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By Margaret Elliott

Credit derivatives have proven their mettle in the Asian meltdown, and are taking off in Latin America. Suddenly everybody is worrying about credit risk.

It's three in the morning and the call comes. It's bad news. Korea, an OECD country with investment-grade debt—and plenty of it—is about to be downgraded. Money managers, bankers, even corporate treasurers saw the unthinkable happen last fall.

Credit risk can bite. It's not a new concept, of course. A man named Michael Milken built a business capitalizing on the vagaries and the mispricing of credit risk. But save for the fallen angels of yore—companies such as Penn Central that fell from grace slowly—buyers knew where they stood when they bought junk bonds: junk could be junk or junk could be gold.

But it took last year's Asian crisis, with its attendant roller-coaster shifts in the credit of sovereign nations, to wake up investors and bankers to the undeniable truth. Credit risk is the biggest unmanaged risk people take when they invest in the capital markets, and it is the most evident in nonequity instruments. "We used to think credit was a buy-and-hold risk, just like interest rate risk was until the 1960s,” says Ron Tanemura, global head of structured debt at Deutsche Morgan Grenfell in London. "And we can apply some of the same models to managing it.”

Like the effect of inflation in the 1970s on bond investors' perceptions of interest rate risk, the Asian crisis alerted investors, corporates and bankers to the need to take credit derivatives seriously. Those lucky and prescient enough to have purchased credit derivatives in Asia before the market meltdown found their portfolios protected from some of the worst shocks. Credit derivatives gave the market a boost no marketing spiel could hope to do. And in certain sectors (total return and default swaps in many emerging markets), a real two-way market has developed. "If you want to sell one of these instruments, it isn't just the dealer who sold it to you who's ready to buy it back,” says Peter Croncota, senior managing director and head of global fixed-income marketing at Bear Stearns. The unofficial estimate of market size stands at about $100 billion notional value, up from an estimated $65 billion a year ago.

Bigger deals

Two examples are illustrative. In January, investors forced a government-linked bank, the International Finance Corp. of Thailand, to pay back $500 million worth of bonds several years before their maturity. This wasn't arm-twisting. The issue contained a graduated put provision exercizable if the bank's credit rating fell below investment grade. And that wasn't all. The issue also contained a provision that allowed investors to receive 50 basis points in additional yield should the bond fall two notches in creditworthiness, with an additional 25 basis points for each additional notch, until the put threshold of below-investment-grade was reached. The bonds fell due when Moody's Investor Services cut the sovereign rating of Thailand to Ba1. In December, a similar set of provisions allowed investors to put back more than $300 million in Korean bank debt.

The success of these kinds of structures in Asia meant that as the currency crisis worsened, investors shifted out of bonds and into instruments better described as credit derivatives because of the synthetic risk protection in the structure. "It was a moment when investors were happy to give up a bit of return for protection against repayment risk,” says Geoffrey Wallier, head of derivatives marketing at JP Morgan Securities in Hong Kong.

The enforceable switch away from the cash markets showed some of the advantages of credit derivatives. DMG's Tanemura gives the following example: in the Korean Development Bank bonds of 2006, the cash markets for these bonds traded at, say, a bid/offer spread of 20–25 basis points, in lots of one by one (meaning $10,000 at a time). The spread would shift after each trade. In the asset swap market, the bid/offer spread was wider, but the lots were 10 by 10 (or $100,000 at a time). "There wasn't more liquidity in the market,” says Tanemura, "but there was the ability to achieve larger sizes at the right price.” This type of trading in asset swaps typically took place between dealers, but hedge funds and other leveraged investors were attracted to this market last fall because of the arbitrage plays.

KDB, because of the number and size of its issues outstanding, was a focus of last fall's credit derivatives activity. And it is unusual in that the market for asset swaps related to KDB bonds continues to be more liquid than the market for the cash instruments themselves. "The volume went up dramatically in KDBs,” says JP Morgan's Wallier. "But it had the added effect of getting people to focus on the credit risk they carried in their portfolio and provided the impetus to sorting out the other issues surrounding credit derivatives, such as documentation.”

New markets

It is in emerging markets that the broader range of buyers of credit derivatives are to be found. Credit derivatives have been around since 1991, but until 1997 most of the activity was between banks and securities houses. The products were initially developed by commercial banks as a way to manage their unwieldy and often undiversified loan portfolios. To date, the vast majority of deals consist of banks selling the credit risk attached to loans as a way to minimize risk exposure to a particular company, country, region or industry sector. Buyers are usually other banks that want the exposure.

Credit derivatives aren't merely one beast, however. Most credit derivatives are over-the-counter transactions, specifically tailored for particular issues, loans and institutions. Until two months ago, there wasn't even International Swaps and Derivatives Association-approved documentation to serve as an international standard. Although few observers would characterize credit derivatives as liquid instruments, however, the proprietary nature of most transactions is creating real markets in parallel to several large groups of publicly traded bonds. "Certainly there is no continuous trading in most credit derivatives,” says Philip Borg, head of credit derivatives at Bankers Trust. "But I am encouraged by the increased trading in credit derivatives based on Brady bonds in Latin America, some Eurobond issues and increasingly on large U.S. corporates. Tradability makes the market more visible.”

Latin interest

Total return swaps are the instrument of choice in Latin America, although credit default swaps are becoming more popular of late. "The most important driver in the incredible increase in the use of credit derivatives in Latin America,” says Lynette Calder, cohead of ING Barings' credit derivatives team in London, "is the lengthening yield curve in Brady bonds and other instruments. These instruments don't make sense in terms of the time and money it takes to structure them, unless you go out beyond one year. With an extended underlying yield curve, this becomes a way to take just the credit risk you want.”

Managing Corporate Balance Sheets
Even corporates, not early users of credit derivatives, are beginning to see applications beyond the simple curtailment of credit exposure to key suppliers. Credit spread options are popular because they allow issuers to lock in financing costs when prices are low, even though they don't plan to issue for several months.

Like firms trading in Asian putable bonds, U.S. corporates are taking advantage of such devices to raise money more cheaply in the capital markets. Last year, Hilton Hotels sold $300 million of 10-year credit-sensitive notes. As investors were worried about the impact of a possible ITT takeover, the issue carried a provision that adjusted the yield upward if Hilton makes a big acquisition or falls below investment grade within three years time.

For multinationals that find themselves in untenable credit situations, credit derivatives can provide protection that is unavailable elsewhere. That's why Jerome Lienhart, treasurer of Toyota Motor Credit Corp., decided to consider a credit default swap in 1997. Toyota had a number of large euroyen transactions on its balance sheet. Following corporate policy, these had been swapped back into dollars. But it left the company in the position of being owed a great deal of money by Japanese banks at a time when the dollar/yen exchange rate was increasing the burden and credit ratings were dropping for Japanese banks.

In order to place a floor under the situation, Lienhart looked at a transaction that would have involved trading Toyota's exposure to a single-A-rated Japanese institution for the counterparty's exposure to Italy, geared 1.5 times against Toyota. Lienhart explains that he turned the deal down because he was unable to evaluate either the gearing ratio or the Italian exposure. Yet although he nixed this deal, he says he would be more willing to consider such a transaction now because he believes that the credit derivatives market is becoming more transparent, both in pricing and terms.

Convertibility risk continues to be a thorny issue for most corporates, and it is likely that treasurers will consider using credit derivatives in this case. But "it isn't an easy sell. CFOs are notoriously unwilling to pay for protection unless they are convinced that they can't live without it,” says Chase's Gregg Whittaker.


Institutions with a high cost of funding find total return swaps a relatively painless way to improve the yield. For instance, by buying an Argentinean Brady that yields LIBOR plus 70 basis points, a bank that has a cost of funds of LIBOR plus 50 basis points isn't making enough return to compensate for the risk. By entering into a total return swap with a better credit, the buying firm can improve its yield.

Credit default swaps will probably overtake total return swaps in Latin America as the market begins to understand them better. "They are totally synthetic instruments,” says Bankers Trust's Borg. "And many banks are prohibited from selling their assets.” He gives the example of a European bank with a Mexican loan that has 95 percent of its principal covered by a credit guarantee. That portion of the loan cannot be sold, but the 5 percent stub can be hedged with a credit default swap, creating liquidity from a previously illiquid instrument.

Options on credit spreads will also be an area of growth in all emerging markets. "Given the volatility of credit spreads in both Asia and Latin America,” says ING Barings' Calder, "it's a natural progression.” These instruments, mostly still on the drawing board, would allow the holder the right to buy or sell the option at a certain credit spread to, say, sovereign debt. Of course, once the underlying went into default the option would be worthless.

"If you want to sell one of these instruments, it isn't just the dealer who sold it to you who's ready to buy it back.”
Peter Croncota
senior managing director and head of global fixed-income marketing, Bear Stearns

The real test for credit derivatives will be a broadening of the user base. "You've seen corporates and institutional investors in the credit derivatives market already,” says Gregg Whittaker, head of global credit derivatives at Chase Securities. "But the real test will be when there is a better balance between these kinds of users and the traditional bank users.” Others see the expanding user base as the future of the business. "Corporates are only one of the last great frontiers of new users,” says Dan Frommer, associate director of global credit derivatives marketing at Bear Stearns. "We're seeing a lot more interest from money managers and institutions, and even smaller banks. There is a lot more that these groups can do in this area. They have seen that credit derivatives are real risk management tools.”

Other new players are nontraditional bank users, according to Reza Bahar, managing director of Standard & Poor's. "Foreign banks that want exposure to key credits in the U.S. and European markets as well as good relationships in the broker-dealer community are using credit derivatives as a way to create synthetic lending,” he says. "Big American credits such as IBM would never use an unknown foreign bank, and on the other side, the foreign bank may not want the exact exposure that buying a loan on the secondary market would give it. So total return swaps allow foreign banks to gain the exposure they want at costs that are competitive and represent a good use of regulatory capital.”

New ideas

Moving credit derivatives from their vaguely parochial use by commercial banks seeking to improve their loan portfolio risk management requires some creative thinking. Offshore investors looking for new ways to own emerging market debt need only to call on the Union Bank of Switzerland family of notes that give exposure to a variety of pools of debt from Latin America and Eastern Europe. The kicker on these bonds, which aren't investment grade, is that investors can earn leveraged returns at ratios as high as 10 to one on the issue.

Chase Securities is happy to set up a secured loan trust note, which uses a total return swap to mimic the equity tranche of a collateralized loan obligation, and then slaps on an investment-grade rating. The investor places funds into a trust, explains Whittaker, which issues the investor a note. Chase then swaps the note to give the investor a leveraged exposure to high-yield bank loans. The investor receives 250 basis points to 350 basis points over LIBOR, and Chase pockets 100 basis points for its efforts. The original funds are invested in Treasuries and pledged to Chase as collateral for the swap. Chase has done more than $6 billion of these transactions to date.

Pricing and the lack of transparency thereof bothers all market participants. "Credit derivatives aren't cheap,” concedes one market player, "but as the market evolves beyond singular transactions to certain market standards, the prices will drop. And on top of that, buyers are beginning to understand that the benefits of managing credit risk have a different cost/benefit analysis today from that of managing interest rate risk.” The differences are most apparent when it comes to operating in emerging markets, but some buyers still wonder if this attitude is simply marketing-speak to keep the products expensive.

Better standards

The entire credit derivatives business will be helped by the recent introduction of ISDA standardized documentation for the product. The "Confirmation of OTC Credit Swap Transactions,” a 19-page document, sets out the framework for the most standardized of credit derivatives. With eight different definitions of credit events that could have an impact on the transaction—bankruptcy, credit event upon merger, cross acceleration, cross default, downgrade, failure to pay, repudiation and restructuring—this documentation provides a welcome relief from the tedious process of producing one-off documentation for each transaction.

"There is an understandable impatience in the market that it isn't evolving faster. But many people would like the anomalies to remain.”
Garry Rayner
director and global head of credit derivatives and structured assets, Tradition Group

Although a certain amount of standardization had already been achieved in the market, simply through the process of doing deals and using the ISDA master swap agreement as a template, the ISDA contract is a welcome relief. "It means that we can begin to seriously expand our group of counterparties and clients,” says one banker. "Before, it was simply too much trouble to try to bring a new party into our stable. It was weeks of lawyers pouring over documents. Once that has been established, and the first deal done, it gets easier. But documentation was certainly a barrier to entry in this business.” Now, of course, market participants are eagerly awaiting further contract documentation on products such as total return swaps due by the end of the year.

But even ISDA's new Chinese menu documentation will never make the credit derivatives market as uniform in its procedures as, say, the interest rate derivatives market. "Credit involves more variables than interest rates: politics, economics, acts of God. Even if you stood still, credit would move on,” says Garry Rayner, director and global head of credit derivatives and structured assets for the Tradition Group.

And even with the new ISDA documentation pushing the market toward some consensus, many legal, tax and regulatory hurdles still remain. Differences between centers in market practice will continue as well. Yet this also means arbitrage possibilities. "There is an understandable impatience in the market that it isn't evolving faster. But many people would like the anomalies to remain,” says Tradition's Rayner.

This won't open the floodgates, however. Other issues remain. Agreeing on methods to assess price of the underlying, measuring credit risk and figuring out the probability of default continue to take up valuable time for players trying to negotiate deals.

Commoditization of certain credit derivatives, like default swaps and total return swaps, will accelerate because of the standardization of documentation, says Bear Stearns' Croncota. But that won't affect the more complicated, specially structured products. And of course, it is in the one-offs that dealers and bankers make their money. So, predicts Croncota, "we will see a tiering of products within the next few years, just like in any other market.”

In response to the surge of activity in the last year, credit derivatives are coming out of the closet. Banks such as Deutsche Morgan Grenfell, ING Barings and Chase Manhattan have reorganized their credit derivatives desks on a global basis as a standalone product area. "It was important for us to bring all the deals under one umbrella,” explains DMG's Tanemura. "Everyone had a bit of the credit business, but it is interlinked and needed to be organized in a global way.” Not only does this type of reorganization suggest that credit derivatives are becoming a more profitable business for banks, but it seems that it wasn't just end-users that heard the Asian wake-up call.