Leading equity derivatives players are pitching higher yields and name diversification to CDO investors. But deals need to be conservatively modelled and attractively priced.
Deal: Goya managed CDO of CDS and EDS
Structurer: SG Corporate & Investment Banking
Manager: Fortis Investments
Date announced: November 5 2004 SG CIB and Fortis Investments are developing new collateralized debt obligation technology through Goya, a CDO that references both credit and equity derivative swaps.
Banks have put EDS in structured credit deals before. In October, Standard & Poor’s rated Chrome, a €62.5 million deal arranged by CDC IXIS Capital Markets. Chrome references 30 second-to-default baskets, each containing three CDS and one EDS. But in Chrome, there were restrictions on how the EDS could be managed in and out of the reference portfolio. Goya is the first CDO where the EDS will be fully actively managed over the life of the deal.
As a less liquid product, EDS should provide a spread pick-up for CDO investors, as well as some name diversification. But as Euromoney reported in September this year, some investors see EDS as badly priced and unsuitable for CDOs.
On November 17, Fitch predicted more issuance of CDOs backed by EDS. Taking an extreme example, Fitch looked at the Dow Jones Industrial Average for the five years after the Wall Street crash of 1929. “It is easily conceivable that every EDS asset in a portfolio could experience an equity event were a similar crash to occur,” says Fitch’s report.
Having Fortis Investment choose and manage the referenced EDS should give investors comfort. Fortis is the first asset manager authorized to trade EDS by the French financial regulator, the Autorité des marchés financiers. Whether AMF authorization is a legal precondition of trading EDS is unclear. But it is a badge of Fortis’s expertise and the quality of its joint credit and equity research.
“In CDOs that reference EDS, you take a risk that is very outside the money on an event that is unlikely to happen, but it might happen,” says Bertrand Fitoussi, head of SG CIB’s structured credit group.
SG CIB and Fortis Investments have worked together before, for example on Monet, the first fully managed CDO squared deal.
EDS versus CDS
In any synthetic CDO, the modelling challenge is to estimate the maximum possible number of credit events in the portfolio, the loss recovery if that level is reached, and correlation within the portfolio. “At the highest level those three components don’t change,” says Richard Gambel of Fitch Ratings. Trigger prices on EDS are dropping, and sometimes approach zero. “The equity has to fall such a long way that it behaves like a CDS.”
That said, Fitch worked out that, historically, EDS would have been called more frequently than CDS written on the same names. Also, EDS performance varies more from industry to industry than CDS performance. That could make correlation risk a bigger problem. And equity events can be triggered by different factors to credit events. This makes modelling potential equity events using a name’s credit rating unreliable.
Since equity sits below debt in a name’s capital structure, if a credit event is called it often co-incides with an equity event. But it doesn’t follow that a name that experiences an equity event will also experience a credit event. If an EDS contract is written near the top of the equity markets, equity values can fall precipitously without the name going bankrupt or failing to service its debt.
“An equity event isn’t the same as a credit event,” says Gambel. Investors should look at how loss distributions change depending on whether losses on EDS contracts move with the equity price or are set in fixed recovery rates. Losses on CDS containing EDS also vary depending on when the EDS were written and their different strike prices. “You need to be conservative in setting parameters and in correlation assumptions,” says Gambel.
A 10% EDS bucket seems about the right size. “That’s enough to take advantage of the yields but not enough to have the rating agencies asking for extra subordination,” says Fitoussi.
Other banks have tried to put EDS into CDOs and found it hard to get the necessary yield enhancement. That’s because of the extra structuring involved, and because the best-yielding names in the EDS universe are often the best-yielding names in the CDS universe. It can be hard to achieve both name diversification and yield enhancement in the same deal.
That leaves the question of whether investors will get paid enough. “I’d be very surprised if people are offering more than 55 to 75 basis points on AAA tranches and 90 to 100bp on AA tranches of these deals,” says one credit analyst. “Investors must ask what adding a few more names actually achieves.”
