Default and total-return swaps transfer the full economic risk of an underlying credit or basket from one counterparty to another. This frees economic and regulatory capital at the same time. However, for banks that wish simply to arbitrage between the market’s and the regulators’ views of capital adequacy, collateralized loan obligations (CLOs) and repackaged credit-linked notes are the answer. The crisis in Japan has already prompted issuance in the straight CLO markets and many more huge deals are predicted as Japanese banks once again struggle with capital adequacy.
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