Tan first used credit derivatives when he was at Keppel Corp and then more extensively at DBS where he ran proprietary credit investment. For the last year he was been studying the subject while on sabbatical at Yale University. Here he explains, why credit derivatives will be the long-term winners from the collapse of companies such as Enron, Kmart and Global Crossing.
Bull Run In Credit Derivatives
The credit derivatives market has exploded in recent years, with the global market for credit derivative contracts growing from about $50 billion in 1996 to more than $1.4 trillion today, a two-thirds increase on the previous year's survey (Risk magazine's 2002 survey). By the end of 2002, it is expected to total $1.6 trillion of notional value compared to $200 million in the loan markets (see figure 1). The strong volume of credit derivatives has expected to be $1.6 trillion of notional value by 2002.
Back in 1996, I remember my first credit-linked notes (CLNs) trade for an Indian entity, in which long-dated bonds were structured into a three-month short-term note. That year marked an early stage in the development of credit derivatives in Asia and I was indeed a novice; curious and eager to learn. That trade became my starting point for using credit derivatives both as hedging and position-taking proxies for my fixed-income portfolio. And I believe that the search for yield and more importantly, a need for effective hedging instruments will continue to be the growth driver for the credit derivatives business. Indeed, the growth in credit derivatives will be similar to the growth in interest rate swap in the 1980s.
Figure 1: Secondary loan and credit derivatives notional amount
Collateralized Debt Obligation (CDO)
The fastest growing sector of the asset-backed securities market is the collateralized debt obligation (CDO) market. CDOs are securities backed by a pool of diversified assets and are referred to as collateralized bond obligations (CBOs) when the underlying assets are bonds and as collateralized loan obligations (CLOs) when the underlying assets are bank loans. CDOs have seen about $500 billion issuance in the past five years in United States alone, driving the growth in global CDO issuance (Figure 2). These synthetic CDO flows have also fuelled a good deal of spread tightening by creating net shorts in the market.
In theory, the CDO structure is specifically designed to mitigate investment risk, as the deep and diverse pool of debt on which the bonds are secured should mean default risk for the investor is spread thinly. It also allows banks, for example, to take low-margin corporate loans off their balance sheets, by passing them through into a CDO set up as a separate company.
Yet the ugly fallout from the corporate debacle has made it clear that CDOs are not immune to declining corporate fortunes. Debt issued by Enron was also used as the basis for several synthetic CDOs in Europe. Standard & Poor's has estimated that the total exposure to Enron via the credit derivative market at as much as $6.3 billion. Much of this exposure lies in CDOs. More failures at Kmart and in the telecoms sector have resulted in a sharp credit downgrade of CDOs, resulting in major losses among insurers and financial institutions. One such example is American Express which had to take an $860 million charge for write-offs.
Figure 2: Global CDO Issuance Amount (rated by Moody's)
Source: Investing in Emerging Fixed Income Markets-Frank Fabozzi 2002
Credit Default Swap (CDS)
Default swaps are the most widely traded credit derivative. Among the largest buyers of default swaps are banks that hedge loans to free up capital for regulatory purposes and want to limit credit exposure to certain customers. Moody's defined credit default swaps (CDS) as instruments that allow one party to "buy" protection from another party for losses that might be incurred as a result of default by a specified reference credit (or credits).
In contrast to CDO, the growth momentum in CDS market is likely to accelerate. CDS in this round of mayhem has proved to be a good leading indicator of corporate credit quality.
Recent International Swaps and Derivatives Association (ISDA) market surveys showed value in credit default swap market rose 45% in the second half of 2001 compared with the first half. The notional value of all outstanding credit default swaps increased from $632 billion to $919 billion. Trading liquidity and arbitrage opportunities have grown tremendously. To take advantage of that divergence between default swaps and corporate bonds, sophisticated investors who own the bond can sell both the bond and the credit protection giving them similar credit exposure at a cheaper price. Credit swaps deepen the secondary market for credit risk far beyond that of the secondary market of the underlying credit instrument.
Many holes still need to be mended
One cardinal investment rule is to FULLY understand the risks of the trade. I learned the lesson the hard way with a "sexy" Leveraged Total Return Swap trade on an Argentine quasi-sovereign issuer that went haywire in 1998. The credit-event was triggered by a devaluation of the Brazilian Real, which moved the prices of Latin American bonds down sharply. In the end, a two standard deviation event occurred and I found myself owning three times more Argentine bonds that I was prepared to. It was indeed a humbling and unforgettable experience. We were able to reduce the losses by holding onto the bonds delivered and finally selling it at a higher price in 1999. Now I scrutinize the fine print on a term-sheet with a magnifying glass.
This lesson underlined a common complaint about structured products: they are not transparent. A key component of the success and integrity of our financial markets is transparency, the ability to "look and see" what is going on. Transparency depends upon the simple concept of disclosure. The greater the level of disclosure, the greater the transparency. Opaque structures in the synthetic CDO and wider credit derivatives markets make it hard to see what is at risk. (For my case, "greed' also played a role).
The lack of an acceptable risk-pricing model mechanism and robust historical database are some of the related challenges. It is important that all institutions build up the capability to fully understand and manage these risks. Simultaneous reforms in accounting of derivatives are needed too; debates on GAAP accounting of these instruments are currently underway.
Although exposure to individual credits within synthetic CDO transactions are limited to very small amounts - the amount of leverage can be quite high, as the junior/equity tranche is usually relatively sizeable. Many of these are private, and transaction managers often do not reveal the names of bond issuers involved in the portfolio up front, making it difficult to assess credit risk.
I still remember the days when International Swaps and Derivatives Association (ISDA) was not the industry standard and the definition of "credit events" were so murkily defined by the counter-parties that you could drive a bus through the loop-holes. The ISDA definitions now set out six credit events that can trigger payment on a CDS. The current ISDA is not perfect, for example severity of loss events under a credit default swap are still not well defined.
I do not claim to be an expert in credit derivatives but I would suggest that these so-called standard ISDA definitions for credit derivatives were designed primarily as a template and not as a catch-all clause. After all, the beauty of structured product is to structure unique risk allocation for the parties involved. To think that standard documentation can capture all aspects of a private arrangement is pure fallacy.
Wall Street has been able to keep three steps ahead of the rating agencies as evidenced by the latter's rating actions. Most of the time, these rating actions usually come so late that even my mother would know about the problems in these "fallen angels". Certainly credit downgrades are going to come faster as a response to all these criticisms. Investors are also likely to scrutinize the way rating agencies assess credit derivative structures. Often, rating standards seem to emphasize 'form over substance' and intelligent investment bankers could easily structure deals to fulfill the rating requirements.
Conclusion
Synthetic products are under intense scrutiny at the moment. The recent setbacks in the credit markets show the need to have good credit hedging instruments that are transparent in risk pricing. The increasing adoption of standardized documentation, while they are not a perfect solution, bode well for all parties: investors, issuers and banks.
There are still good opportunities for banks, which are willing to invest in the less developed financial markets in Asia. The current lack of good customized software packages to report and process credit derivatives is similar to the operational challenges faced in the development of the interest rate swap market fifteen years ago. Integration of credit derivatives into risk management system and backroom support is key.
The liquidity in secondary loans and bonds in Asia is wanting. The buy-and-hold investors who are reluctant to sell exacerbate the liquidity situation. Credit derivatives will provide the much-needed depth to the secondary market. The liquidity of the credit derivatives market will continue to lure investors. But do it with the eyes' opened; know what are the risks you are prepared to take.
