I am traveling so I can't post them all at this point. Here is the first one.
Loan-only CDS poised for take-off
By Richard Beales
Published: July 24 2006 18:25 | Last updated: July 24 2006 18:25
Bankers love the kudos and rewards of creating an entirely new financial instrument. Most innovations, however, are more evolutionary than revolutionary – although they can still be immensely profitable.
That is the hope for loan credit default swaps, or LCDS. These credit derivatives allow market participants to buy and sell a type of insurance against a borrower defaulting on its debt.
The market for credit default swaps based on unsecured debt - generally speaking, bonds - of companies and countries has sky-rocketed in recent years to reach more than Dollars 17,000bn globally by the end of 2005, a figure that measures the total exposure underlying outstanding derivatives contracts.
LCDS contracts, by contrast, are designed to track the credit of secured loans - specifically the leveraged, or junk-rated, loans used mainly in private equity-led buyouts. When a company defaults, its secured debtholders typically recover more of their money than unsecured lenders do, making secured loans less risky. But lenders may still need to hedge their exposure, while hedge funds and other traders are increasingly making speculative credit bets in-volving all parts of a company's capital structure.
The potential for LCDS is clear. Lisa Watkinson, head of structured credit business development at Lehman Brothers, says that in the unsecured CDS market, the total exposure underlying derivatives contracts has mushroomed to become worth a multiple of the value of the actual unsecured debt trading in the cash, or physical, market.
The nascent Dollars 5bn-Dollars 10bn LCDS market, meanwhile, remains only a tiny fraction of the volume of all leveraged loans outstanding. If the LCDS market ends up following the same path as unsecured CDS, it could grow to be worth many trillions of dollars.
Several factors point to an acceleration of LCDS trading on both sides of the Atlantic.
To begin with, there is huge interest in gaining exposure to the leveraged loan market through derivatives. Dramatic growth in the issuance of the loans in the US and more recently in Europe has been fuelled both by hedge fund activity and demand from investment vehicles known as collateralised loan obligations, or CLOs. A CLO holds a portfolio of loans and repackages them as securities with different levels of risk for sale to a variety of investors. Demand for CLOs - which offer extra yield compared with other similarly-rated fixed income investments - has spawned a plethora of vehicles, which in turn compete to buy leveraged loans.
CLO managers are itching to get the same credit exposure in derivative or synthetic form, which they can achieve by selling protection in the LCDS market.
Meanwhile, non-bank in-vestors are increasingly active in the leveraged loan market - once dominated by big lending banks - making the use of complex derivative strategies much more likely. Bankers say that as much as 80 per cent of US leveraged loans are provided by hedge funds and other non-banks. In Europe, banks still make up more than half the market, but their share is falling rapidly.
Two other developments could help the LCDS market take off. First, the US and European markets now trade on largely standardised, although currently somewhat different, documentation templates - reflecting in part the different composition of the two markets.
"Standardisation of the documents is the key," says Tom Price, director of Markit, the data and valuation group. Reaching this landmark has proved crucial to the liquidity and growth of other CDS markets.
In addition, in both the US and Europe, bankers are developing LCDS indices tracking the combined credit of dozens of companies. In the unsecured CDS market, indices have become by far the most heavily traded instruments, both as ways to take broad bets on credit and as ingredients in complex strategies.
For LCDS, the iTraxx LevX index in Europe and the LCDX in the US could both go live this autumn.
Yet despite its potential, one problem for the LCDS market so far has been a shortage of buyers of protection, such as lenders hedging loan exposure or investors taking a negative view of credit. "(At a recent conference) the joke was there were 400 in attendance, but 398 were protection sellers and only two buyers," says Mr Price. But he adds that the situation is now improving. "Things have started to even out more."
One reason is that new capital rules for banks may also encourage the most obvious buyers of LCDS protection - big lending banks - to use the instruments to manage their exposures, says Richard Stuart-Reckling, product manager for European credit derivatives at Morgan Stanley.
The Basel II rules, which are due to take effect next year, are designed to match better the capital that banks are required to hold with the risks that they take, and Mr Stuart-Reckling says banks' returns on capital could suffer in some cases unless they hedge more of their loans.
In addition, betting against the credit performance of leveraged loans no longer seems the non-starter it did for a time.
Default rates declined in recent years and remain at historical lows, but are now widely expected to start ticking higher. That means LCDS protection, typically bought under a five-year contract, could become more valuable.
Hedge funds and other market players are becoming more and more sophisticated and increasingly invest across the spectrum of a company's capital, from equity through to senior debt. And LCDS offers them something they did not have before.
"Now investors finally have a way to short leveraged loans," says Jeremy Vogelmann, LCDS trader at Lehman. "They look at it as a relative value play."
If those investors ultimately find the LCDS market useful, the sky could be the limit. |
