Sunday, 19 November 2017

US Credit Derivatives Roundtable 2006: Transcript

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IFR: How has the nascent market for loan-based credit derivatives developed and what does the sector need to become liquid?

Doug Warren (Barclays Capital):

I think what the market needs to become liquid is probably a sell-off from the credit markets. At this point, I think most of the involvement has been between loan asset managers, hedge funds and dealers. It is not entirely clear where the natural short is in the market. I think there is clearly a desire to get long through the market. For the natural short you would expect bank loan portfolio managers, but generally they have not been that active. I think they have seen sufficient liquidity in the cash market and they are not as concerned about blowing up a relationship by selling the loan. So we thus far have not really seen a tremendous amount of activity, although there are probably about 60 different counterparties trading it. We've got an index set up with a hundred names in it. People are quoting US$5m-by-US$5m markets, which is decent size considering the cash market probably trades in smaller sizes, although there are a lot more trades in the cash market. But size is decent in LCDS.

So I think it's going to play out over time with the same thing we saw with unsecured CDS, where it took several years before we really saw good liquidity and then it took a downturn in the market really to get people involved. If you look back to 2001, that is when we really started seeing a lot of hedge funds getting involved in CDS and that is when the liquidity really took off.

Andrew Feldstein (BlueMountain Capital): I think it's maybe a little more liquid now than some of Doug's comments implied. We are taking off Bloomberg each day about a hundred different names in LCDS. If you look at anywhere from two to five counterparties, quoting the names, if you look at the inside bid offer across what we are downloading, it looks to be about 10% of the spread, maybe a little less, which isn't a horrible transaction cost. I absolutely think that a downturn would probably jumpstart even more liquidity. But we are starting to do more and more long-short trading within loans, so keeping our long-short trades to the secured-asset class. And we are starting to do a fair number of capital structure trades, the loan asset class versus senior secured and senior unsecured, as well as some basis trades.

It's pretty interesting in loans because there are bases for differences in optionality and your prepayment or your refinancing assumptions make a difference when you are trading a spread-based instrument, which LCDS is, and a price-based instrument, which the actual loan is. So there are some interesting trading opportunities and the opportunity for market participants to express opposing views on those bases.

So I guess I see it maybe a little more liquid than Doug does and the liquidity growing a little faster than he does, even absent a downturn, although I do have to admit a downturn would jumpstart the investor.

Rene Canezin (Lehman): The standard documents this spring helped a lot in terms of liquidity. Clearly, a downturn or a widening of spreads would help substantially. Nonetheless, I think hopefully the upcoming CDX portfolio product will help. The timetable could vary I imagine, but if it was sometime this year it would be nice. That would also lead to either bespoke or tranche-type trading, which I believe will increase sometime in 2007. I think those things would contribute to a substantial increase in liquidity even without spread widening. But clearly, that would be a healthy aspect to the market.

In terms of generic liquidity, it is getting more liquid. There are probably 50 names that we would feel comfortable making two-way prices in on a daily basis. And I guess if you polled across five dealers, you would probably get up to 100 quite easily. But in terms of overlapping names, it is probably in the range of about 50 to 100. I think bid-offer spreads have contracted and I think a lot of that is dealer contraction to get clients more comfortable with the product, as opposed to true liquidity being seen in the marketplace. I think we have to be a little cautious around that. But I think guys are seeing more relative value in the trading and I think ultimately the growth will come from capital arbitrage types. There are going to be some bank loan guys, but when people are comfortable with the capital arbitrage aspect of the product, then you'll start to see more guys getting involved in both sides and two-sided markets. And we're starting to see that already.

Tom Jasper (Primus Guaranty): We hired a high-yield team earlier this year and are certainly very interested in the space. We are ramping up a CLO right now. But clearly, one of the reasons we hired the team was to not only do CLOs but also to look at loans as an asset class which ultimately we potentially could invest in.

The question is: does it fit the Triple-A DPC model? I think the jury is still out on that. And I think a lot will depend upon what the rating agencies decide on what kind of recovery values you can put in for leveraged loans. Certainly when you talk to people in the marketplace, their expectations in terms of recoveries tend to be very high. I'm not sure that Nik and his team would be that comfortable with a recovery that high, given what we know they feel about senior unsecured-type paper.

Nik Khakee (S&P): I think Tom is on the key point. At Standard & Poor's, we have been rating loan portfolios going back to balance sheet trades in 1998. So seeing loans in a credit derivative format in a synthetic CDO, for example, is not new. What is new is the new documentation and the fact that these are non-banks. The old trades that we were looking at were primarily banks looking for regulatory relief on their own balance sheets.

This is different, this is a traded product. So what the team is doing right now is focusing on the new documentation, looking at what recovery rates are going to be assigned. In the old transactions, we did give a recovery benefit because that documentation was very specific. For example, it was secured loan only, and if you couldn't deliver on that, you couldn't collect on the protection. So we did give credit in our recovery for those types of trades where there was that type of documentation. I think the team right now is excited because I think they believe that this is going to be something that we are going to be rating over the course of this year and next year.

IFR: Do bank loan hedgers simply have an issue with the way their books look at the moment? Are they less active due to mark to market losses, and how are banks are coping with those in reporting them?

Derek Smith (Deutsche Bank): I continue to think that of all the new products out there, loan CDS probably has the most potential. We are seeing it growing at a pretty sharp pace and I think that is a function of loan portfolio managers getting familiar with the contracts and also finding a satisfactory pricing difference in the unsecured general CDS versus specific, for them to be interested in actually using it as a hedging vehicle. They definitely are using it, but I think it is a little bit a function of where spreads are.

IFR: What was the experience with the preferred CDS market and how has it evolved in its second year?

Amit Agrawal (AIG): Trading volumes have increased, but liquidity remains to be desired. The wide market participation is still lacking. Only three dealers actually make markets in PCDS currently. And the document just became standard a couple of months ago. Hopefully more dealers will get on board. If you look at the preferred asset class, it's still a small asset class, roughly US$350–$500bn in preferred deals and about, say, 50 names that actually should trade in swaps.

For any market to have a two-way market, you need natural buyers of protection. When the market came into being, I didn't see any because the preferred market is a retail market and retail don’t hedge, they just buy yield and put it away. We certainly got involved with the Tier 1 ECAP structure that came to market. A lot of insurance companies went through with the NAIC on whether these things are clarified as equity or debt. And because of that, there has been huge volatility in the space. It is a great relative value trade if you think, say, preferred should trade three times the unsecured CDS, and it is trading four times. For people who are looking at fundamental-based relative value, I think it is an asset class to get involved in.

But I see a problem for preferred CDS, as the history of preferred defaults is there have been very few defaults because most of the issuers are banks. Banks don't go in default on their preferreds or miss a payment because it sends a bad signal to the market. If they default, eventually they go into bankruptcy anyway.

So risk management becomes a very difficult job because you don't know whether you're getting paid enough because there is no history group to take cues from. I think that becomes a problem. The market has not been tested yet with any kind of default here. It is a good market to look at in terms of relative value and capital structure arbitrage. I'm not sure it is a great hedging tool yet.

IFR: You mentioned only three dealers. Have you suggested to other dealers that they start making markets and that you would reward them if they did?

Agrawal: There was a meeting spearheading the effort to make documents as standardised as possible. I think there's volatility in ECAPs and there is money to be made. So I think dealers do want to get involved. It is just a question of time; I think they will get involved. We have asked a couple of guys to make markets. We went long positions with guys who are not active.

Canezin: Also you don't have the same type of traders necessarily in the preferred world that you may have had in the high-grade and high-yield credit world traditionally, in terms of their derivative expertise.

I think that is also going to take a little longer to get guys up to speed.

But eight dealers signed on to a new contract in June, or sponsored it. We have traded with six of those dealers already, so definitely there are guys in there. That doesn't mean they make two-sided markets every day, but there are dealers out there making markets.

IFR: What are the issues for trading credit derivatives on the asset-backed side?

Feldstein: We are not active on the asset-backed side. We just haven't gotten comfortable with that market yet. I think that the degree of transparency in the market is less, certainly than the LCDS market. The ABS-CDS market right now is characterised by two big opposing camps doing trades, doing a single trade in the opposite direction. You have got CDOs selling protection and you have got hedge funds and some dealers buying protection. It is just a big bet on opposite sides of what happens to the housing market. All the trading is going through the market in these big lists coming out each day. Lots and lots of volume, but it is very hard for somebody to know where things are really clearing and to know that there really is two-way price transparency.

So you have got all the maturity CDOs on the one hand and you have got mark to market traders on the other hand, and if the housing market does blow up, I just wonder, given the prevailing liquidity in the market, and some of the protocol around two-way prices, whether those guys are really going to be able to get out where they thought they were going to be able to get out.

The other issue that concerns us is that the most common underlying ABS tranches in the market – the Triple B's and the Triple B-minuses – typically are US$10m to US$20m tranches out of the structured financings. Yet they can have hundreds and maybe even billions of dollars of CDS written up on them – so much more than we have ever seen in the corporate market, there is a very big imbalance between the structured flow and the underlying. And the contracts were all pay-as-you-go contracts as opposed to contracts with a necessarily logical settlement date if something bad were to happen. So there's a lot of difference in our mind between the ABS market and the corporate CDS market. We just have not gotten comfortable enough yet to get involved in it.

Warren: Pay-as-you-go was developed to avoid the physical settlement problem that you would have had, having US$100m or US$200m size written on a US$20m tranche. But it's not clear that it necessarily will work mechanically. The question is what will happen to the market when it does happen, which has not been tested yet.

IFR: Are recovery locks being widely traded?

Canezin: Recovery locks are unique in that, historically, everyone has used for modeling purposes a 40% recovery on a lot of bonds, whether they felt that way or not. It was just standard analysis. I think recovery locks have added a lot of insight into the marketplace in terms of the arbitrage we talked about before with either loan CDS or other type of CDS, preferred as well. We have seen an interesting dynamic in that as credits become more volatile, recovery locks become more active, obviously for things that are on the run CDS names.

The auto sector, for example, has been very active in recovery locks, and trades with very tight bid-offer spreads in size. And most of that is because they obviously are in the news a lot, they have near-term volatility and longer-term volatility and you can even get a sense of what the recovery lock curve would look like -- meaning you could make a one-year, three-year or five-year view on the autos in terms of recovery. That has made it very interesting from a capital arbitrage standpoint.

As names become distressed in virtually any sector, then it becomes more active but with a lot more volatility in the recovery lock market.

IFR: What are standard recovery lock bid-offer spreads?

Canezin: Something like GM would trade with a four or a three-point bid-offer spread. It is not the same traditional points as bond points because everything is adjusted by probability of default. So a recovery lock might trade 48–52 in GM, where there is a relatively tight bid-offer spread.

Warren: The issue with recoveries is that default swaps basically trade on expected loss, and when you have a high probability of default, then recovery rate becomes very important and then people start trading the recovery rate. So when you make that transition to a high likelihood of a credit event, you get the transition at the same time from trading probability of default to trading loss in the event of default.

Smith: I think for those of us who have been around for a while, recovery swaps or locks, whatever you want to call them, are probably the oldest derivative credit-like contract. It was very popular in EM credit derivatives and was traded pretty liquidly on Russia, Argentina and a lot of the names that had some problems in the late 1990s. It has actually been relatively slow to develop in the credit market, but we have always had the expectation that it should be a liquid and significant product. You need people that are actually opining on the eventual recovery of an entity and it has really been the growth in distressed players in the credit derivative market that has opened up that avenue of investors. And then on the flip side of the derivative players who use them are ones that are hedging open recovery risk in their typically more structured books, but even in a vanilla derivative contract.

So you needed a time where you had a big build-up in open contracts of names and then they actually had to get in trouble and then you had to have distressed investors, too. Now we have all that and players who are up to speed on, for example, the term structure of volatility.

IFR: On the subject of volatility, is options trading liquid?

Canezin: Portfolio options do trade actively, whether it is high-grade or high-yield, and there are three to five dealers in those products that are active two-way in size and other players who are involved as well. Single-name credit options are pretty much still by appointment only, and they tend to again be more topical-type credit issues. So if a name becomes very distressed or has some kind of digital outlook to it, like a deal or no deal scenario, you tend to see more interest in option contracts. But for traditional volatility trading you do not see single names with any kind of liquidity yet.

Agrawal: It is too bad it hasn't developed because there are natural buyers and sellers of options. You just need the credit cycle to turn and a lot of traders will come back to the market for this market to really develop. I think one thing we need to develop is standardised pricing, because dealers’ markets are not always defined. That is a function of the volatility they use when they use CDS history volatility, the equity volatility.

Warren: I think one of the issues is that credit volatility is significantly different than looking at, say, rates volatility. Rates move in small increments and you are not going to see an interest rate, at least on a G7 government, move 200bp in a day. In credit you can see that. So I think in the absence of having good liquidity to get out of positions, people are pretty loathe to put on big gamma positions. Because you really are trading gamma, you are not really trading volatility at this point, we are really much more trading gamma because they're all one-month, three-month, six-month, and maybe a little bit of one-year expirations. So it is much more sensitive to gamma than it is to vega. I think there are definitely uses in that market and I think insurance companies should be big players in terms of selling covered calls, which I think is a slam-dunk in a tight-spread environment. People should be looking to do that all the time. But we haven't really seen that and I think part of it is because insurance companies typically are relatively slow to embrace new products.

We do see tremendous liquidity in the index options and a lot of players and maybe five dealers are active. In the single names, it is difficult to find dealers who will really get involved. I think one of the things that happened is dealers did start trading the single names, getting ahead of themselves, kind of like Rene was saying in the PCDS. They were making the bid-offers tighter than the liquidity really warranted and they got caught in short gamma positions and so people have backed away from doing that because there is not enough liquidity to get out.

IFR: One issue this year has been the topic of successor entities for default swaps due to corporate finance shifts. How has that been handled in the US and Europe?

Feldstein: In terms of how the market has reacted as a community in the different events this year, I think it has been great. There has been pretty open dialogue. But some of the language and the definitions need to be clarified. The definitions, as we have seen repeatedly over the last five years, when they are written can't capture every potential scenario. As we learn more about the markets and the way things play out, we need to modify the definitions. And so I think it is a good thing that people are taking a look at the succession events this year and the clarifications that might be needed in the definitions.

IFR: There have been some concerns about whether banks have information on exactly how a restructuring is going to work in terms of the new entity, or whether they have corporate finance conversations that could give them useful trading information. Is that an issue?

Feldstein: I think that given our level of activity, both in the US and in Europe, we would be one of the counterparties screaming the loudest if we thought that were true. And we're not screaming. We are perfectly comfortable right now that to the extent there is inside information, which I'm not sure there is or isn't, it certainly isn't being transmitted in any kind of systematic or devious way to the trading desks.

Jasper: The succession issues are a big thing for us in terms of how it plays out for the cash bond investor versus the CDS investor which, of course, is what we are. I think it's an important issue and we have become much more active with ISDA on this topic in trying to push through a view that comes from an end risk-taker in this marketplace versus a hedge fund or a dealer. I am not sure that the issues are fully understood by those people that are end risk-takers, like the insurance companies, that are getting involved in it. And certainly the rating agencies need to pay attention to it, too. So we are quite concerned about how it ultimately turns out.

Smith: Succession, when it was in its last incarnation, was actually thought about quite a lot when it was written. It is a little bit like restructuring in that initially it was written to try and contemplate all the things that could possibly happen in corporate actions. Perversely, a similar thing that happened to restructuring is going to happen to succession, I believe, which is that it is actually going to be simplified.

The thing I'd say that is of note and likely to be pushed through is the idea of a two-stage test, meaning first you're going to have a succession event where it has to be a defined corporate action and then you apply the 25% test. It is going to be simplified, where we're not even going to try to say what are all the possible corporate actions that qualify. Instead, we are going to say in connection with a general corporate action, that if this has happened, and more than 25% of obligations have moved, that will qualify as a succession event and the appropriate thing will happen to the contract. It will or will not split 50-50. Even this will have potential issues that you were referring to in that the big issue is if debt moves in connection with an exchange, are you left with an entity that has no deliverable obligations and that CDS essentially gets worthless?

We think the key to solving that is that it has to be understood, and to educate. We have had success in educating bankers and capital markets people, basically the issuing side, because if they understand that there is a large body of CDS on a particular name or piece of their future corporate structure, it actually behoves them to issue into it, because there is some demand where they can get improved pricing. At times that can be something like 100bp. So actually the market will take care of it, in a large degree, itself.

IFR: Do treasurers understand that now when you explain it to them?

Smith: Well, the number of succession events we have has been increasing but is still small. In recent cases, I think that the treasurers did understand it well and, where possible, thought about it to incorporate it into their issuing strategies.

Feldstein: I don't think it is that complicated an idea to understand. There are shorts out there, those shorts will expire worthless, in which case you will be selling your new bonds to people who aren't short and you will pay more spread to people who aren't short. Or you can satisfy the short sellers and sell your bonds to them, and allow them to cover, thereby saving money. I think a couple of corporate actions have been structured apparently to appeal to that market dynamic.

There are a couple of things that ISDA panellists are thinking of changing. Number one is the idea that used to be the case in connection with a succession event that a series of events, if connected, would all be treated as one and the same. That could cause a lot of problems because if it happens two days later, is it the same thing and how connected does it have to be and what does it mean to be substantially connected? They are talking about doing away with that notion.

Khakee: For us, it is just a matter of measuring default. First, did a default event occur? Second, have the parties agreed to what the resolution is. I mean, in most of the transactions that we have rated, this either leads to a replacement so that somebody can actually fill the balance back up in the portfolio, or an agreement that the balance of the portfolio swap is going to be reduced. For us, it is all a ratings volatility question to make sure that the parties have agreed what action is going to be the right action, given that a successor event has occurred. Shrinking the balance may actually have a ratings effect simply because all the new calculations are being done based off of different percentages now. You just don't know.

Warren: I think, from a trading perspective, that the problem that people have had with the succession definitions is that you can have two different ways of getting to the same economic outcome, one of which will be a succession event and one of which won't, I think initially the intent of setting up the working group was to solve that problem. I think people got to the point where they said there's just too many different ways that these things can happen and there's no way you can cover them in a definition and then just went to a very fact-based, simple formula for figuring out whether there was a succession event or not, and who the successors were.

Agrawal: A succession event is important when it comes to when people put on basis trades and the bonds could actually tighten and the CDS could go wider. So I think it is something that people have to focus on. This is an issue which should be on the front burner and to the extent we can simplify the documentation for it, it will go a long way.

IFR: Moving on to the issue of settlement, is everybody happy with how full cash settlement will work, and development of a system for deliverability dispute resolution.

Warren: Resolution is not resolved yet, that is the one outstanding issue. I think the concept of having experts is a nice concept, but the question then is who are going to be the experts, and thus far nothing has sprung to mind that everybody has agreed upon. In terms of the mechanics of it, I think the most important thing was having a process that was in place that people agreed to, that would satisfy the basic requirements of what we wanted. There are nuances that could have been done differently, but I think people are generally pretty happy with it. Because clearly, once we got trading indices, there was a disaster waiting to happen, trying to settle all these contracts physically. Just operationally it was overwhelming.

Smith: The large outstanding issue to be addressed is that of dispute resolution. I think the market started tending towards this idea of having a panel of three arbitrators, and then when it actually came to practically trying to choose the arbitrators as an exercise the market has found it difficult. So I expect us to maybe reconsider the idea of having a panel of a combination of dealers and end-users. Maybe something like nominating people for X period of time, a year or two, and rotating through would work well.

Feldstein: I think that there are probably a variety of solutions. That sounds like a reasonable one. The devil will be in the detail. But I would agree that getting dispute resolution right is one of the big outstanding issues.

And I think that the idea is to try to utilise this set of rules for the next couple of defaults to work them out before memorialising them in some kind of official addendum to ISDA. So I think it will be easier going into the next default than it has been in the prior four or five big ones, because there the market was adapting the last protocol that was used and in a rush, trying to sort out what some of the issues were. And now, the next time around, through the participation of dealers and users, a lot of the issues have been worked out and this protocol will get used the next couple of times and hopefully flesh out a few more issues, and then it will be in all likelihood memorialised into an addendum.

IFR: Has the whole issue of trade novation been resolved?

Feldstein: We never thought it was that big of an issue.

Warren: We did.

Canezin: It actually has improved quite dramatically – though it is still relatively inefficient. I mean, we still trade e-mails as we do a novation process every day. There is no central repository exchanging that information between client and dealer and the second dealer. That is obviously something that has to be worked on. I think everyone would agree to that. Whether that goes onto the back of the warehouse discussion, in terms of something that helps consolidate everything in terms of the non paper-based system and gets rid of all the e-mails, or if it is separately handled through some kind of electronic platform, I think we all agree that we still do need some kind of straight-through-processing for assignment issues. But I think the process has gone remarkably well and I think for the dealers it was a dramatically welcome change in how we do our business with their clients.

Feldstein: It was funny to me because the novation protocol was simply an agreement to enforce the rules that already existed under ISDA, and the reason I did not think it was a big deal is because we already followed the rules under ISDA. Basically, the dealer community got together and agreed that there would no longer be a race to the bottom by permitting novations amongst their clients and themselves without adherence to the rules. The reason it has gotten better is because there is this effective agreement among the dealers that everyone will follow the rules. I think the same thing to some extent is true of straight-through processing. With respect to over 90% of our trades, we do straight-through-processing to our prime brokers. Our average outstanding daily confirmations are about two days' worth of trading volume, so the confirmation and the straight-through processing issue for us again is something that we solved with our prime brokers.

I think that the issue is that there continues to be in bilateral agreements among market participants a willingness to do things on e-mail, to do high volumes of trades before the confirmations have been all caught up to date and I think that it may facilitate the process for the dealers again to all get together and say look: ‘We are going to bind our hands together so that none of us can do this race to the bottom and allow these kinds of volumes to float through the market without papering them right’. But it is perfectly possible to solve that problem simply by your bilateral relationships with your counterparties and bilaterally agreeing not to do business without having the documentation aspects all squared down.

Jasper: I'm with Andrew on this point. It has never been an issue for us. Any novation that we needed to address was all documented. We are not actively trading a book, so from our standpoint, the volumes were not that significant. The protocol I agree was just basically papering what had already been agreed to, certainly in the way in our relationships with our counterparties.

IFR: Is everybody comfortable with the way the CDS trade warehouse is likely to work?

Smith: I think the combination of the novation protocol and mandating that any significant participant has to electronically match trades has dramatically affected the market. The statistics as best we can tell industry-wide are something like at least a five-times decrease in outstanding confirms. It seems like the last link in the chain for that will be the trade warehouse. This will in general help efficiency overall, and help us do netting on a regular basis in a more efficient way. And, probably most critically, it will allow streamlined credit event processing. I think in general we are comfortable with the evolution. We have been comfortable and as best we can tell, the Fed has been comfortable with the progress that dealers and end-users are making and expect this to be the last link in the chain, at least for vanilla products, to be completely electronically traded.

Warren: Initially, the purpose of the warehouse was to help with settling credit events. I think over time, people will find more and more uses for the data that is there because it is basically a complete record of the trades that have taken place. So I think it will evolve in terms of what people use it for. I think using it to net settlements is a great additional benefit that you get from having all that information concentrated in one place.

IFR: Amit, you mentioned that in some of the markets that you are in, there are too few market makers. Are there any other changes in relations with dealers that you would like?

Agrawal: I think there are two issues here. There is information exchange and trading levels, or liquidity. In terms of information exchange, it has gotten better. When you see a new name show up, you always get colour, and you know why it's trading. We still have issues where we think the dealer community and bank hedgers sometimes have information that we are not privy to. That fear or concern has lessened over time, but it is still out there. In terms of the trading level of liquidity, that has improved dramatically and we see markets are a lot tighter. But CDS is commoditised now. Back when we were primarily trading bonds, it was more relationship-based. When you called a dealer, they knew exactly where the bones were buried and where the bonds were and they could put in an order that was a lot more fundamental-driven and do a lot more work to get you the right levels. As CDS is more commoditised, you can get levels everywhere. The relationship which we felt was there is less in CDS than it was in bonds.

Also there's a lot of momentum trading in CDS where spreads are just blowing out and it just keeps going wider, and we are scratching our heads sometimes about what is going on.

IFR: How often is information asymmetry brought up as an issue to dealers?

Warren: Almost never. It is pretty rare that you hear that. Years ago, from time to time you would hear rumours that somebody was doing something right ahead of a bond deal coming out. But I almost never hear that any more. I think that compliance departments are pretty powerful in the banks and they do enforce Chinese walls pretty strongly. So there is not a lot of information leakage going on inside the institutions, at least not my institution.

Feldstein: I think that kind of activity would be very visible to the market, and I think there are a lot of people in the market who would not hesitate to publicise that kind of activity very loudly. So I think it is not only the compliance departments of the banks, which I agree have gained much greater relative leverage over the past several years, but it is the market itself that has an ability to discipline participants who would try to do that.

Smith: I see three areas that people are concerned about. One is the area of material inside information and loan trading. I think that for several years, dealers have had an extremely heightened sensitivity to this, since probably 2002 in the credit derivative market, and probably the biggest change has been that the ability to have permeable walls is not at all constrained any more to the dealer side. Hedge fund participants are probably just as worried about it or more worried about it. The loan market now is much more than exclusively a bank product. Something like 60% of the loan market is now public side and hedge funds are a huge participant in extending loans. For them, it is actually a newer problem to deal with Chinese walls. I think they are being very aggressive about it, especially at the bigger hedge funds. But I think for them it is probably more of a challenge than at broker dealers and banks.

The second issue around moral hazard in the market that we still see is around the restructuring issue. Potentially you can see them around successor issues. But again, dealers are very much in the same position as the rest of the market community.

That leads me to the third one, which is this idea that dealers want to control the market and there are 10 to 15 major participants. There is so much focus and so much money involved in the credit derivative market that I don't think anybody who's looked at this market through objective eyes can point to a single decision and say that market participants and dealers were not trying to find the right solution, and not a particularly short-term favorable solution for the outcome of any of their trading books.

IFR: There are increasing numbers of applications for credit derivatives product company ratings. What are the issues are in terms of obtaining Triple A rating approval, and how might increased competition affect the market?

Khakee: For us, DPCs go back a long time, to the 1990s and high-rated intermediation vehicles between lower-rated broker dealers and the market. They needed higher-rated counterparties because there was less appetite for collateral posting and less belief in collateral posting, and you still had a large number of market participants that preferred higher-rated counterparties. The CDPCs are now focusing on the credit derivative market, but their mandate is a different one. For the most part, so far they are long risk-takers, so they look more like buy-and-hold entities. There is certainly nothing that precludes them from being more active traders, but that is the type of proposal that we have seen so far. They have come in two flavours, one which focuses on single-name credit risk. And then you see more movement across all of the discussions that we have been having with more tranche product and how to look at ABS.

The focus is on the basic types of contracts – selling protection on single-name corporate credit risk, portfolio credit risk, single-name ABS and portfolios of ABS and CDO tranches. People have not gotten more complicated than that yet, although these things tend to grow, and as this industry matures that will change too. I think the core ratings paradigm for Standard & Poor's is that since these are not being rated as mark-to-market trading books, we take our lead from CDO-type models and look at the probability of default models along with what type of correlation assumptions are appropriate - again from the perspective of default and not so much where prices are going to move in the book on any given day. And obviously recovery assumptions are part of that.

Where market price comes into the analysis is that because these are being given counterparty ratings, we then are also rating the entity's ability to make good on any termination payments. Most swaps that we see have some sort of second option or the ability for a manager to pay a termination payment if that were to occur. We have seen that as a core part of the ratings process, so that these managers are not only able to be rated on the basis of making good on the credit protection contract, but also to be able to close on a swap if they were ever to face an event where that was a possibility under the ISDA. It is default-based modeling, using Monte Carlo simulation, looking at ABS, corporate credit and tranches.

Jasper: It is a very efficient model. So the likelihood of other CDPCs coming to the market is something that we have been expecting for a long time, and we have been somewhat surprised that it has taken this long to happen, though depending upon who you talk to at the five to 10 different institutions that are trying to get to the market, that does not surprise us. We welcome it. It doesn't really have any impact in terms of our strategy going forward. I think we fully understand the limitations to the model as well, and there are some. The basics of how we operate and now that we're a public company are pretty well known to everybody. But we do come to the market with a different type of business model than certainly anybody else around the table here. So clearly we have different interests in a lot of the issues that we're talking about. There are now two CDPCs and maybe there will be four in a year, or five. I think that's perfectly reasonable and something that, again, we are not concerned about from a competitive standpoint. Given the amount of capital that these entities can bring to bear to the credit swap market, it is tiny in comparison to the size of the overall market.

IFR: What is the appeal for banks in setting up credit DPCs?

Canezin: It is two-fold for banks. One, banks can actually help set them up and effectively be functional equity owners and participate in the market that way. The second way is just from a banking perspective, obviously bringing clients to the marketplace and acting as the banker on the deal. I agree with Tom that it clearly has been much slower to develop than many would have envisioned when the first one came on line. And I think also that we won't see seven new ones next year; we will probably see closer to two to three to four coming on line. So I think the market will continue to be cautious in how these things come. It is a long process to form one of these. There are many hurdles to go through from a ratings perspective and obviously there are two agencies to deal with around this as well, many times with different requirements. I helped set up some of the DPCs in the '90s designed for interest rate swaps, so I do remember all the pain that you go through in setting these things up, and they're not easy. And that was in a rate market which has more historical analysis to be done. With credit there is much less data available and I think the agencies therefore are rightly a little more cautious in how they approach it and what the model leverage permits.

I think it will have a relatively small impact on the overall single-name market in terms of additional capital to be put to work, and probably will be slower in terms of developing than maybe some think.

IFR: Another thing taking a while to develop is a credit futures market. Are futures a good thing and will they affect the market materially?

Warren: It would be a very different trading model than we currently have. Basically now the dealers intermediate the risk and the dealers will take down the risk and hold it. In the futures market, it is a question of whether the dealers continue to be big participants and provide liquidity, or are we going to be looking at any issuers to try to provide liquidity to each other. I think the latter model, while eventually it may work, is going to take a long time for it to get to the point where you really are going to be able to have good liquidity in the futures contracts. Generally the dealers probably are not that keen to have futures contracts. So it is not something that we on our side have been pushing for the question is whether without dealers actively trying to get into there, it can get there or not.

On single names, given the size of the market that you need in order to have a successful futures contract, I think it limits the number of single names that could ever have futures contracts. The index is obviously the most likely candidate for a futures contract, but then you start running all the single-name risk through one market and the index risk through a different market and I think you wind up with dislocations that probably are difficult to overcome.

Canezin: I agree. It could lend itself to an index product. It is very unlikely it would ever be a single-name product. The sizes aren't there anyway and clearly the dealers are a big part of taking down the risk on those trades. So I would agree that if the futures market does develop, which it could over time, it would be a relatively small player. Even if it does launch it may go the way rates futures have gone, which was nowhere. So I think we already have the history on this one as to where this is going to go.

Smith: Even if you are agnostic on it, you should just look to what the demand is in the market. And if the demand in the market is there it'll happen, and if not, it won’t. I probably get a call from either an exchange or a similar institution once a week on whether a futures contract should be launched or it shouldn't be launched, or ‘what do you think of this one’. I have yet to get a single incoming phone call from any user or a broker who was actually asking for an exchange.

Canezin: You can get a locked market on the index most days, for US$1bn up. So I don't know what the advantage would be. And if you're going to do a large contract, you want it to be OTC anyway.

IFR: Regulators seem satisfied with progress on processing. Which other regulatory issues are likely to develop?

Jasper: I think the market continues to be very exposed to headline risk. With the Amaranth problems in the last couple of weeks, again the D-word was attached closely to what happened there. Some of the issues we have talked about today, such as insider trading, come out occasionally and again there are calls for regulation. There is always this fear in the marketplace over how big the market is, how it works and whether we should be controlling it. The derivatives market is vulnerable to that and will continue to be vulnerable to that, and I think that it is incumbent upon the dealers in particular to self-police, to make sure that that ultimately it does not happen. Because I think we all understand the implications of that. It's going to be an ongoing issue. Has been for a long time and will continue to be.

Warren: I think one thing you have to look at is how regulated the entities are that are highly involved in this market. The hedge funds are not regulated, but I don't know who is more regulated than banks and dealers. So there are a lot of checks and balances. You do have people come in and look at what we have on. We do have the Fed exerting pressure, and we have heard it in some comments recently about how much collateral we are getting from our customers and what kind of loans we are making to hedge funds. So there's always talk about it, and I think that once it is held up as the stick it makes people accept the carrot as their alternative, which is self-policing.

Agrawal: There was a crisis at Amaranth, so there will be talk of regulation and that's the cycle we go through. After LTCM there was talk of regulation, and there is talk of regulating the rating agencies every time there is a default. But I don't see any reason to regulate at this point in time. You guys are doing a phenomenal job self-policing so far and I haven't seen anything warranting any regulation yet.

IFR: The credit cycle still hasn’t turned and some new markets are being hampered by low spreads. What are the most rewarding trading areas at the moment?

Feldstein: For us, it has been very broadbased this year. The correlation markets – while obviously much calmer than last year – have offered a lot of opportunities and good returns. Single-name trading, both in long-short strategies as well as capital structure strategies, has been quite profitable. We do a fair amount of debt-equity trading. Ours is very fundamental-based, so we are looking for stories where our fundamental analysis tells us that the debt in equity is either going to diverge or converge. We have had good success there trading credit both against individual equities as cash equities and as equity derivatives. Our index trading has been quite profitable - again, index arbitrage-style transactions as well as macro trading indices and expressing views on the state of the credit markets by trading an index against another, either across the volatility levels of indices - IG versus high volatility versus crossover versus high yield - or across regions, Europe versus the US, for example.

Jasper: The Single A market generally speaking has not been very attractive this year, but we have found the bespoke market to be quite attractive and it still offers us very good risk-returns. But generally speaking, a turn in the credit cycle is something that we, like a lot of people, would like to see.

Agrawal: Long-short fundamentally-based relative value strategies have been most profitable. One other big trade is the front end of the auto basis swap market. Those have been very profitable trades because you have a good crystal ball over when it is going to happen and you can just clip your coupon and load it down to zero. So those trades have been very profitable. But it is largely the long-short trade and taking advantage of the technicals in the tranche market when dealers have to hedge. You can take advantage of that.

IFR: In trading debt against equity or just the tranche markets, do models give useful signals?

Feldstein: We are not dependent on Merton-style models in the way we look at things. We do have screening tools, where we are looking at market prices, historical prices, and financial statistics of different issuers, to develop a universe of names to screen. But the decisions about what to trade are all themselves fundamentally based.

Smith: With the large increase in M&A transactions and LBOs, debt-equity trading has changed in that we have a lot more traditional merger arb-type players coming into the market. To put it most strikingly, Merton would classically tell you either to be long in equity and short debt, or long debt and short equity. Often a trade that looks attractive and has proven in hindsight to be correct is to actually be long both of them or short both of them. So that alone will tell that reliance on your traditional models is not the correct thing to apply in these situations. We have seen a vast increase in the number of users who are putting on new-style arbitrage, and what we mean by that is not only using equities, long-short of equities, but using the debt components as well in new ways.

IFR: How many new participants of this type have come into the CDS market?

Smith: Certainly over 50.

Warren: I think anybody who is involved in credit has to be very cognisant of LBO activity and that blows up the Merton model, because the Merton model had static thresholds and fixed amounts of debt outstanding and did not encompass the potential for corporate action. So we have seen a lot of people very active in LBO names using both debt and equities as instruments.

Agrawal: One thing that has grown this year is curve trading. A lot of people are putting flatteners and steepeners. I think there are good trades to put on if there's an LBO, and the curve will steepen. One of the developments this year is the liquidity in all points of the curve, which has really helped put on curve trades. The five-year is always liquid, but the 10-year point has seen a lot of increased liquidity this year because a lot of CDOs are down at the 10-year point now, which creates inventory in which you can source that risk.

IFR: Are bond to default swap basis dynamics widely understood in the market?

Smith: When asked the question:

‘Do you understand the drivers of the bond basis?” People will say: ‘Sure, we understand it. It is balance sheets, repo and synthetic CDO client demand and balances.’ But in terms of how efficient the market is in basis, we actually do see opportunity, and are seeing opportunities now in it. For example, particularly in widespread names, we are seeing negative-basis trades. In tight-spread names, we just don't think that is a sensible long-term equilibrium, so we are seeing trading opportunities there.

IFR: How will the market evolve in 2007?

Canezin: In terms of product development, I think LCDS will potentially have the biggest growth next year in the marketplace, both in terms of single-name trading and in index and in the correlation. I think many feel that the credit cycle is poised to turn in 2007. Having said that, the market has been looking for the credit cycle to turn for some time now. I don't think the trade is to set yourself up to anticipate the credit cycle turning because it may not come and you'll have a pretty disappointing 2007. So effectively what we've tried to do is enhance our activity around the products that will have growth absent of a cycle turn. Obviously, with a cycle turn virtually all products work, because then you have volatility.

Jasper: To the extent that we see better opportunities to invest – i.e. wider spreads – clearly that's a good thing. The other thing that we certainly are hopeful for is a broadening out of the CDS of ABS markets and more liquidity coming into that market. We are quite interested in how that market develops and clearly are keeping an eye on the LCDS market as that evolves and trying to figure out exactly how that will play out from our standpoint.

Feldstein: I agree that LCDS could be one of the bigger products of next year, I definitely think that's something to keep an eye on. There is a lot of private equity capital out looking for higher returns. So there is a potential for adverse consequences to debt holders. I don't know if that is the thing that tips the market to wider spreads, because each of those events as they accumulate still seem to be viewed more idiosyncratically. There is still this standoff where the mezzanine and senior investors in synthetic CDOs still have sufficient capacity and interest that if spreads back up even a little bit, the pipeline resumes again in earnest. That is keeping a check on spreads. And so the question is what kind of event or change of view causes spreads not only to widen out 5bp to 10bp, just to be pressed back down, but out past that checkpoint of the mezzanine buyers - which basically means what event causes mezzanine buyers not to come back in. I am not sure any of us know what exactly the tipping point would be.

I don't think an isolated default would do it. I think a series of defaults very well may. I don't know how many defaults in widely-used names would cause large-scale downgrades to the synthetic CDOs. My assumption is one wouldn't, but maybe five or six would.

Khakee: I think it depends on the products. We have been saying this for a number of years. The high-grade deals have a lot less room for multiple downgrades and multiple defaults. I think that if you're in an ultra-high-grade portfolio, you probably have room for certainly more than one but not 10 or 20 before you start to see ratings impact. Whereas if you're in a high-yield or low-rating portfolio transaction, you have a lot more room.

For CDPCs, the time it takes to get these ratings completed has been shrinking. The projects that we have in-house right now, the first threshold is what we call our preliminary rating letter and that type of letter now is something that we can deliver in anywhere from four to 12 months, which represents a significant shortening of time relative to when Primus first came in. That has a lot to do with general criteria being agreed. Where time is now spent is when you move into more complex portfolios.

Agrawal: Right now, the credit cycle is well-behaved. But it is not going to take a lot of defaults for people to get scared of investing in CDOs. One or two high profile defaults can bring that fear back into the market. I think that could be the catalyst that Andrew was looking for.

I'll make one observation.

You have seen a lot of people participate in this market, but insurance companies and money managers have not been really actively involved, I mean, in terms of really taking advantage of this market. So what we will see going forward is breaking down the barriers to a situation where insurance companies can look at all instruments across the gamut, from senior debt to preferred and then create this long-short effort.

The favorable accounting treatment on CDS is also a boost for insurance companies to get involved in this market. And capital structure arbitrage continues to be one of the big areas of development going forward.

Smith: We are probably in a prolonged tight-spread environment. Inevitably in a low risk premium environment, we think investors will be forced to take more risk for equal returns. So we see probably an extension in maturity of traded CDS beyond 10-years. We think we'll start to see 15-year CDS in companies that have outstanding debt.

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