Times have changed

IFR Derivatives 2008
10 min read

Things seemed to be developing nicely in the leveraged loan credit default swaps (LCDS) market, particularly in the US, where new documentation has been in the works. Yet Lehman’s bankruptcy, and the deepening credit crisis, has turned the market on its head. Jean Haggerty reports.

At a leverage finance conference in Barcelona just days before Fannie Mae and Freddie Mac were taken into conservatorship by the US government, attendees commented that Lehman Brothers was noticeable by its absence. Alongside Morgan Stanley and Goldman Sachs, it was a major player in the LCDS market in both the US and Europe.

Earlier this year, Lehman hired Dresdner Kleinwort’s Tom Johannessen, head of secondary loan sales and trading in London, to develop its LCDS business. Morgan Stanley and Johannessen’s team at Dresdner Kleinwort executed the first inter-dealer senior secured LCDS trade in the European market nearly three years ago.

The number of counterparties for LCDS is dwindling, and has been for some time. Deutsche Bank and Dresdner Kleinwort have backed away from the market, as did ABN AMRO once it merged with Royal Bank of Scotland. Bear Stearns was another significant player in LCDS.

For the LCDS market, the most positive outcome of JPMorgan’s acquisition of Bear Stearns might be if the acquisition gives LCDS a new lease on life. However, that is looking somewhat unlikely, given the state of the credit markets.

Even before the summer of 2007 when the meltdown began, the contraction in the number of counterparties in the LCDS market was already exerting a negative influence over the market. Then, as now, users of the instrument were concerned about concentrating counterparty credit risk with a small number of dealers. Yet now the situation has become far more acute, particularly in Europe. LCDS require a cost base that may not be sustainable with such low volumes. “The challenge is getting more dealers involved,” one official said before global credit markets went off the rails. “[Some] dealers lost money [in LCDS] last year, and it is hard to get the resources and capital to justify a new product.” The LCDS indices, LevX and the LCDX, took a beating last autumn as dealers used it to hedge warehouse risk when the credit crisis began.

Those responsible for LCDS trading at the dealers still involved in the LCDS market may have the ear of management now, but if events continue they might need to scale back their operations.

Until September, credit structurers in New York were focused on developing ways to get funding. The LCDS tranche market seemed stable. “The trouble with cash CLOs is that there are no Triple A buyers anymore,” a New York-based structured credit desk head said in late August.

LCDS tranches were holding up largely because they do not require the whole capital structure. At that time, market participants were saying that the great thing about the synthetic tranche market is that LCDS tranches offer superior returns to the cash product.

In Europe, at least one dealer was optimistic that a LevX tranche market might take root. Yet even before last month there were several other market participants questioning the rationale of introducing a complex tranche market before the underlying was trading with any vitality.

By some estimates, a total of about 360 names have traded in the US and European LCDS markets since its inception. About 30 names were trading regularly in Europe during the summer. In the US around 50-75 single name LCDS could be described as liquid.

“You see good two-way volume on LCDS [in the US] because the credit hedge fund investor base still exists. In Europe, it was hurt [last autumn],” a market participant in London noted, noted in early September. How the credit hedge fund investor base will fare in the current crisis will therefore play an important role in the US LCDS market’s future.

The future is non-cancellable

This summer the US LCDS market was excited about the prospect of non-cancellable documentation. Loan CDS dealers designed the non-cancellable single-name LCDS contract to enhance liquidity, by eliminating uncertainty linked to the cancellability of the current market standard contract. Before the credit crisis flared up last month, some dealers stopped providing liquidity and were running into unwind problems, due to the difficulties related to modeling the cancellability option.

A non-cancellable contract should put to rest worries about the orphaning of contracts. Additionally, credit hedge funds were keen on the shift to the non-cancellable documentation because it could mean that LCDS contracts stay active for longer.

If and when market participants agree on a market standard non-cancellable single-name loan CDS contract, Markit, the index administrator, said it will integrate the language and characteristics of this contract into the LCDX.

Earlier this month, Markit postponed the roll of the index LCDX index into Series 11 until new single-name loan CDS documentation is launched.

The delay of the LCDX roll is not expected to be too persistent. Market participants are confident that after the October 10 auction to determine the final price for certain Lehman Brothers obligations, focus will shift onto dealing with other issues, including central clearing and the new non-cancellable LCDS documentation. The non-cancellable LCDS documentation was submitted to the International Swaps and Derivatives Association (ISDA) in August.

There are pockets of resistance to the US non-cancellable documentation, most notably, the International Association of Credit Portfolio Managers' (IACPM). Almost two years ago, the trade group requested that the documentation supporting US LCDS be altered to include a cancellability option, on the grounds that the syndicated, secured obligations that loan portfolio managers would want to hedge are frequently repaid or refinanced.

"Risk managers have to be able to cancel the related swap or there will be a mismatch between the hedge and the underlying loan asset when it is refinanced. At the very least, that can increase overall hedging costs,” Som-lok Leung, executive director of the IACPM, said at the time.

Although IACPM argued that a more favourable position on cancellability would encourage risk managers to use the product and help the market grow, their position has not been taken on board.

"I can understand the hedge funds and dealers' goals. They may not be participating in the cash market. It is clear that they don't agree with us... Though now, it is a moot point because there is not a lot of liquidity in the LCDS market," Leung said.

As dealers have been willing to write reasonably priced, bespoke cancellable contracts with credit portfolio managers on an ad hoc basis, Leung said that the IACPM it will not take issue with a move to a non-cancelable contract. Market participants said that they are not worried that writing these contracts will have much of an impact on non-cancellable liquidity.

A non-cancellable contract has long been desired among European market participants, but even before the turmoil hit the market, participants were doubtful that such a move was imminent.

“In Europe, to broaden the market you need movement on the public/private [primary loan market information] issues,” an official said. In the US, the market can trade on a reference entity, but in Europe, the information to do that is not publicly released. As such, the European market trades on reference obligation.

Market participants waited a long time for a documentation template for single-name credit default swaps referencing European leveraged loans. After much back and forth, the documentation arrived in August 2007. But the effort spent on getting to that point further undermined the enthusiasm for changing the documentation to accommodate non-cancellable LCDS contracts in Europe.

ISDA in early October launched a revised documentation template for credit default swaps referencing the iTraxx LevX index of European leveraged loans. The revised template incorporates provision for settlement by reference to an auction following a credit event, bringing the European documentation in line with the North American loan CDS documentation in this regard.

“Market participants have seen the benefit of auction settlement in the North American loan CDS market and in senior unsecured CDS and were keen to incorporate it into this product,” said David Geen, ISDA general counsel. The ISDA iTraxx LevX standard terms supplement for use with credit derivative transactions on leveraged loans is designed to document credit default swap transactions, where the reference obligation and the deliverable obligation are a European syndicated secured loan listed in the index.

Earlier this month, ISDA also published a revised version of the single-name standard terms supplement for use with credit derivative transactions on leveraged loans. This template was updated to include auction settlement on the same terms as the index version, providing consistency for those entering into single-name loan CDS trades on reference obligations that are listed in the index.