Credit's quiet revolution

Czekalowski

Participants

Peter Lee, Euromoney  Let's start by asking why investors – particularly those in Europe who are newer to structured credit –  should consider investing in this asset class?

Paul Czekalowski, UBS  In a word optimization. Credit structuring means liquefying credit – identifying sources of credit risk and then transforming that risk's form or characteristics. This forces you to ask more broadly: what is credit? A promise to pay? What kind of assets or contracts involve a promise to pay? Defined like that, "credit" can be insurance contracts, receivables, secondary insurance, reinsurance; it can be all sorts of counterparty risks and contract risks. Obviously only a small proportion of those are currently tradable, so the structured credit market uses a range of tools and techniques for juggling that risk around, rating it and distributing it in formats tailored to a variety of investor bases. Until recently, this type of optimization primarily meant slicing up credit risk and repackaging it within a collateralized debt obligation (CDO); but my group is now just as concerned with other forms of optimization – tax and accounting, for example.

Antoine Chausson, BNP Paribas  Optimization and also flexibility. Structured credit is issuer and counterparty risk management delivered in a flexible format – whether embedded in a bond, a loan, a trade receivable or in an unfunded form – driven by the development of credit risk management using credit derivatives. Maybe an investor in one jurisdiction wants counterparty risk packaged as pref shares; another may prefer a debt security or Schuldscheine and so on.

David Peacock, Cheyne Capital  As an investor our objective is to exercise our credit view, to defend portfolio quality, and to be able to trade to generate returns. Structured credit for us is an efficient means of creating and financing the sort of leverage and risk/return profile that investors need. The danger is to focus too much on the structural issues and ignore the ultimate aim: managing the underlying credit risk.

AC, BNP Paribas  That's a fair point but in general still the value of structured credit, both to hedge funds who can look at just the economic returns and to the broader real money investor base, which operates under complex regulatory constraints, is that it delivers customized credit portfolio structures that create the exposures they want in the format they need.

Chausson: the rapid growth of the credit default swap market is bringing new issuers to the debt markets and allowing dealers to create diversified portfolios customized to investors' requirements

PL, Euromoney  But are investors getting value for money? Structured often just seems to mean complex.

PC, UBS  Well, I know it sounds like a cliché but it does mean something significant: the market is now much more about delivering certain risk/return profiles than it is about delivering a product. Five years ago if you were, say, a credit derivatives' structurer, you could create a decent business out of just that one product. Now, because all the other structured finance areas are starting to use these tools, you've got to be able to say, "Well this structure makes more sense for you than a cash CDO, because of x y and z."

Your clients are very sophisticated about their objectives and you have to be able to explain your solution in a cross-product context. It's not enough just to know about your products any more; you have to have a much deeper understanding of the broad range of tools that your client could be using or seeing from other markets. And that is what is driving the convergence of delivery mechanisms from the cash and derivatives sides of the market. So for example, a lot of cash CDOs use synthetic techniques for efficient financing: also, if the basis between cash and synthetic looks attractive, then CDOs can arbitrage this on the asset side.

Brett Tejpaul, Barclays Capital  And one thing that has spurred the development and acceptance of structured credit is that the ability to customize has been increasingly put in investors' hands as opposed to bankers'. So, five to seven years ago, when structured credit was a new-ish asset class with a limited toolkit, product creation was done at the banker level and then pushed out the door. Now there is a menu of options that investors can use to customize products for specific circumstances. This means investors are becoming increasingly sophisticated in constructing tailor-made products resulting in pull versus push product creation.

AC, BNP Paribas  I agree. Customization has been crucial. Two years ago the single-tranche CDO [STCDO] market was basically static portfolios. Increased volatility in corporate ratings led to the introduction of self-managed and third-party managed single-tranche transactions. These were designed to allow investors to express changing credit views throughout the life of the portfolio using multiple substitutions. This boosted the attraction of private transactions where liquidity is traditionally limited as it gave investors the ability to keep their investment strategy current with the product.

PL, Euromoney  As well as customization, investors need to be able to hedge, they need liquidity and they need access to a wide range of underlying credits. Can the market deliver these requirements?

AC, BNP Paribas  Absolutely. Clearly a key driver has been the development of the credit default swap (CDS) as one of the crucial building blocks in a structured transaction. The growth in CDS liquidity has provided dealers with the opportunity to create – and also risk-manage on a delta-hedged basis – the exact portfolio tranches specified by investors. This has set the stage for creating customized, synthetic, structured credit as a new asset class.