxation of the protection buyer 384

Integration with the reference obligation 384Option contract treatment 384Notional principal contract 385

Meaning of notional principal contracts 385Are credit derivatives notional principal contracts? 386Hedge tax rules applicable to notional principal contracts 386No hedge tax accounting for NPCs 386

TROR swaps 387Is it a case of constructive transfer of the asset? 387

Taxation of CLNs 388Taxation of the protection seller 388Mark-to-market rules 388

Book/tax conformity and safe harbor rules 389Tax treatment in other countries 390Taxation of derivative transactions in UK 390Taxation of CLNs 391Tax treatment of closeout settlement 391

Chapter 22: Accounting for credit derivatives 393

Whether derivatives accounting standards applicable? 393The meaning of a derivative 393Physical settlement deals 394CDSs and financial guarantees 394Total rate of return swap 397Credit-linked note 398

Basics of derivative accounting rules 398Basics of accounting for financial instruments 398Basics of hedge accounting 399

Why and when hedge accounting? 400Impact of hedge accounting 400Conditions for hedge accounting 400Fair value hedge accounting 401Cashflow hedge accounting 401

Accounting for CDSs 402If the CDS is a financial guarantee contract or credit insurance 402If the CDS is not merely a financial guarantee contract 402

Accounting in the books of the protection buyerNo hedge accountingHedge AccountingFair value hedgeCashflow hedgeExamples of CDS accounting in the books of a protection buyer

Accounting in the books of the protection sellerExamples

Accounting for TROR swapBooks of the protection buyer

ExampleBooks of the protection seller

Accounting for a CLNSeparation of embedded derivativeBooks of the protection buyerBooks of the protection seller

ExampleValuation of credit derivatives

Contents xxiii

403403403403404404406406407407408408408408409409410410

Chapter 23: Regulatory capital and other regulationson credit derivatives 413

Evolution of regulations 413US supervisory guidance of 1996 414

Guarantee-like treatment 414Examiner-determined treatment for the protection buyer 415Dealing with structured credit risk transfers:

Guidelines of 1999 415The FSA UK's guidelines of 1998 416

Basel II and credit derivatives 416Basic approach of Basel II 416Credit risk, market risk and operational risk 417Three approaches to risk assessment 417Basic approach on credit derivatives: Credit risk mitigation 419General conditions for capital relief in case of credit derivatives

and guarantees 419Operational requirements for credit derivatives 420General rules for capital relief 420Computation of the risk weights 421

Substitution approach 421Tranched cover 421Maturity mismatches 421

Risk weights in case of the protection seller 422Basket default swaps 422

Treatment of first-to-default protection 422Treatment in case of second-to-default protection 422

x x i v Contents

Treatment in case of IRB approaches 422Trading book treatment 423Second pillar: Capital charge for residual risk 423

Chapter 24: Operational issues 425

Credit derivatives procedures 425Master Agreements 427How trade is done 428

Confirmations 428Trade information warehouse 428Short form and long form confirmation 429

Confirmation options: electronic matching,centralized counterparty 430Outsourcing of backroom operations 430Centralized clearing 430Electronic trade matching services 430

Netting of payments and centralized clearing services 431Assignments and novations 431The operational risk issue 432

Growing number of trades 432Trade capture errors and rebooking of trades ^— 432The problem of unconfirmed trades 433

Regulatory intervention on unconfirmed trades 433

Chapter 25: Credit derivatives terminology 435

Index 463