Credit Derivatives Market Overview with Focus on Collateralized Debt Obligations - Essay Example

___________ ____________ ____April 2006 Credit Derivatives Market overview with focus on Collateralized Debt Obligations This paper analyses the credit derivative products and their markets in terms of product characteristics and broad methodology in structuring such products. A preliminary measure of credit derivatives' market is made identifying the major participants and achieved market sizes. Then basic credit derivative structure of Credit Default Swap is examined with juxtaposition of advantages inherent in use of credit derivative products. Finally we focus on Collateralized Debt Obligations and take up for discussion characteristics, risks and issues associated with Collateralized Debt Obligation (CDO) .We conclude the paper with uses and implementation methods utilized under CDOs. Introduction to the Credit Derivatives Market and securities in this market Credit derivatives are instruments essentially leading to transference of credit risk between two parties-a seller and a buyer- with the terms of such transference being codified in bilateral agreement(s). Agreements can either cover a stand alone credit event or a diversified pool of such credit events (as is the case in synthetic Collateralized Debt Obligations-CDOs- which tend to sell the risk on complete and well defined credit portfolios). Credit derivative contracts (agreements) are normally written over-the-counter (OTC) to include the particular credit event or events and are, therefore, usually custom built to match the specific needs of the customers. Due to recurring nature of a lot of credit events a lot of standardization has crept of late in Credit derivative instruments and in today's credit derivative markets a substantial proportion of transactions are quite standardized. Credits risks are assumed by varied players in today's credit markets. These include. These include banks, government Agencies, corporates, securities companies, pension funds, insurance companies, fund managers, hedge funds etc. All of these entities have a calculated and strategic need to assume, reduce or manage credit risks and therefore the credit derivatives markets have typically players comprising of these entities. However the economic or regulatory motives of each of these entities differ because they have different market positions and are governed by varying regulations. Therefore each type of entity would have different strategic motive for taking on positive or negative credit postures at any given point of time. Generally speaking Credit derivatives enable users to transfer credit risk, generate leverage or yield enhancement, proactively manage credit risk on a portfolio basis, manage regulatory capital ratios, decompose and separate risks embedded in securities (such as in convertible bond arbitrage), use as an alternative vehicle to equity derivatives (such as out-of-the-money equity put options), hedge and/or mitigate credit exposure and synthetically create loan or bond substitutes for entities that have not issued thus far for specific maturities. Since much of the activity in credit derivatives is OTC and a good proportion of these negotiations are private and involve off balance transactions, size of the market turns tedious for exact measurement and only information that is available if of the nature of volunteered information from various market participants. An estimate of the global size of this primarily privately negotiated market was placed at $100 billion to $200 billion at the end of 1996. The British Bankers Association (BBA) estimated the size of the London market only to be about $20 billion at the end of 1996. These figures did not include the credit derivative transactions taken up by a good number of Japanese securities firms, which was mainly of the type to include credit default puts embedded in privately placed transactions. British Bankers Association (BBA) published a "Credit Derivatives Report" based on data collected from 25 major international players concerning their involvement in this market. As of year-end 2001 the report estimated that global market size to be $1,189bn (excluding asset swaps) and it forecasted that the same would reach $1,952bn by 2002 and $4,799bn by 2004. Credit derivatives are the products which involve the transfer, in part or entirety, of the credit risk of a credit obligation (or a pool of credit obligations), without in any manner resulting in transference of the ownership of the reference credit product. As the conditionalities governing the basic credit products are evolving into sophisticated and fine tuned structures resulting in varying, splitting and multi-timing of credit risks so are the derived credit derivative products turning diverse and complex almost making for a robust and vibrant credit derivatives' market. Credit default swaps (CDSs) have turned really popular instruments in present day's credit derivatives' market. CDS are bilateral contracts agreeing to transfer the credit risk of one (single name CDSs) or more (portfolio swaps as well as CDS indices) reference entities (which are the underlying names on which credit risk is transferred). A CDS is essentially an insurance genre' contract, in that it seeks to protect the "protection buyer" against predefined credit events, in particular the risk inherent is event of default, threatening the reference entity (or entities), during the valid term of the contract, in return for a prefixed and periodic fee paid to the "protection seller." The buyer of protection is therefore in a position similar to that of a short seller of a bond issued by the reference entity, and the market price of the CDS mirrors the degrees of risk inherent in the underlying credit asset. Upon the happening of the credit event, CDS transactions settle either physically (that is by ensuring the actual delivery to the protection buyer of defaulting bonds/loans for an amount equivalent to the notional value of the swap) or in cash, with the net amount owed by the protection seller to buyer being determined after the credit event .Figure 1 represents the diagrammatic representation of the transaction: Figure 1: Pay offs in a Credit Default Swap Credit-linked notes (CLNs) are essentially funded securities trading just like normal bonds issued by the reference entity, and, therefore, they replicate a funded CDS.CLNs are meant for investors either averse or unable to transact directly in derivatives. Structured credit products can be created using various methods of securitization of debts and with each of these variants one can have associated transactions of the transfer of the inherent credit risk in a portfolio of reference entities (i.e., a pool of underlying collateral). These are named variously and include several variants of the vanilla CDS (i.e., "portfolio swaps") and collateralized debt obligations (CDOs). Structured credit products are often identified and issued in "tranches" (an alternative reference is product's "capital structure"). Each tranche can be taken as a separate synthetic structure bond, with a given risk-return profile determined by the performance of the underlying portfolio and the tranche's seniority in the capital structure (seniority implies the priority of tranche's claims on the cash flows of the overall collateral pool). Depending upon the seniority of claim we can divide the entire pool in layered tranches.For each layered tranche we can prefix default related loss absorptive capacity in terms of percentage of losses and call it a 'detachment point'. Thus in a typical tranched capital structure one can have an "equity" tranche that absorbs default-related losses (often representing outlier risks) on the underlying portfolio up to the 5 percent "detachment point". Then one can have one or more "mezzanine" tranches that absorb losses that exceed the 5 percent "detachment point" and up to a 10 percent "detachment point" .Then there can be one or more "senior" tranches (absorbing 10-35 percent default losses), and a "super-senior" tranche (absorbing the final 35-100 percent).The senior tranches are taken to reflect the systemic risk inherent in the credit event. Traditional "cash" CDOs are generally backed by bonds and/or loans. Whereas "synthetic" structures CDOs have references to portfolios of other credit derivatives (i.e., CDSs). Synthetic structures makes it possible for arrangers to offer tranches in unfunded and notional forms, because in all such structures the underlying reference assets need not be owned however credit default risks can still be bought and sold. Moreover, in departure from the "full capital structure" cash CDO transactions, where all of the risk is bought and sold in capital markets, in synthetic structures, only selected and specified portions of the reference portfolio are offered in the capital markets (with the overall portfolio risk retained and duly hedged by the structurer). This would also be possible with cash CDO, however then the structurer would have to fund the retained risk. A "partially funded" CDO structure will typically seek to transfer credit risk in both funded (say most or all of the first 20 percent of potential losses) and unfunded form (say when the losses are above 20 percent, these are typically purchased by highly rated and cushioned insurers and banks). Synthetic structures are pliable and used often to get more customization of the transaction. For instance, synthetic CDOs resulted in the development of portfolio swap products based on customized stand-alone reference portfolios (i.e., single-tranche CDOs and portfolio swaps, termed as "bespoke" structures), and standardized CDS indices and tranches thereon.CDS indices and related sub indices track the performance of baskets of the most actively traded single-name CDSs. The standardized features of indices (i.e., maturities and risk tranches, credit ratings, and sectoral delineations) have increased the liquidity of credit risk trading. Analysis (a) Characteristics, risks and issues associated with Collateralized Debt Obligation (CDO) A collateralized debt obligation (CDO) is a structured transaction comprised of fixed income securities whose cash flows are connected and to the incidence of default in a pool of debt products. These debt instruments may include asset-backed securities, loans, revolving lines of credit, other emerging market corporate and sovereign debt, and subordinate debts from structured transactions. When the collateral is mainly made up of loans, the transaction is termed a Collateralized Loan Obligation (CLO); when it is mainly made up of bonds, then the transaction is termed a Collateralized Bond Obligation (CBO). The basic idea behind a CDO is that a pool of defaults prone bonds or loans can form the basis for issuance of CDO securities, cash flows of which would be supported by the cash flows due on the backing loans or bonds. These cash flow payments can be prioritized to the various tranches of issued securities and thus it would be possible to redistribute the credit risk inherent in the pool of loans or bonds and new securities can be created with varying credit risk profiles. This way the originating pool of assets which had little investor attention on stand alone basis because of their illiquidity or poor credit rating can be turned into new issued securities having different risk profiles and which cater to varying risk-return expectations of segmented investors. In fact it tantamount to unbundling the basis pool of securities and offer to the capital market parts of such securities with varying risk-return profiles. Usually the collateralized assets are handed over to a created entity called a special purpose vehicle (SPV), which then works to divide the pooled assets into tranches depending upon their risk-return profiles primarily determined by a concept called seniority and issues several tranches of new securities. The newly issued securities end up having varying levels of seniority in the sense that the super senior and senior tranches have coupon and principal payment priority over the lowly placed mezzanine and equity tranches. Terminology of tranches itself clearly exhibits that an equity tranche has the lowest payment priority and is serving as akin to equity in the holistic capital structure of the backing pool of assets or collateral. This simply translates into the fact that earned and realized income from the pooled collateral assets' is first paid to the most senior tranches of the CDO securities and it is followed by junior tranches. Junior tranches, as indicated above, includes the mezzanine and the equity tranches. The prioritizing rules determining the priority of payments between different tranches comprise what is popularly called the waterfall structure .Determining an entire waterfall structure can be quite involved and complicated. A typical CDO structure is represented in a diagrammatic form in figure 2 below: Figure 2: A typical Structure of a Collateralized Debt Obligation (CDO) (b) Use and implementation methods utilized under CDOs Essentially the CDO transactions target to realize the spread differential between the yield on a pool of collateralized assets or portfolio of such assets and the weighted average cost of funding the varying debt classes issued under a CDO structure. Provided that such backing assets do perform according to their usual terms of repayments and that there are no significant interest or principal repayment defaults, income that is generated from the collateralized assets is used to pay all debt investors net of any or all fees and expenses. The remainder and residual cash flow is paid to the equity investors. Principal and interest payments received on the portfolio of collateralized assets form the underlying cash flows and these are distributed to CDO investors based on the preset priority of payments schedule or "Waterfall", as noted above. The CDO liabilities are structured in a manner so to form several debt classes with accompanying credit ratings and coupons that offer capital market investors numerous options to match their varying risk-return appetites with an option of a single layered unrated equity. This equity option subscribers would have their cash flow claims subordinated to the claims of other debt classes issued within the CDO structure and would have a fully leveraged exposure to the portfolio of collateralized assets. In order to assume this high risk the equity tranche subscribers would expect an equivalently high rate of return; given the prevalent market for investible funds and realized returns on them such expectations regarding equity returns may typically fall in the range of 15-20% range. It is seen widely that CDOs are typically structured in two main variants viz a cash flow version and a synthetic version. In cash flow version investors' capital is used to fund the outright purchase of the underlying collateral of assets or pool of such assets. The acquired portfolio of collateralized assets is then usually held in the books of an entity created for the purpose and called a special purpose vehicle, as above. This entity is a creature of the CDO and is set up solely for serving the needs of the varying CDO tranche subscribers. This entity ensures that the cash flows received from the collateralized assets is deployed in making both principal and interest payments to the debt and equity investors. Typically the underlying collateral assets are not marked to market, but are held at book values barring the occurrence of a credit default event (which may range from a soft part payment default to an extreme of a bankruptcy). Synthetic CDOs are normally taken up as off-balance sheet transactions and essentially result in an exchange in cash flows through the instrumentality of a credit default swap or even a total return swap. Simply put, the CDO sells the credit protection, or promises the return of par value after a credit default event, on a reference portfolio and in exchange receives all of the net cash flows generated on the reference portfolio. The cash flows are netted primarily for the financing costs paid to the swap counterparty and secondarily for transactional expenses. Synthetic CDOs have turned extremely popular in present day capital markets. A variety of attractive features of synthetic structures have contributed to this popularity. These are essentially features which were found lacking in cash flow structures to a large extent. These features also represent the uses of such structures to investors, issuers and reference entities. Synthetic structures can be designed for shorter time period tenors when compared to cash flow deals in that they obviate the need to have a ramp-up period. Ramp-up period popularly refers to the time taken in purchasing the underlying collateral securities .accessing them on books and make them ready for being leveraged for CDO issues. Synthetic structures also have considerable ease of execution not only in terms of facile documentation but also in their ability to offer customized solutions even using a single tranche transaction that issues simplistically only one debt class. They are basically intended to unbundled risk-returns of a reference portfolio without affecting ownership of the underlying and hence they can result in much larger turnovers then the cash flow variants. Portfolio managers prefers to deal in synthetic CDOs, for instance the synthetic CDOs backed by credit default swaps, as they permit the portfolio manager to sharply focus just the credit risk of the underlying reference portfolio as payments to the protection buyer occur only in the eventuality of a credit default event. Finally, a CDO's underlying portfolio of collateral assets may be either actively managed or even managed in a static manner or passively. Passively managed portfolios are usually observed to be confined to CDOs that are primarily structured to augment regulatory capital for the issuer. These are called Balance Sheet based CDOs and result in vehicles backed by majority of higher rated securities or securities with lower credit rating volatility in terms of few or stray migrations. Most typically, the underlying assets in the collateral pool are not replaced or changed, however the portfolio manager may have the option of replacing such static assets in predefined and limited circumstances. Actively managed CDOs, on the other hand, have the collateral of lower rated or non-investment grade securities. The portfolio manager may replace assets by means of buying and selling the collateral assets with an objective of minimizing the credit losses and improving the net proceeds. Sales proceeds from any replaced asset is applied in acquiring other assets as collateral. This replacement process can continue during the reinvestment period which is typically placed at 3-5 years from the date the CDO closes. Commercial banks, insurance companies, and money managers often utilize a CDO to leverage their high-yield portfolios. Their target is to obtain the spread differentials between high-yield sub-investment-grade securities and less risky investment-grade securities. It is because of his that such transactions are called "arbitrage" CDO's. They have specific portfolio use for money managers as these transactions not only tend to result in creation of a high return asset but also earn a regular fee income. Such transactions also increases the number and quantum of assets under active management and tend to lock in funding for a relatively longer term of 3- to 7-years. Arbitrage CDO's have been usually designed either as cash flow structure or as a market value structure. In the cash flow variant, the principal on tranches is repaid to CDO subscriber using parallel cash generated from repayments in the collateral loans. The chief risk in cash flow arbitrage CDO's is, therefore, of the credit default in any of the collateral assets. Whereas in market value arbitrage CDOs, the principal is paid to CDO subscribers by selling the underlying collateral itself. Here the investors are exposed to the variations in the market value of the underlying collateral. It is because of these variations that the underlying collateral securities are marked to market weekly or bi-weekly. The CDO debt class ratings therefore are determined as much by price volatility factors as by the diversity and credit quality/ratings of the underlying collaterals. In capital markets it is usual to find much greater float of Cash flow CDOs than the market value CDOs. The composition of typical arbitrage CDO collateral can have up to 25-50 loans or securities. The credit quality of the collateral pool in arbitrage CDOs has been observed to be of lower quality when compared to a typical balance sheet CDO, say it can carry pooled instruments rated at best from BB to B. Transaction sizes are also smaller say $200 million-$1 billion for arbitrage CDOs and say, $1-$5 billion for balance sheet CDOs. The pricing of CDOs is essentially dependent on the rating of the collateral instruments. To be able to entirely reckon the risk of the portfolio, the adopted rating methodology should consider the shape of the portfolio loss distribution. This rating of the CDO is generally done by the various rating agencies who have full access to data about the structure of the underlying collateral pool of assets and use this very structure to leverage it to determine the credit quality of the various tranches of the CDO.Any rating methodology must reckon the role of default correlation and exhibit it finally in the form of risk in the issued securities under the CDO tranches.Industry standard methodology developed by Moody's uses its Binomial Expansion Technique, which combines a measure of default correlation across the collateral pool of assets, a knowledge of the average credit quality of the different assets in the pool, and the details of the prioritizing waterfall structure to output an expected loss for each CDO tranche. The default correlation is measured using the Diversity Score. This is calculated using a methodology that reckons the number of assets that are in the same industry and aims at representing the number of unrelated and independent assets that would have the same loss distribution as the actual portfolio of correlated assets. As an instance we might consider a portfolio of 45 assets having a diversity score of 20.Which, in turn simply means that the reckoned 45 correlated assets have the same loss distribution as the 20 independent assets. The output of this model is in the form of an expected loss for the CDO tranche being rated. This need be less than the target expected loss that Moody's specifies for the required rating in order to result in good pricing. The actual pricing of a CDO tranche is, however, subsequently, calculated by reckoning the prices of similarly rated CDO tranches trading in the secondary market. Standard and Poor's approaches CDO pricing by setting concentration limits for the maximum number of obligors in the same industry instead of using the Diversity Score approach as done at Moody's. Standard and Poor is comfortable with an 8% concentration limit on a single industry. Default correlation is reckoned as well by specifically but implicitly stressing the default probabilities of the assets in the collateral portfolio. A multinomial probability distribution is used for computing the portfolio loss distribution. Documentation of credit derivatives can be quite a deterrent to their market development. Documentation problems were first addressed in 1998 by the International Swaps and Derivatives Association (ISDA) which issued a standardized Long Form Confirmation that made it possible to trade default swaps within the framework of the ISDA specified Master Agreement. Recently, and owing to several documentation problems highlighted by the Russian crisis of August 1998, ISDA published an updated credit swap documentation that aimed to standardize definitions across the board. Till this juncture most of the default swap documentation had been written in-house for each issuer; resulting in documentation variations that led to emerging concerns in the market participants about the issue of Legal basis risk. Legal basis risk is the risk that the definitions or legal structure used in the purchase of protection differs that used by this transaction's hedge, leaving issuer exposed to legal risk of varying interpretation of terms in agreements. Since the credit derivatives are triggered by the happening of a credit event; the ISDA has been careful enough to clearly define at least six credit events' categories. These are usually defined in relation to a reference entity and can be stated as: Bankruptcy, Failure to Pay, Obligation Acceleration/ Obligation Default, Repudiation/Moratorium and Restructuring. The obligation used in the definition of a credit event itself needs to be defined. In order to recognize a credit event as it relates to an emergence of an obligation, it is required that the different categories of obligation are specified with equal clarity. ISDA specifies six possible obligations' categories of bond, bond or loan, borrowed money, loan, payment, and reference obligations only. It is observed that most trades will specify the obligations using bond, bond or loan, or borrowed money.ISDA specifies a further eight obligation characteristics which are used to refine the nature of the obligation viz Pari Passu Ranking, Specified Currencies, Not Sovereign Lender, Not Domestic Issuance, Not Domestic Law, Not Contingent, Listed and Not Domestic Currency. These essentially structure the manner of distribution on trigger. Conclusion Credit derivatives are instruments essentially leading to transference of credit risk between two parties-a seller and a buyer- with the terms of such transference being codified in bilateral agreement(s). Credit derivatives enable users to transfer credit risk, generate leverage or yield enhancement, proactively manage credit risk on a portfolio basis, manage regulatory capital ratios, decompose and separate risks embedded in securities, use as an alternative vehicle to equity derivatives, hedge and/or mitigate credit exposure and synthetically create loan or bond substitutes for entities that have not issued thus far for specific maturities. Credit derivatives come in variety of structures and forms depending upon the need and nature. There may be vanilla Credit Default Swaps (CDS). A collateralized debt obligation (CDOs) is a structured transaction comprised of fixed income securities whose cash flows are connected and to the incidence of default in a pool of debt products. When the collateral is mainly made up of loans, the transaction is termed a Collateralized Loan Obligation (CLO); when it is mainly made up of bonds, then the transaction is termed a Collateralized Bond Obligation (CBO). Credit-linked notes (CLNs) are essentially funded securities trading just like normal bonds issued by the reference entity, and, therefore, they replicate a funded CDS.Synthetic CDOs are more popular as are the cash flow arbitrage CDOs.ISDA has been standardizing the terminology and contracts used within the global trading of credit derivatives and this market is likely to leverage to gigantic proportions considering the expansion and sophistication in underlying credit products and Basle II capital requirements which are based on a comprehensive risk assessment of credit products. References This paper makes acknowledges the extensive use of the under mentioned standard published literature in the area: Lehman Brothers.S t r u c t u r e d C r e d i t R e s e a r c h. Credit Derivatives Explained. Market, Products, and Regulations. March 2001. Merrill Lynch. Credit Derivative Handbook 2003. A Guide to Products, Valuation, Strategies and Risks. Europe. 16 April 2003. Credit derivatives: The latest new thing. Chicago Fed Letter. THE FEDERAL RESERVE BANK OF CHICAGO. Number 130.June 1998. Read More