Credit Derivatives and Structured Credit Trading (Revised Edition) Credit Derivatives and Structured Credit Trading (Revised Edition) Vinod Kothari John Wiley & Sons (Asia) Pte.Ltd. Copyright©2009VinodKothari Publishedunderlicensein2009byJohnWiley&Sons(Asia)Pte.Ltd. 2ClementiLoop,#02-01,Singapore129809 Allrightsreserved. Nopartofthispublicationmaybereproduced,storedinaretrievalsystemortransmittedinanyformor byanymeans,electronic,mechanical,photocopying,recording,scanningorotherwise,exceptasexpressly permittedbylaw,withouteitherthepriorwrittenpermissionofthePublisher,orauthorizationthrough paymentoftheappropriatephotocopyfeetotheCopyrightClearanceCenter.Requestsforpermission should be addressed to the Publisher, John Wiley & Sons (Asia) Pte. Ltd., 2 Clementi Loop, #02-01, Singapore129809,tel:65-64632400,fax:65-64646912,e-mail:[email protected]. 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PrintedinSingaporebyMarkonoPrintMediaPte.Ltd 10987654321 Dedicated to Vishes, my son C O N T E N T S Foreword xxv Preface xxvii PART1 MARKET,INSTRUMENTSANDMOTIVATIONS Chapter1:Creditderivatives:Structure,evolution,motivations,andeconomics 3 Creditrisk:Thechallengeof ourtimes 4 Derivatives:Thebuildingblockof creditderivatives 5 Securitization:Theotherbuildingblock 5 Instrumentsof creditrisktransfer 6 Meaningof creditderivatives 6 Whatisacreditderivative? 6 Adefinitionof creditderivatives 7 Aquickguidetobasicjargon 7 Aquickexample 9 Syntheticlending 10 Reasonsfortradeincreditrisk 10 Theelementsof acreditderivative 11 Bilateraldealsandcapitalmarketdeals 11 Referenceassetorportfolio 12 Structuredportfoliotrade 12 Baskettrades 13 Index-basedcreditderivativetrades 13 Creditdefaultswaps(CDS)onasset-backedsecurities 13 Loan-onlyCDS 14 Protectionbuyer 14 Protectionseller 14 Fundedandunfundedcreditderivatives 15 Creditevent 15 Notionalvalue 16 Premium 16 Tenure 16 Losscomputation 17 Thresholdriskorlossmaterialityprovisions 17 Cashandphysicalsettlement 17 Deliverableasset 18 ISDAdocumentation 18 viii Contents Quickintroductiontothetypesof creditderivatives 19 Creditdefaultswap 19 Totalreturnswap 19 Creditlinkednotes 20 Creditspreadoptions 20 Portfoliodefaultswaps 21 Indextrades 21 Creditderivativesandtraditionalfinancialguaranteeproducts 21 Creditderivativesandguarantees 22 Creditderivativesandcreditinsurance 22 Creditderivativesandloanassignments 22 Creditderivativesandsecuritization 24 Motivations 24 Motivationsfortheprotectionbuyer 24 Reducingregulatorycapital 24 Economiccapitalrelief 25 Offerseasieralternativetosecuritization 25 Reductionof creditconcentration 26 Betterportfoliomanagement 26 Solvingcross-borderproblem 27 EnhancingRARoC 27 Tradingmotive 27 Motivationsfortheprotectionseller 27 Syntheticlending 28 Arbitragingopportunities 29 Yieldenhancement 30 Riskdiversification 30 Balancingtheriskbalancesheet 30 Farfewerexpenses 31 Resolvesproblemsof availabilitybycloningcashassets 31 Motivationsforthetradersandre-packagers 31 Economicimpactof thecreditderivativemarket 32 Thepositiveside 32 Financialstability 32 Bankstofocusoncreditassetcreation 33 Reducingthecostof credit 33 Thesupplyof bankcreditincreases 34 Effectiveriskmanagementbydiffusionof risk 34 Securitizationresultsintodisintermediation:Creditderivatives reinforcestheroleof commercialbanks 36 Creditderivativesandpricingof creditrisks 37 Thenegativeside 37 Lackof transparencyintransferof risks 37 Cross-sectorrisktransfers 38 Contents ix Transferof riskstothelesserinformed 39 Increasedleverage 39 Creditderivativespromoteriskierlending 39 Insidertrading 40 Unconfirmedtradesandoperationalproblems 41 Creditderivativeshavenotbeentestedinadversemarketconditions 41 Chapter2: Creditderivatives:Market,evolution,andcurrentstatus 47 Evolutionof creditderivatives 47 Creditderivativesandsecondarymarketsinloans 48 Theemergenceof credit-linkednotes(CLNs) 49 Fourstagesof development 49 Pre-1997:Earlyperiodof skepticism 50 The1997and1998crises:Creditderivativesgetaboost 51 Enron,WorldCom,Argentina 53 Standardizationof CDS 53 Adventof indextrading 54 Adventof creditderivativeproductcompanies 54 Syntheticbalancesheetsecuritization 55 Currentstateof themarket 55 GrowthincreditderivativesrelativetootherOTCmarketsegments 55 Majorcentersof creditderivativesactivity 58 Majormarketplayers 58 Protectionbuyers 58 Protectionsellers 58 Banks 60 Concentricnatureof thecreditderivativesmarket 61 Tradingversushedgingmotive 63 Insurancecompanies 64 Financialguarantors 64 Hedgefunds 64 Dealers 65 Hedgefundsandcreditderivatives 65 Growthof thehedgefundindustry 66 Theadventof creditstrategieshedgefunds 66 Roleof hedgefundsandcreditderivatives 68 Hedgefundsassuppliersof equitytocreditderivatives 69 Creditderivativeslossesandhedgefunds 69 Implicationsof theintensivehedgefundsrole 71 Majorproducts 72 Referencerisks:sovereignversuscorporate 72 Creditqualityof referenceentities 74 Physicalversuscashsettlement 76 x Contents PART2 SINGLE-NAMEINSRTUMENTS Chapter3:Creditdefaultswaps 81 Meaningof CDS 81 Summaryof terms 81 Numericalillustration 83 Maintermsof theCDS 83 Referenceobligation 83 Notionalvalue 84 Premium 84 Creditevents 85 ISDA’screditevents 85 1Bankruptcy 85 2Obligationacceleration 86 3Obligationdefault 86 4Failuretopay 87 5Repudiation/Moratorium 87 6Restructuring 87 Commoncreditevents 87 Noticeof creditevent 88 Termsof settlement 89 Physicalsettlement 89 Deliverableobligation 89 Cashsettlement 89 Valuationof thedefaultedobligation 89 Thresholdamount 89 Collateralprovisions 90 FundedCDS 90 HowdothepartiestoaCDSencashvalue 91 Impactof timedecayonmark-to-marketvaluation 92 CDSonsovereignnames 92 Basketdefaultswap 92 PortfolioCDS 94 Structuredportfoliodefaultswap 96 Binaryswaps 98 Chapter4:Totalrateofreturnswaps 99 Meaningof TRORswaps 99 CDSandTRORswaps 100 Impactof aTRORswap 101 Termsof aTRORswap 101 Referenceasset 101 Creditevents 102 Settlementmethods 102 Examplesof applicationsof TRSs 102 Contents xi Advantagesof aTRS 103 Createsoff-balancesheetsyntheticassets 103 Avoidsproblemsof availability 103 Avoidsregulatorybarriersinowningthetargetasset 103 Providesveryhighleverage 103 Avoidsregulatorybarriersingivingatraditionalloan 103 Providesbettersecurityinterestforthesyntheticlender 103 Index-basedTRSs 104 StructuredTRS 104 TRORswapsandequityswaps 104 TRORswapsandpropertyderivatives 104 TRSsandcamouflagedlendingtransactions 105 Chapter5:Credit-linkednotes 107 Meaningof aCLN 107 Distinctivefeaturesof CLNs 108 StructuredrisktransferthroughCLNs 109 CLNsissuedbySPVs 109 Self-referencedCLNs 111 Chapter6:Creditdefaultswapsonasset-backed securitiesandderivativesexposures 113 NeedforCDSsonasset-backedsecurities 113 Developmentof CDSonABS 113 MajordifferencesbetweenCDSofABSandcorporatedebt 114 Documentationtemplatesfordifferentstructuredfinanceproducts 115 Specialfeaturesinthedocumentationtemplates 115 Notionalvalueof theswap 116 CrediteventsinthecaseofABS 117 Crediteventsinthecaseof MBS—physicalorcashsettlementterms 117 Meaningof FailuretoPay 117 FailuretoPayduringthetermof thetransaction 117 FailuretoPayuponfinalmaturity 118 Meaningof lossevent 118 Bankruptcyasacrediteventincaseof CDSofABS 118 Ratingdowngradetodistressedlevel 119 Restructuring 119 CrediteventsunderthePAUGterms 119 PhysicaldeliveryoptionunderPAUG 119 Twomodesof settlement:PAUGandtraditional 120 Paymentsbytheprotectionbuyer 120 Paymentsmadebytheprotectionseller 121 Write-down 121 Principalshortfall 121 Interestshortfall 121 xii Contents CDSof CDOs 122 Crediteventsincaseof CDSof CDOs 122 ContingentCDS 122 Notionalamountof thetransaction 123 Mark-to-marketvalue 123 Interimpayments 124 Creditevents 124 Chapter7:Loan-onlyCDS 125 Meaningof leveragedloans 125 Marketforleveragedloans 125 TheLCDSmarket 126 Motivationsof parties 127 Motivationsof theprotectionbuyer 127 Motivationsof theprotectionseller 127 Distinctivefeaturesof LCDSascomparedtovanillaCDS 128 EuropeanandUSLCDS 128 Securedloans 128 Physicalsettlement 128 Relevantsecuredlist 129 Auctionprotocol 129 Cancellabilitywhennodeliverablesof requiredseniorityexist 129 ISDAdocumentationforLCDS 130 LCDSbasis 130 Reasonsforbasisspreads(LCDS:leveragedloans) 130 Reasonsforbasisspreads(LCDS:CDS) 130 LCDX 131 iTraxxLevX 131 Chapter8:Creditderivativesoptionsandvolatilitytrades 133 Creditspreadtrades 133 Creditdefaultswaptions 133 Payeroption 134 Receiveroptions 136 Outof moneyswaptions 140 Combinationtrades 140 Straddle 140 Strangle 141 Butterfly 143 Swaptionsonindices 145 Knockoutfeature 145 Constant-to-maturityCDS 145 DistinctiveFeaturesof CMCDS 147 Genesisof CMCDS 147 Usesof CMCDS 147 CappedCMCDS 148 IndexCMCDS 148