| Stephen Stonberg | ||||||
Credit derivatives lie at the heart of the structured credit market and nearly all credit derivatives are based on credit-default swaps.
These instruments are often poorly understood by outsiders. But a plain-vanilla single-name credit-default swap is a very straightforward contract. The complications arise when the swaps are embedded in larger financial structures or are linked to more than one name.
A credit-default swap works like an insurance policy. A protection buyer, most often a bank that owns a loan or bond it wants to hedge, pays an annual premium to a protection seller. In return, the protection seller commits itself to making a one-off payment if the reference credit defaults on any of its debt. The premium is calculated as a percentage of the underlying asset.
Last month, for example, it cost around 75 basis points to buy protection on Ford in a five-year contract – the most liquid maturity. In a standard $10 million contract, the protection buyer would pay $75,000 a year to the protection seller for the next five years. If Ford defaults before May 2006, the protection buyer will deliver $10 million-worth of Ford bonds (at face value) to the protection seller.
The protection provider will buy the bonds at par, giving the protection buyer $10 million, and will then try to recover some of its loss by selling the defaulted bonds for their residual value.
The market is still only liquid for a small number of names. Large bond issuers such as Ford and Deutsche Telekom are widely traded. There is also growing liquidity in high-grade European names that rarely issue bonds. “There is not as much cash issuance in Europe as in the US,” says Sanjeev Gupta at Credit Suisse First Boston. “For many investment-grade names in particular, the credit derivatives market can offer much better liquidity than the underlying cash market. We trade around $250 million in volume every day in European names, many of which have little tradable debt outstanding.”
Single-name credit-default swap trading remains a large and growing part of the market. But what has turbocharged the growth of credit derivatives in the past couple of years is their use in portfolio swaps, synthetic CDOs and other structured products. As more and more institutions commit resources to this business, participants are convinced it is reaching a point of critical mass.
“Today the credit derivatives market is only at the stage the interest-rate derivatives market was in 1986,” believes Stephen Stonberg, head of Deutsche Bank’s structured products group based in London. “Since then, volumes in that market have increased manifold, and the same will happen in the credit derivatives market.”
But portfolio trades are not the only kind of structured credit derivative trade. First-to-default basket trades, in which protection sellers pay up for a small basket of credits as soon as one of them defaults, have been around for just as long as tranched portfolio transactions. Although they have been eclipsed by the rise of CDO-type structures, these baskets remain a common way for credit derivative investors to take leveraged credit exposure. “First-to-default baskets have been around for several years,” says Charles Kermisch, director in structured credit at CSFB in London. “But over the past year and a half they have become very popular as clients seek additional leverage.”
Baskets and other structures can also be highly customized. This is the world of the exotic credit derivative, where quant-savvy traders seek out obscure arbitrages and where credit derivatives are combined with other structured products to create highly tailored exposures. “Credit is permeating the whole range of financial products,” says Mike Connor, head of structured credit derivatives trading at UBS Warburg. “We are structuring a wide variety of instruments with embedded credit derivatives that allow different types of investors to gain additional yield.”
Connor’s exotics desk at UBS Warburg is part of the bank’s derivatives and FX division rather than its credit and fixed-income business. At other firms, a small group of exotics traders sit alongside the flow traders. One characteristic of this market is that it is relatively underdeveloped in the US. “Exotic credit derivatives are a bigger market in Europe than in the US,” says Connor. “Many US investors remain nervous of highly structured products after all the scares over structured notes in the 1990s. European investors have a smaller range of cash products available to them and are more willing to look at customized credit products.”
But as the market expands in all directions, one cloud darkens the sunny horizon for credit derivatives. In recent months rating agencies and regulators have raised doubts about the reliability of the market. They worry that some contracts will turn out to be less than watertight when credits default in large numbers, something that is starting to happen increasingly.
A fierce dispute between protection buyers and sellers has raised alarm bells. Protection sellers complain that they are being asked to pay out for events that fall short of outright default. The use of restructuring as a standard default event has proved a particular bone of contention.
But credit derivative practitioners are united in their belief that the market will emerge stronger from the current downturn of the credit cycle. They also think it is beneficial for wrinkles to be ironed out of the documentation while the market is still young. “A few arguments over documentation are not necessarily a bad thing for the market,” says Jeremy Vice, head of Dresdner Kleinwort Wasserstein’s portfolio credit structuring group in London. “It means the robustness of these structures has been tested.”
