by Michael Peterson
When credit spreads narrowed sharply in early May, investors and issuers breathed a sigh of relief. But the rise in corporate bond prices was not driven by a rally in equities or an interest rate cut. A new and powerful force was at work in the credit markets. “That tightening of credit spreads was driven almost entirely by the credit derivatives market,” says a senior credit derivatives trader. “Banks have been buying massive amounts of credit to cover short positions.”
In the past, it was difficult to take a big short position in the credit markets. That has now changed with the arrival of bulk credit derivative trades known as portfolio swaps or synthetic CDOs (collateralized debt obligations). By combining credit derivative tools with the tranching techniques of securitization, banks can sell large pools of credit without the need to transfer the assets physically.
These trades were developed originally to shed credit risk from bank loan books. But they also allow firms to place large directional bets. In many recent cases, banks have sold portfolios without owning the underlying credits. They were betting they could buy the bonds at a lower price later.
“The big trade of the last few months has been a rating agency arbitrage,” confirms the trader. “The market was taking a more negative view of credits such as KPN and Lucent than the rating agencies.” That meant banks could assemble synthetic portfolios of high-yielding assets, buy protection on them cheaply and pocket a comfortable spread. “Of course, these credits were trading wide for a reason,” says the trader. “When the rating agencies caught up with the market and downgraded them, the investors who bought the junior tranches of these deals got hit badly.” And the banks in turn made a killing.
Taking a big one-way punt is just one way of using the credit market’s favourite new tool. Portfolio credit derivatives can also provide leveraged credit exposure for long-term investors and bring disparate instruments together into liquid pools. Some bankers play down the importance of short trading using these structures, but all agree that portfolio credit derivatives have become a significant part of the world of credit.
“Portfolio trades are driving the credit derivatives market,” says Glenn Barnes, global co-head of credit derivatives at Merrill Lynch in London. “Investors need the credit product, and these structures allow them to take exposure to a diversified pool of assets.”
Credit derivatives and securitization are proving an explosive mix. The pooling and tranching techniques developed in the asset-backed market have given a huge boost to the volume of credit derivatives trading. No longer is protection simply bought and sold on individual names. “The credit derivatives market is much broader than just single-name credit-default swaps,” says Robert Heathcote, European head of credit derivatives at Goldman Sachs in London. “It comprises a whole range of products that bring together institutions looking to manage credit risk with those looking to take it on.
Increasingly, risk is tending to get distributed in tranched form, thereby providing a mechanism to reach a wider range of investors seeking a variety of credit risk profiles.”
At the same time, credit derivatives have made it possible to securitize portfolios that could never have been packaged into traditional asset-backed bonds. “Cash and synthetics are coming together on both the investment side and the liabilities side,” says Charles Kermish, director in structured credit at Credit Suisse First Boston (CSFB) in London. “On the one side, investors have to look at both cash and synthetic instruments to achieve their required level of risk and reward. On the other side, banks are laying off increasingly complex portfolios involving multiple jurisdictions and varied documentation using credit derivatives.”
The range of assets that can be pooled and laid off using these structures is growing all the time. The market began with investment-grade corporate loans, but in the past year or so it has grown to include high-grade corporate bonds, junk bonds, commercial mortgages, residential mortgages, mezzanine loans, private equity and aircraft loans.
“Credit derivatives are a powerful tool for transferring risk in a way not feasible before,” says Stephen Stonberg, head of Deutsche Bank’s structured products group in London. “We are starting to see them used in a number of different applications and to transfer risk on new asset classes. But we are only scratching the surface of what is possible.”
Hot property
The fertile terrain where credit derivatives and securitization meet is often referred to as structured credit. A useful definition might include any product that relies in some way on credit derivatives to transfer risk. This market could be said to include six broad categories of activity: plain-vanilla credit derivatives, portfolio credit derivatives, exotic or customized credit derivatives such as first-to-default baskets, synthetic CDOs, repackaging and cash CDOs enhanced with credit derivatives.
What all of these areas have in common is that they need an understanding of how credit derivatives work. That has propelled the pioneering credit derivative traders of the mid 1990s into new star roles.
Hermann Watzinger is a case in point. He began his career in the early days of the credit derivatives market, trading credit-default swaps and other instruments for Citibank. In those days the market was dominated by a small number of big commercial banks.
Citibank itself was the biggest customer for Watzinger’s team. The bank bought credit protection on billions of dollars of its own assets every year in the latter part of the 1990s.
As the markets for credit derivatives and securitization began to merge, Watzinger’s skills and knowledge of credit derivatives documentation came into their own. In early 2000 he joined Merrill Lynch and now co-heads a team that structures synthetic CDOs and portfolio credit derivatives.
“In the early days of the market, an understanding of the documentation and regulatory issues was the most important quality for a credit derivatives professional,” says Watzinger. “In those days it made sense to have a standalone credit derivatives team. But as that knowledge has become commoditized what matters now is to understand the potential applications of credit derivatives in different areas of the business and to integrate credit derivatives within the rest of the business.”
Veterans such as Watzinger and his co-head Michael Donahue are hot property. But there is fierce competition even for rank-and-file credit structurers. Unlike colleagues in corporate finance or equity capital markets, these bankers have little to fear from the current round of bank cost cutting.
Stephen Shanahan, a recruitment consultant with Anderson’s Financial Recruitment in London, says that there is heavy demand for structured credit professionals. “It is not easy to find people with a combination of market knowledge and quantitative skills on the one hand and structured finance, tax and legal expertise on the other,” he says. “Those people are very much in demand at the moment.”
Shanahan reckons that a credit structurer with a couple of years of experience could command a salary in excess of $300,000. But the big names in the market can name their price. “These are not poor people,” he comments.
Big names on the move
Quite a few of those big names have been on the move recently. Last September JP Morgan hired Jonathan Laredo from Rabobank to head its international structured finance business, a division that includes both conventional and synthetic securitization.
Merrill Lynch, Dresdner Kleinwort Wasserstein and Commerzbank have all hired structured credit heads in the past year or so. Olivier Moreau became Commerzbank’s global head of credit derivatives in April 2000, joining from BNP Paribas. His colleague there, Matteo Mazzocchi, jumped ship a couple of months later, becoming head of credit derivatives and securitization at the then Dresdner Kleinwort Benson.
Glenn Barnes moved from Dresdner to Merrill in October 2000 and now heads the international structured credit group which includes the division run by Watzinger and Donahue. Only months after Watzinger joined Merrill with several of his colleagues, Donahue’s team arrived from Deutsche Bank.
More recently, HSBC has hired Bank of America’s structured credit products head Rick Ziwot to become its head of credit derivatives. Last month the bank announced that Ziwot would join its New York operation along with two of his colleagues.
Some of the most sought-after credit structurers and traders are those who work for the two biggest names in the credit derivatives business, JP Morgan and Deutsche Bank. In the wake of JP Morgan’s merger with Chase it has suffered a string of defections.
At the end of last year two structured credit traders, Filippo Lanza and Georges Assi, left to join Lehman Brothers in London. Then senior credit structurer Paul Czekalowski defected to Deutsche Bank. Lehman also lured credit structurers Paul Varotsis and Frank Iacono from the Chase side of the merger, while David Schwartz, a senior structured credit salesman for Lehman in New York, went to Dresdner Kleinwort Wasserstein.
Rivals like to suggest that JP Morgan’s dominance of the market is coming to an end. But these defections are probably no more than could be expected following a large merger. Certainly, the bank’s heavy hitters in structured credit, notably structured finance head Bill Demchak, remain firmly in place and have secured leading positions in the newly enlarged firm. JP Morgan undoubtedly remains one of the biggest players in structured credit. It claims 100 people worldwide working on CDOs alone and maintains one of the largest credit derivatives trading desks.
Deutsche, for its part, claims some 100 credit derivatives traders worldwide, with a further 96 professionals involved in credit structuring. Like JP Morgan, its bankers are routinely poached by newcomers to the market. Most recently, Dresdner Kleinwort Wasserstein recruited structurer Alarik van Doorn, Deutsche’s specialist in the vital link between capital markets and the insurance industry.
It is no secret why most of the big players in credit derivatives and structured credit are commercial banks rather than investment banks. Both JP Morgan and Deutsche Bank have transferred billions of dollars-worth of assets from their commercial loan books using structured credit tools.
This ready supply of deals has given them a head start in winning third-party business. “It is very valuable to be able to tell clients that we have executed these transactions using our own balance sheet,” says Deutsche’s Stonberg. “It means we have already gone through the process of structuring the deal and explaining how it works to rating agencies and investors.”
Other commercial or universal banks, such as Credit Suisse, UBS and Bank of America, have begun to emulate JP Morgan and Deutsche, doling out chunks of their balance sheets into the market and hiring credit structurers and traders. CSFB, which has an established credit derivatives trading team, has recently built up a sizeable structuring business. UBS Warburg has grown a large plain-vanilla credit derivatives trading desk from scratch in the past two years and has also stepped up its CDO business.
Capital efficiency
Another reason commercial banks have been so keen to move into credit derivatives is that it gives them new ways of serving their traditional clients without consuming so much capital. “Take three traditional commercial banking type products: a guarantee, a liquidity facility and a secured loan,” says Forbes Elworthy, co-head of structured credit and repackaging at Dresdner Kleinwort Wasserstein in London. “In each case we can offer a synthetic solution which requires less capital for us and can therefore be offered at better pricing for the client.”
But in the past year or so, investment banks such as Merrill Lynch, Goldman Sachs and Lehman Brothers have been striving to close the gap on commercial banking rivals. Goldman signalled its intention to build up its credit derivatives business in 1999 when it hired one of the market’s biggest names, Ron Tanemura, from Deutsche Bank. In the past year it has increased its headcount by 55 to nearly 90 in global credit derivatives.
Merrill Lynch, already a leading market maker in credit derivatives, has been working hard in the past year to add to its credit structuring capabilities. In addition to hiring Watzinger, Donahue and Barnes, it recently added CBO specialist Vincent Dahinden from CSFB. Barnes’s structuring unit now comprises some 34 bankers in addition to the separate structuring division in New York and its big trading team.
The investment bankers tend to reject the suggestion that credit derivatives requires a hefty allocation of capital. “We’re a client-focused business – sourcing, warehousing and then distributing credit risk,” says Heathcote at Goldman Sachs. “We turn over our balance sheet pretty rapidly. Where we add value is in the risk transformation process and running derivative basis risks. Neither of these are balance sheet intensive.”
They also say that a captive supply of marketable synthetic assets provides no overwhelming advantage in this business. “Our strengths lie in distributing risk,” says Merrill Lynch’s Barnes. “As such, our balance sheet is not as important as our distribution capacity.”
And the investment banks have succeeded in capturing a respectable chunk of the market. Lehman and Merrill, for example, arranged some of last year’s biggest public synthetic CDOs. Lehman Brothers has structured balance sheet deals for three French institutions: Natexis, BNP Paribas and Crédit Lyonnais, and Merrill has a strong franchise among mid-size German banks.
Bulge-bracket investment banks are not the only aspirants. Smaller European banks such as Banca Commerciale Italiana and CDC Ixis Capital Markets have recently hired experienced professionals in London and New York.
Two German banks, Dresdner Kleinwort Wasserstein and Commerzbank, have been among the most aggressive hirers of structured credit bankers. Dresdner has increased its global headcount in credit derivatives to around 50. In the past year its new credit derivatives and securitization head, Matteo Mazzocchi, has hired Elworthy, formerly of Merrill Lynch, and Greg Lieb from BNP Paribas to run a new structured credit unit.
Commerzbank’s Moreau has dramatically increased the bank’s presence in structured credit this year. Mike Staveley was recruited from CSFB in late 2000 to run an integrated cash and derivatives credit trading desk. Two other credit traders with a derivatives background, Brett Golledge and Kristian Sharp, joined Staveley in October. This year’s recruits include New York head of structured credit trading Peter Tchir, who joined from Deutsche Bank, Walter Womersley from Dresdner, Mario von Kelterborn from Deutsche and, most recently, Lehman Brothers repackaging specialist Judith Tan.
Turf wars
As well as hiring credit structurers at a frenetic pace in the past year, firms have also been putting them through a bewildering series of organizational changes. There are a couple of marked trends in all this restructuring.
One is the fashion for bringing together traders in different credit instruments. “If you have different traders selling bonds, repackaged notes and asset swaps on the same credit, you have three traders selling essentially the same product,” says Sanjeev Gupta, managing director in CSFB’s credit derivatives and asset-backed conduit financing groups in London. “Our approach is to have one desk for pure cash trades and one we call the credit derivatives desk that trades everything else. And the two are joined at the hip.”
All firms pay lip service to the concept of integrated credit trading. But traders are a notoriously independent-minded bunch. One firm recently announced the creation of a single credit trading group. But a banker at the firm admits that in practice the group consists so far of only one individual – the head of the unit. Deutsche Bank, Merrill Lynch and Commerzbank all claim to have integrated credit derivatives and non-government bond trading in the past year or so.
Getting cash and derivatives traders to work together smoothly may be a challenge, but a bigger source of tension in many firms is the uneasy relationship between credit derivative structurers and securitization bankers.
These markets have converged so fast that firms have struggled to update organizational charts in time. “We found that our asset-backed and credit derivatives people were bumping heads more and more often,” says a structured credit head. “They were pitching for many of the same transactions and clients were getting confused.” This banker’s firm, like several others, has brought both sorts of structurer into a single profit centre.
Every structured credit banker claims that at other firms there are still regular turf wars over deals. “You will have the asset-backed people saying it’s a securitization deal while the credit derivatives team insists it’s a structured credit derivative,” says one banker. “Of course, what they are arguing about is whose P&L the profit should be booked on.”
The community still divides clearly into bankers with a derivatives background and those who come from cash securitization. And different firms, in turn, tend to come to the business from one direction or the other. “The way we approach this business differently from other houses is that we are managed by people with a derivatives background,” says one credit structurer. “Where cash guys are in charge, they haven’t got a clue.”
Of the major players, Deutsche still has the clearest demarcation between synthetic securitization and portfolio credit derivatives. Its big balance sheet CDOs, such as the Globe, Cast and Blue Stripe series of deals, are run by the global asset securitization business.
Credit derivatives are a separate unit within Deutsche’s global markets division. Within global credit derivatives, a parallel structured products group runs more customized portfolio credit derivatives and synthetic CDOs.
JP Morgan can boast more success in integrating these two converging businesses than most. Securitization and structured credit derivatives are run together as part of the firm’s global structured finance division. However, unlike Deutsche Bank, JP Morgan is fragmented geographically. It has two separate credit structuring divisions, one based in New York and another in London.
Goldman Sachs operates a single global division, known as credit derivatives, which includes cash and synthetic CDOs, credit derivatives trading, structured credit products and other structured credit activities such as repackaging.
In other firms, organizational structures are in flux. From the beginning of this year, Merrill Lynch has brought together all international securitization and credit derivatives structuring within a single group headed by Barnes in London. But the US domestic business retains separate securitization and credit derivatives business groups. CSFB is another firm in the process of making changes. In London, Scott Ulm oversees all credit derivatives and securitization, but three business units – securitization, CDOs and credit derivatives – also continue to report to separate global heads.
Ever-expanding synthetics
Of the different businesses that together make up the world of structured credit, the most visible is the synthetic CDO market. This was born in 1997 at around the time big commercial banks such as NatWest and UBS began to securitize their loan portfolios.
The term CDO (or CLO or CBO – collateralized loan or bond obligations) was borrowed from the domestic US market where for years asset managers had been putting together portfolios of high-yield bonds and securitizing them in what were dubbed arbitrage CDOs. But the big commercial banks began to issue CDOs not as a market arbitrage but as a regulatory arbitrage. The current Basle capital regime penalizes them for holding high-grade credits and rewards them for keeping the dross. So the object of the exercise is to shed capital-intensive blue-chip loans from their balance sheets without the need to snub these clients.
Banks quickly realized that they did not need to sell their loans physically in order to gain regulatory capital relief. JP Morgan’s Bistro structure became the template for a new type of securitization. It enabled banks to reduce their capital by hedging their loan books using credit derivatives. By 2000, many large banks on both sides of the Atlantic had jumped on the CDO bandwagon.
Synthetics meet securitization
Most bank-balance-sheet CDOs are now being done synthetically. According to research company Creditflux, $83 billion of credit risk was sold through public synthetic deals last year. Only around 25% of that was transformed into bonds, with the remainder transferred through unfunded credit-default swaps or retained by the originating bank.
In the past two years, the penny has dropped that this technique is a suitable alternative to just about any type of securitization. An institution that wants to shed risk from its balance sheet in order to originate new assets can do so using credit derivatives.
The first wave of corporate loan synthetics were followed by a wave of German residential mortgage deals. More recently there has been a flurry of deals involving loans to small and mid-size companies and a handful of deals backed by portfolios of asset-backed securities. “There is a merger in the market between securitization and credit derivatives,” says Ulm, managing director and head of European structuring at CSFB in London. “There are few categories of securitization where a discussion of credit derivative applications is not appropriate.”
And no longer are these deals simply motivated by a desire to outsmart the regulator. Some banks are actively building portfolios with a mind to securitizing them. They buy high-yielding, often illiquid assets in the secondary market, collect them into diversified pools and sell or hedge them by issuing rated asset-backed bonds or by buying credit default swap protection.
Peter Tchir, head of structured credit trading at Commerzbank in New York, notes that synthetic transactions tend no longer to consist simply of static pools of credit as they did in the early days. “We see an increasing trend towards more active management of these portfolios,” he says. “We are starting to see professional managers appointed to run synthetic portfolios just as they are on traditional cash CDOs.” In effect, some banks are putting together and managing what look like US-style arbitrage CDOs.
“People talk about arbitrage trades and balance sheet trades, but I don’t see why they should be perceived as separate transactions in all circumstances,” says Richard Williams, head of credit derivatives at Abbey National Financial Products in London. “The CDO gives you a tool that can be used either to risk-manage your balance sheet or to manage the pattern of your asset growth.”
When Abbey National issued its own synthetic CDOs in early 2001, it did not fit into the pattern of a commercial bank seeking to reduce its regulatory capital. Abbey National Treasury Services is best known as a savvy investor in asset-backed securities and it is also a large seller of single-name protection in the credit default swaps market.
Its Marylebone Road CBO 2 transaction, launched in April, leaves Abbey National with a small, leveraged exposure to the underlying $1.5 billion portfolio of assets. This is because the bank retained a portion of the first-loss tranche of exposure. But by buying protection on the bulk of the portfolio, the bank caps its exposure to the pool of corporate bonds and credit default swaps.
This structure may provide little or no regulatory capital relief to Abbey National, since any CDO equity exposure retained on a bank’s balance sheet attracts a one-for-one capital charge under current rules. But it has freed up capacity to acquire assets in terms of its own economic capital calculations.
“A proportion of the names in the second Marylebone transaction are credits that we previously had on our balance sheet,” says Williams. “But we didn’t necessarily use the on-balance sheet positions for all of the transaction. For a large part of the transaction, we went into the market and bought bonds or wrote default protection in order to create a portfolio with the characteristics we required.”
But for Williams the distinctions between arbitrage and balance-sheet CDOs are less important than the commitment and quality of the asset manager. “The manager of a CDO, whether it is regarded as an arbitrage or a balance-sheet transaction, has to produce stable returns that will ensure the debt components of the CDO carry a stable rating,” he says. “You also have to convince the equity participants that the transaction will produce the returns they require.”
Risk-management hiatus
While some banks are issuing CDOs to shrink their balance sheets – at least in regulatory terms – and others are expanding their balance sheets using these trades, few seem to be using CDOs simply as an everyday risk-management tool. “The trade that was supposed to happen in Europe was that banks would rebalance their portfolios to achieve better diversity,” says Ulm at CSFB. “That hasn’t happened yet to any significant degree. But as we move into a model-based world, we would expect to see a great deal more of that kind of activity.”
But the flow of balance sheet deals continues, as banks in more and more countries grasp their benefits. “Many of the initial loan portfolios transferred were from German, French and UK banks,” says Watzinger at Merrill Lynch. “Increasingly we are seeing Italian, Spanish and Portuguese banks becoming active as protection buyers. The next wave may be the Nordic region, as banks there shift focus from consolidation to capital efficiency.”
Taking flight
Meanwhile, the synthetic structure is being applied to an ever greater variety of assets. The latest innovation is a CDO of aircraft loans. Arrangers Merrill Lynch and Banca Commerciale Italiana (BCI) launched Leonardo Synthetic in May to hedge the credit risk on a $1 billion pool of aircraft loans. “Transferring the risk on aircraft loans synthetically avoids many of the complications of transferring ownership of these assets,” explains Merrill’s Donahue. “In addition, the bank that originated the loans continues to own and service the portfolio.”
The only difference between this structure and most other recent synthetics is that Merrill Lynch takes an intermediary role between the originator of the assets, BCI, and the market. Merrill hedges the credit exposure it has taken off BCI by buying three separate credit default swaps. The senior and junior swaps are contracted directly with credit derivative counterparties. The mezzanine swap is sold by a special purpose vehicle that then issues bonds and invests the proceeds in low-risk collateral. The income from the credit pool is used to pay the default swap premiums and the bond coupons.
If there are losses on the portfolio during the life of the deal, the CDO investors, rather than BCI, will be hit. If losses reach $65 million, the junior counterparty will stump up the cash under the terms of the credit-default swap and the swap will be cancelled. If losses exceed that amount, investors in the $155 million-worth of euro-denominated bonds will lose their principal and future interest payments and the collateral will be used to reimburse the losses. If some catastrophe wipes out more than $220 million of the pool, the senior credit-default swap counterparty will be called on to pay up.
For the end investor, this greater diversity of assets is a godsend. “We are starting to see a rotation from purely corporate assets into more diverse types of assets,” says Patrick Gonzalez, managing director at XL Capital Assurance, an insurance company that has sold credit-default swap protection on a number of CDOs. “European banks in particular are beginning to securitize residential mortgages, consumer loans and aircraft loans. This is a very welcome development since it allows us to diversify XL’s overall book.”
Smaller and lumpier
Although Leonardo Synthetic can be described as a synthetic CDO, it is close in many respects to another category of structured credit product. Portfolio credit derivatives are not very different in structure from synthetics, but they tend to be based on less diverse – lumpier, in the jargon – portfolios than synthetic CDOs.
“In addition to the large, granular portfolios that for several years have been sold through synthetic structures, we are now able to do deals using smaller, more highly concentrated portfolios,” says Stonberg at Deutsche Bank. “These deals tend to be driven by the needs of the investor to gain exposure to a particular type of credit risk.”
Another characteristic of these deals is that they tend to be done privately. In most cases there are no public bonds issued and no need for a public rating. In some cases, however, investors will demand that the issuer gets a credit rating for the credit default swaps they are being asked to write.
Because they do not generally involve rating agencies or require special purpose vehicles, these deals are quicker and cheaper to put together than public market synthetics. So they cover a wide range. Several recent deals have been based on portfolios of billions of dollars, others are for as little as $100 million.
Both JP Morgan and Deutsche Bank have issued large volumes of these portfolio swaps. JP Morgan’s deals tend to be called Bistro, the same brand name it uses for balance sheet transactions. The bank claims to have transferred $46 billion of credit risk using the Bistro structure in 2000.
Deutsche, by contrast, calls the swaps-only trades put together by the bank’s structured credit division Repons (Return Enhanced Portfolio Notes). This is to distinguish them from the Cast, Globe, Blue Stripe and Haus deals arranged by the bank’s securitization team and which are based on various sections of Deutsche’s own loan book.
Several of the swaps-only version of JP Morgan’s Bistros have suffered significant credit deterioration recently. Between November and February, Moody’s downgraded one or more junior tranches of six different Bistro trades. Since many Bistro transactions are unrated, it seems likely that other trades have suffered the same fate and that many credit protection sellers have suffered losses.
The structured credit market is not just about transferring risk to credit derivative investors. Increasingly, credit derivatives are being used within cash CBOs to make them work more effectively.
Typically, such a portfolio may consist mainly of bonds and other physical securities, but will contain a small proportion of credit derivatives.
For several years, rating agencies have allowed asset managers to include a certain basket of credit-linked notes and other structured products in their high-yield CBOs. As the cash arbitrage CBO has moved to Europe in the past 12 months or so, credit derivative enhancement has become even more useful to these structures.
Two very similar cash CDO transactions launched this year illustrate the trend. Both Cabral No.1, arranged by Credit Suisse First Boston in February, and Tagus Global Bond Securitization No.2, a deal put together by Merrill Lynch and Deutsche Bank last month, consist of pools of credit originated by Portuguese banks. As a result, these portfolio are highly lumpy: in the case of Tagus, three credits account for a full 27% of the portfolio.
To make the pools more diverse, the arrangers sold credit-default swap protection to the vehicle on credits that are uncorrelated with the rest of the pool. “Increasingly we are seeing hybrid portfolios comprising a mixture of cash and synthetic credit,” says Kermish at CSFB. “In the Cabral transaction we arranged recently, for example, we used credit-default swaps to add diversity to a pool of Portuguese risk.”
Removing the packaging
The final component of the structured credit universe is the repackaging desk. A footnote to most bankers’ descriptions of their structured credit operations, it is in fact central to the business of slicing and dicing credit.
The repackagers are the bankers who specialize in documentation and setting up special purpose vehicles. Very often they simply transform one kind of cash asset into another, stripping out some unwanted element or converting a bond from one format into another. They are used to overcome legal or tax barriers or to tailor assets to the preferences of a certain group of investors.
In one common trade, repackaging desks will buy undated tier-one securities and issue dated bonds. They also buy convertible bonds and strip away the equity exposure. Another example involves buying bonds and repackaging them as Schuldscheine, the only type of debt instrument most German insurance companies will buy.
But repackaging desks also play a vital role in offloading the credit exposures accumulated by other parts of a credit derivatives operation. A popular method is transferring credit risk to retail and life insurance company investors as principal-protected securities.
New risk takers
Of course, only so much credit risk can be offloaded as low-risk bonds. The biggest end- risk takers in the structured credit market are those willing to take direct exposure to credit by writing credit-default swap contracts.
In the past two or three years, insurance companies have become some of the most important end users. They first became apparent as sellers of the most senior tranches of protection. With banks unwilling to put this low-risk exposure on their balance sheets because of its high capital charge, insurance companies were the natural holders. “Insurance and reinsurance companies often use their own economic models to allocate capital,” says Staveley at Commerzbank. “As a result, it can be efficient for them to hold various tranches of risk in synthetic form – such as supersenior and mezzanine – that many banks are penalized for holding.”
Since the late 1990s, insurance companies have become important investors in well-rated synthetic credit, and have become increasingly adventurous in moving down the credit curve.
As protection sellers, they fall into three broad categories. The most important are those specializing in credit, particularly monolines insurers such as MBIA and Ambac and monoline reinsurers such as Ace Guaranty Re.
Also known as the financial guaranty business, monoline insurance has traditionally centred on providing triple-A credit wraps for bond issues. In the past few years CDOs have grown to become a major part of the monolines’ business and a few insurance companies have recently entered the financial guaranty business attracted by the increasing diversity of risk it now offers.
One new entrant is monoline insurer XL Capital Assurance, a subsidiary of Bermuda-based XL Capital. It was set up after the group decided to move into the monoline business two years ago. “The CDO market is integral to our business strategy, says David Czerniecki, head of XL Capital Assurance’s structured finance group. “XL affiliates have been active across all sectors of the CDO market, both cash and synthetic transactions, both domestic and international and with a variety of underlying asset types.”
Czerniecki calculates that just over half the $12.5 billion notional par value insured the company and its affiliates have generated in the past two and a half years consisted of CDOs and similar transactions.
Monolines tend to sell protection only on highly rated tranches so as not to jeopardize their essential triple-A credit ratings. Most have a threshold of single-A or triple-B. “The spectrum of credit risk we take has been quite broad,” says Czerniecki. “It has ranged from as high as triple-A down to our house minimum of investment grade.”
Recently, mainstream insurers and reinsurers have begun to muscle in on the credit derivatives market. But these large, highly rated entities are proving less attractive as credit derivative counterparties than many had hoped. Many protection buyers worry that these multiline insurers, coming from a culture in which assessors can take years to agree on a pay-out, will be unwilling to pay up quickly if a credit event happens. A subsidiary of AIG caused concern recently when it failed to pay out on an insurance policy written in support of a film royalty securitization.
In response to these concerns, rating agency Standard&Poor’s last year unveiled a new scale of ratings for insurance companies. Its insurer financial enhancement ratings measure not an ability to pay but a commitment to the principles of the capital markets and, in particular, a willingness to pay up on the nose.
A third group of insurance participants are the small, less well-rated companies that are willing to take the riskiest exposures. Few of these specialists are willing to talk about their credit derivatives activities, but they are thought to include Australian insurer QBE and Alia, the former Rhine Re. One insurer that has publicised its involvement in portfolio credit risk transfer is Bermuda-based Centre Re. Last year, for example, it took the first loss position on a small portfolio of Bank of America’s loans.
The entrance of so much insurance capital into the market has tended to push credit-default swap prices down in the past 18 months, although pricing now seems to have stabilized. “We have seen a lot of new players come into this market from the insurance industry, with varying degrees of success, particularly in the last year,” says Pamela Snyder, managing director at XL Capital Assurance. “As a result, prices are now firming up considerably.”
One reason some insurance companies may be taking flight is that they have been dumped with the banking sector’s least savoury assets. “Insurance companies are always concerned about the quality of the assets they are being asked to take exposure to,” says Julian Roberts, director at insurance intermediary Aon Capital Markets in London. “And they are aware that the banks know more about these credits than they do. But they also know the banking industry has genuine reasons for offloading these risks, such as regulatory capital arbitrage.”
Caution on credits
Still, in an environment of declining credit quality, end investors need to be vigilant about which credits banks are choosing to put into their CDO pools. “We are cautious about taking exposure to credits that may be weaker than their credit rating implies,” says Czerniecki at XL Capital Assurance. “We do see some of the same names over and over again in different portfolios. Where this happens it doesn’t necessarily make a deal a non-starter. It just means there is a little more structural work that needs to be done.”
First-loss investors are so important to portfolio credit derivatives and synthetic CDOs that deals are often structured to suit their requirements. The future growth of the market depends to a large extent on the willingness of investors to take on the very riskiest exposures. But traditionally, insurance companies like to take mezzanine and senior risk not the most junior position. In almost any insurance policy, the insurer will insist that the policyholder takes a small first-loss exposure themselves.
If insurance companies are not the ideal buyers of first-loss risk, can alternative homes be found for this type of credit exposure?
Possibly. Some hedge funds have dabbled in this market, for example. And CDO equity has long been marketed in the US as an alternative investment alongside hedge funds and private equity.
Indeed, with its potential for huge losses and impressive gains, structured credit could yet become the perfect retail punt. It is not for nothing that the first-loss tranche of a structured credit pool is called equity. Perhaps in future, credit structurers will succeed in repackaging this exposure for the investor in the street. For a bruised dot com investor, that may seem like an attractive proposition.
