SURVEY - DERIVATIVES: Synthetic deals take on natural growth curve: SECURITISATION by Claire Smith: Synthetic securities are becoming increasingly commonplace but the complexity of some deals adds in the possibility of operational and legal risks
Financial Times, Sep 25, 2001
By CLAIRE SMITH
The fastest growing sector of the ebullient credit derivatives market is synthetic securitisations, which accounted for over Dollars 200bn of the Dollars 800bn total global market size in 2000.
Whereas default swaps continue to dominate the market in terms of notional amounts outstanding, synthetic securitisations, which use default swaps to supply the credits exposure which backs the securities issued, account for the biggest percentage of average dollar volumes traded.
These, together with credit-linked notes - which are issued by banks and contain credit derivatives - account for 59 per cent of trading volumes.
Credit default swaps arrived in 1999 and were first included in hybrid collateralised debt obligations (CDOs) that include both loans and credit default swaps. These days completely synthetic deals are commonplace, with the underlying credit assets being simply a collection of default swaps.
Issues based on default swaps command a higher yield, as spreads on them are bid up due to demand for credit protection from banks, corporate treasurers and hedge funds.
The involvement of investors is transforming the credit derivatives market by transferring risk through to the best marginal buyer, says Mike Connor, managing director of structured credit derivatives at UBS Warburg in Stamford, Connecticut.
One industry initiative, aimed at satisfying the demand from money market funds for good quality short-dated paper, is to create notes of the required maturity and currency by incorporating interest rate and currency derivatives, linked to a longer dated exposure to a credit within a special purpose vehicle, which issues the securities.
A danger arises from any inversion in either the yield curve or the credit spread curve, which will make the longer term assets more expensive to finance.
Sourcing, parcelling up and selling on of credit exposure to suit investors' demands has taken the place of issues of bulky multi-tranche collective debt obligations, driven by a bank's desire to slim down its balance sheet. This is not to say that the deals are necessarily smaller. New entrants into the credit market are demanding sizeable ready-made portfolios, according to Jonathan Laredo, head of structured products at JP Morgan.
"We have seen as much business this year driven by investors as wasdriven by issuers in 2000, as euro zone investors switched their attention from equities to credit in the aftermath of the stockmarket downturn," he says.
With a typical notional amount of Euros 500m-Euros 1bn across a portfolio of 50 to 100 corporate entities, investors can achieve significant exposure to corporate credits without having to identify and deal in a single cash instrument.
It is understood that some 20 deals of this type took place in the first half of this year, and thus a significant increase above the 2000 figure of Dollars 40bn can be anticipated in 2001. Lack of capacity among European corporate entities could limit future growth, however, with Mr Laredo citing just 300 liquid names.
Antoine Chausson, head of credit derivatives structuring at BNP Paribas, remarks on the increasing flexibility provided by derivatives to the securitisation and repackaging market, whereby credit exposure can be warehoused or assets financed on a longer term basis by using a ring-fenced transaction issued by a vehicle which has no credit rating.
One example of a fully synthesised securitisation programme is the BNP Paribas Riviera Finance One, an arbitrage CDO special purpose vehicle, which issued three tranches of five-year notes of varying degrees of seniority on Euros 1bn notional of credit default swaps on 52 different entities diversified by industry and geography.
According to Mr Chausson, insurance companies typically take the most junior paper (the most risky element) for additional yield, whereas banks and finance companies take the more senior tranches.
Credit derivatives could also supply a rather elegant solution to the change in the treatment of liquidity facilities which are usual in asset-backed commercial paper (ABCP) programmes that is flagged in the Basel 2 Capital Adequacy Accord.
Rather than suffer a charge for capital usage for providing a liquidity facility, the ABCP issuer might offer a credit default swap to the holder of a portfolio of credits, with the swap providing the credit exposure on which commercial paper is subsequently issued.
Inclusion of exotic features is increasing, for example, 'knock-in' or 'knock-out' of an interest rate or currency swap that is triggered by a credit default. This means that any default of the credit could either create or extinguish the swap transaction and adds further complexity to risk management, in what is still a fundamentally illiquid and developing market. Reserving of profits on open positions and using conservative assumptions in risk parameters minimises the risk of booking unexpected losses.
This is a market where disputes over terminology and trigger events on the simplest default swap are frequent. Thus, creating back-to back credit derivatives deals, and adding in associated transactions in derivatives on other assets, might seem premature.
Witness the lawsuit between Deutsche Bank and UBS when Deutsche Bank refused to pay up on a credit default swap because the name of the reference credit had changed following a transfer of ownership. Banks must be careful to ensure that the end product accurately reflects the features of all of the instruments underlying the transaction.
Operational and legal risks occur when linking derivatives transactions together.
Jeanne Bartlett, partner at legal firm Orrick Herrington and Sutcliffe, has worked with a number of banks to set up guidelines incorporating checklists and flow charts showing what approvals and which form of documentation are necessary.
Copyright: The Financial Times Limited
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