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Vinod Kothari's
Credit Derivatives and Synthetic Securitisation
A guide to commoditisation
of credit risk
with updates upto May 2003
Contents
Preface VII
about the author 14
chapter 1: Credit Derivatives: Structure, evolution, motivations and economics 17
Credit risk: the challenge of our times: 18
Derivatives: the building block of credit derivatives 18
Securitisation: The other building block 19
Meaning of credit derivatives 20
What is a credit derivative? 20
A definition of credit derivatives: 21
Quick guide to basic jargon: 22
Synthetic lending: 23
Why do they do it? 24
The elements of a credit derivative: 26
OTC derivatives and capital market deals: 26
Reference asset or portfolio: 26
Basket trades: 27
Index-based derivatives: 28
Protection buyer 28
Protection seller 29
Funded and unfunded credit derivatives: 39
Credit event: 30
Notional value: 30
Premium: 31
Tenure: 31
Loss computation: 31
Threshold risk or loss materiality provisions: 32
Cash and physical settlement: 32
Deliverable asset: 33
ISDA documentation: 33
Quick introduction to the types of credit derivatives: 34
Credit default swap: 34
Total return swap: 34
Credit linked notes: 35
Credit spread options: 35
Credit derivatives and traditional financial guarantee products: 36
Credit derivatives and guarantees: 36
Difference between traditional guarantees and credit derivatives 37
Credit derivatives and securitisation: 39
Evolution of credit derivatives: 39
Credit derivatives and secondary markets in loans: 39
Emergence of credit linked notes: 40
Early period of scepticism: 41
The 1997 crises: credit derivatives get a boost: 45
Current state of the market: 46
Growth out of crises: the 1997 and 1998 crises 48
Enron and Argentina: 48
"We are a credit derivatives company" 49
Synthetic securitisation of retail credit products: 49
Product development: 50
Major centres of credit derivatives activity: 51
Major market players: 51
Banks: 52
Investment banks: 54
Insurance companies: 54
Major products: 55
Reference risks: sovereign versus corporate 56
Motivations: 56
Motivations for the protection buyer: 57
Reducing regulatory capital 57
Economic capital relief: 58
Offers easier alternative to securitisation: 58
Reduction of credit concentration: 60
Better portfolio management: 60
Solves cross border problem: 60
Much higher RARoC returns: 61
Motivations for the protection seller: 61
Synthetic lending: 62
Arbitraging opportunities 62
Yield enhancement: 64
Risk diversification 64
Much less costly: 65
Resolves problems of availability by cloning cash assets: 65
Motivations for the traders and re-packagers: 65
Economic impact of the credit derivative market: 66
The positive side 67
Allows banks to focus on credit asset creation: 67
Effective risk management by diffusion of risk 67
Securitisation results into disintermediation: credit derivatives reinforces the role of commercial banks: 68
Credit derivatives and pricing of credit risks 68
The negative side 69
Lack of transparency in transfer of risks: 69
Cross-sector risk transfers: 70
Transfer of risks to the lesser informed: 70
Increased leverage: 71
Appendix 1 : issues in cross-sector risk transfers (FSA) 72
Appendix 2 : Credit derivatives terminology 76
Chapter 2: Credit default swaps 101
Meaning of credit default swaps: 101
Main terms of the credit default swap: 102
Reference obligation: 102
Premium: 103
Credit events: 105
ISDA's credit events: 106
1. Bankruptcy 106
2. Obligation Acceleration 107
3. Obligation Default 108
4. Failure to Pay 108
5. Repudiation/Moratorium 109
6. Restructuring 109
Notice of credit event: 109
Terms of settlement: 110
Physical settlement: 110
Deliverable obligation: 110
Cash settlement: 110
Valuation of the defaulted obligation: 111
Collateral provisions: 111
Basket trades: 112
Portfolio trades: 113
Structured credit derivatives: 114
Binary swaps: 116
Index-based credit default swaps: 116
The restructuring controversy: 117
Convertible, exchangeable and accreting obligations: 119
chapter 3: Total Rate of Return swaps 121
Meaning of TROR swaps: 121
CDS and TROR swaps: 123
Impact of a TROR swap: 123
Terms of a TROR swap: 125
Reference asset: 125
Credit events: 126
Settlement methods: 126
Index-based total return swaps: 126
chapter 4: Credit linked notes 129
Meaning of a credit linked note: 130
Distinctive features of credit linked notes: 131
Substance of CLNs: a funded avatar of an unfunded derivative: 132
CLNs issued by SPVs: 133
chapter 5: Synthetic Securitisation 137
Cash structure securitisation: 137
Synthetic securitisation: 138
Modus operandi: 139
Structured credit risk transfer: 140
Leveraged risk transfer: 142
Super-senior swap 143
Advantages of synthetic securitisation over cash transfers: 145
Minimizes funding and reinvestment problems: 145
Alleviates transfer-related problems: 146
Does not require artificial separation of origination and servicing functions: 148
Lesser legal costs: 149
No upfront taxation: 149
Avoids double taxation of residual profits: 150
No accounting volatility: 151
Does not reduce book size: 152
Retains flexibility in customer service: 153
Distinction between cash-funded and synthetic securitisation: 153
Elements of synthetic securitisation 155
Originator: 155
Obligor portfolio: 155
Type of Credit derivative: 156
Credit events and loss computation: 156
Special purpose vehicle: 157
Assets of the SPV: 158
Liabilities of the SPV: 159
Non-SPV structures: 160
Sizing of the credit enhancement: 161
Swap calculation agent: 163
Trustees: 163
Super senior swap provider: 164
Other swap counterparties: 164
Arbitrage synthetic CDOs: 164
Difference between arbitrage synthetic CDOs
and balance sheet synthetic CDOs: 167
Collateral manager: 168
Over-collateralisation and interest coverage ratios: 168
Application of OC and IC triggers to synthetic CDOs: 171
Paydown structure: 172
Sequential paydown: 172
Pro-rata paydown: 172
Fast-pay/ slow-pay structure: 173
Evolution and growth of synthetic CDOs 173
Investing in synthetic CDOs: 176
chapter 6: Case studies 179
DBS Bank Singapore's Alco 1: 180
Transaction structure: 180
The SPV 180
The notes: 181
Risk transfer: 182
Reference portfolio: 183
The credit default swap: 184
Investment of the collateral: 186
Interest rate swap and put option: 186
Economics of the transaction to DBS Bank: 186
CAST 1999-1 Non-SPV structure 188
Features of CAST 1999-1 189
Principal protection to subordinate class: 191
Investor interest 192
Cast 2000-1 193
Promise program by KfW Germany 195
Promise A 2002-1 196
Transaction structure: 196
The notes and Schuldscheine: 198
The reference portfolio: 199
Loss structure: 199
Amortization of the notes: 200
Promise-I 2002-1: 201
Jazz synthetic arbitrage CDO 202
Hybrid between cash and synthetic structure: 203
All that Jazz it has: 204
Synthetic versus cash liabilities: 205
The collateral manager 206
Liquidity facility: 207
Over-collateralisation and Interest cover tests: 208
Robeco arbitrage synthetic CDO: 208
Synthetic Credit asset securitisation: SMART from Australia: 211
Synthetic versus cash transfer of lease receivables: 211
Credit protection: 212
Asset structure: 214
White Oak synthetic CDO of structured obligations: 214
The reference portfolio: 215
Credit events: 215
Funding: 215
Regulatory arbitrage? 216
chapter 7: Legal aspects of credit derivatives 217
Legal nature of credit derivatives: 218
Credit derivatives and contingent contracts: 218
Credit derivatives and actionable claims: 218
Contract of guarantee or surety: 219
Contract of indemnity: 224
Credit derivatives and bank letters of credit: 226
Credit derivatives and insurance contracts: 227
Are they gaming, gambling or wager contracts: 228
Are they securities? 228
Are they investment contracts 229
Bilateral contract or transferable: 229
Enforceability of credit derivative contracts: 231
Regulatory enforceability of the derivative contract: 232
Enforceability of the reference obligation: 232
Derivatives-related regulation applicable to credit derivatives: 233
Commodity derivatives laws 233
Commodity futures law in the USA: 234
Exemption to OTC derivatives 234
Commodity Futures Modernization Law: 236
Legal nature of a credit default swap: 238
Legal nature of total return swaps: 238
Legal nature of credit-linked notes: 238
Permissibility for banks: 240
Whether a part of banking business 240
Whether banks can be protection buyers: 241
Whether banks can be protection sellers: 242
Legal position of netting rights: 242
Bankruptcy Code safe harbour to credit derivatives: 243
Early bankruptcy safe harbour in the USA: 243
Financial Contract Netting Improvement law 244
ISDA Documentation for credit derivatives: 245
Master agreement 245
Termination and close-out Netting: 246
Representations: 246
Undertakings: 247
Events of default: 247
Termination events: 248
Consequences of events of default/ termination event: 248
Transferability of the derivative contract: 249
Confirmation: 249
Introducing line of the confirmation: 250
General terms of the Confirmation: 252
Financial terms: 253
Notice requirements: 253
Credit events: 253
Obligations and Obligation Characteristics: 254
Settlement terms: 256
Terms relating to cash settlement: 256
Terms relating to physical settlement: 257
Dispute resolution: 259
Notices etc: 259
The Definitions: 259
Additional documents: 260
chapter 8: Taxation of Credit Derivatives 261
Key issues in taxation: 261
Taxation of the protection buyer 262
Integration with the reference obligation: 262
Option contract treatment: 263
Notional principal contract: 263
Meaning of notional principal contracts: 263
Are credit derivatives notional principal contracts: 264
Hedge tax rules applicable to notional principal contracts: 264
No hedge tax accounting for Notional principal contracts: 265
Taxation of credit linked notes: 266
Taxation of the protection seller: 266
Tax treatment in other countries: 266
chapter 9: Accounting for credit derivatives: 267
Whether derivatives accounting standards applicable? 268
Whether a derivative: 268
Physical settlement deals: 268
Credit default swap and financial guarantees 269
Exchange traded derivatives: 274
Total rate of return swap: 274
Credit linked note: 274
Basics of derivative accounting rules: 275
Basics of accounting for financial instruments 275
Basics of hedge accounting: 276
Why and when hedge accounting? 277
Impact of hedge accounting: 277
Conditions for hedge accounting: 278
Fair value hedge accounting: 278
Cashflow hedge accounting: 279
Accounting for credit default swaps: 280
If the CDS is a financial guarantee contract: 280
If the CDS is not merely a financial guarantee contract: 280
Accounting in the books of the protection buyer: 281
No hedge-accounting: 281
Hedge Accounting: 282
Fair value hedge: 282
Cashflow hedge: 282
Examples: 283
Accounting in the books of the protection seller: 286
Examples: 287
Accounting for total rate of return swap: 288
Books of the protection buyer: 288
Example: 289
Books of the protection seller: 290
Accounting for a credit linked note: 290
Books of the protection buyer: 290
Books of the protection seller: 290
Example 291
Valuation of credit derivatives: 292
What is fair value 292
Sources of exit price information 292
Computation of exit price: 293
Disclosures of credit derivatives: 294
Examples of disclosures: 295
chapter 10 Regulatory and economic capital: impact of credit derivatives 297
Evolution of regulations: 298
The US regulatory guidelines: 299
The 1996 guidelines: 299
Guarantee-like treatment 299
Examiner-determined treatment for the protection buyer: 301
Capital relief to the protection buyer: 301
Funded portion 302
Unfunded portion 302
Senior uncovered position: 302
Capital implications applicable to protection seller: 304
Funded derivatives 304
Unfunded derivatives: 304
The FSA UK's guidelines 304
Stress on risk management issues: need to have proper systems: 305
Legal and reputational risks: 306
Liquidity: 306
Impact of credit derivatives on the remaining assets: 306
Will credit derivatives qualify to be on trading book of banks: 307
Demonstration of trading intent: 307
Marking credit derivatives to market: 308
Where credit derivatives are part of the banking book: 308
In case of funded derivatives: 308
In case of funded derivatives that provide partial risk protection: 308
In case of unfunded derivatives: 309
Where the reference asset and the underlying are not the same: 309
Impact of currency mismatch: 310
Impact of maturity mismatch: 310
Multiple obligors: 311
Capital treatment in the books of the protection seller: 311
In case of funded contracts: 312
In case of unfunded derivatives: 312
In case of multiple obligors: 312
Amount of payout: 313
Conditions for risk transfer by credit derivatives: 313
Conditions to be satisfied by all derivative contracts: 313
Conditions applicable to single-name funded derivatives: 313
Conditions applicable to funded packaged derivatives: 314
BIS-II proposals: 316
Credit risk mitigation: 316
Common conditions for credit derivatives and guarantees: 316
Specific operational requirements for credit derivatives 317
General rules for capital relief: 318
Computation of the risk weightage: 319
W factor 319
Partial protection: 320
Tranched cover: 320
Regulations in other countries 320
Economic capital considerations: 323
Meaning of economic capital: 323
Economic capital models: 324
Credit derivatives and economic capital: 325
chapter 11: Pricing of credit derivatives 327
Approach to pricing of a credit derivative: 328
Nature of a credit derivative contract: 328
Defining the contract: 328
Defining the cash inflows and outflows: 329
Expected value of the protection payment: 329
Expected value of protection payment in case of a credit derivative: 330
Expected value of the CDS premium: 333
Imputing the CDS premium: 334
Estimating default probabilities: 335
Estimating recovery rates: 335
Multiple obligor credit derivatives: 338
Basket trades 338
Pricing of CDOs: 339
Structured risk transfer: 340
Models on credit derivatives pricing: 341
Merton model: 341
The KMV model: 342
Measuring default probability: 343
Asset value and volatility: 344
Computing the distance to default: 344
Computing default probability: 345
The Jarrow Lando Turnbull model 345
Hull and White Model: 349
Pricing of credit derivatives versus cash assets: 350
Fundamental reasons: 351
Funded versus unfunded assets: 351
Deliverable asset: 351
Default definition: 352
Balance sheet/ off-balance sheet transaction: 352
Difference in loss given default due to difference in cost price: 352
Counterparty risk: 353
Encashability of gains: 353
Market reasons: Demand and supply factors: 353
The Hull and White Model: 354
The Jarrow-Lando-Turnbull (JLT) model 357
The Das-Tufano(DT) model 359
The Duffie-Singleton model 360
Merton's Model: 360
chapter 12: Recent Advances in Credit Risk Management: A Comparison of 5 Models (by guest contributor) 363
Abstract 364
The Conceptual Background – It all started with Black-Scholes 364
Merton's Model 366
Credit Risk Models – Structural versus Reduced Form 368
Key Features of Credit Risk Models 369
Correlation Assumptions: 373
Bottom-up versus Top-down: 374
Economic Data: 375
The Models in Detail 375
KMV's Portfolio Manager 375
JP Morgan's Credit Metrics 377
Kamakura's Risk Manager 378
CSFP's Credit Risk+ 379
McKinsey's Credit Portfolio View 380
So what's the best model? 383
chapter 13: Pricing Multi-name Credit Derivatives (by guest contributor) 387
Introduction 387
Single-name modeling approaches 389
The structural approach 389
The reduced form approach 390
Difficulties in multi-name modeling 391
Multi-name modeling approaches 392
Multivariate structural approach 293
Multivariate reduced form approach 394
The hybrid approach 394
Importance of dependence structure 395
The Normal dependence structure 397
Conclusions 399
References 400
SUBJECT INDEX 403
Contents of the Updates May 2003
Current state of the market: 3
Major markets: 4
Major products: 5
Role of insurance companies in the credit derivatives market: 6
Economic impact of credit derivatives: 6
The Greenspan vs Buffet debate: 6
Cross-sector risk transfers: 9
FSA Discussion paper: 9
Insurance regulators' study: 10
Financial Stability Forum: 10
Surety bonds and credit derivatives: 11
ISDA documentation: Master agreement 11
Credit Derivatives Definitions 2003 12
Obligations as guarantor: 13
Restructuring relating changes: 13
Bankruptcy: 14
Revision of IAS 39: 15
FAS 133 developments: 15
Exposure draft of amendments to FAS 133: 15
DIG Issues 16
Regulatory guidelines in Thailand: 19