Portfolio Insurance
November 20, 2006; Page C1
The world is awash in credit. For the sake of investors, it had better be awash in good credit analysis, too.
So far this year, a record $2.3 trillion in investment-grade bonds have hit been issued globally, according to Thomson Financial. This already tops last year's $2.1 trillion.
The rise in bond issuance is a trifle compared with what is happening in credit-derivative markets. The issuance of credit-default swaps, which are basically insurance contracts written against debt default, is soaring. As of the end of June, such contracts had been written against a total value of $26 trillion in debt, according to the International Swaps and Derivatives Association. That was up from $17.1 trillion at the end of 2005 and $8.4 trillion at the end of 2004.
Banks and other debt holders can buy credit-default swaps to limit risk. If a borrower goes into default, debt holders will lose money on the debt, but the default swaps they hold will rise in value, helping to mitigate the loss.
On the other side of the trade, sellers of credit-default swaps have a nice source of income, as long as the issuer whose debt they are backing doesn't go belly up.
The boom in credit-default swaps, as well as other derivative instruments that allow creditors to mitigate risk, and the run-up in bond issuance may not be unrelated. The decision to buy or underwrite a bond is easier to make if you can offload some of the risk associated with it. By diffusing risk, the chances for financial blowups seems to be diminished.
But in the process of spending so much brain power slicing and dicing risk and passing it around, Wall Street might miss more fundamental questions about the underlying health of companies issuing bonds.
Frank Partnoy, of the University of San Diego, and David Skeel Jr. of the University of Pennsylvania Law School illustrated this point in a recent paper by pointing out that the banks that financed Enron's debt used massive amounts of credit derivatives to limit their own risk of the company going into default. That is one reason they might have fallen asleep at the switch.
The real test for credit derivatives might not come until the next recession, when the chances of corporate debt defaults will rise. Nobody can say when that downturn will come, but when it does, it will be a nail-biting time.
Write to Justin Lahart at justin.lahart@wsj.com1
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Derivatives Tails Are Wagging Corporate Bond Dogs: Mark Gilbert
By Mark Gilbert
Nov. 23 (Bloomberg) -- The bond vigilantes may have retired; the derivatives vigilantes are saddling up.
Last week, London-based hedge fund Cairn Capital persuaded Experian Group Ltd. to change the terms of a bond issue to safeguard derivatives holders. In October, New York-based hedge fund Blue Mountain Capital told cable-television operator Liberty Global Inc. that the company could have won cheaper borrowing by consulting with derivatives owners before selling new bonds.
Bond prices for Delphi Corp. and Dura Automotive Systems Inc. whipsawed as owners of debt insurance on the two bankrupt U.S. auto-parts makers raced to buy securities to resolve the contracts. And for weeks, European indexes that track credit derivatives have bounced around as traders try to second-guess whether new securities are about to flood the market.
All of which is evidence that the credit-derivatives tail is starting to wag the corporate bond market, altering the behavior of borrowers and directly influencing the value of the securities that derivatives such as credit-default swaps are based on.
Suppose you signed up for a five-year auto-insurance policy, only for your car to disappear in a way not covered by the insurer (zapped by aliens, say). You would still owe the annual premium even though the policy had become worthless.
That's one of the risks facing credit-default swap holders. They may have bought derivatives insurance to safeguard their corporate debt investment, only for the bonds to disappear because the company decided to repay them early, which often happens when a borrower gets taken over.
Reconciling Needs
To get paid on a credit swap, the holder has to hand over the defaulted securities, just like a driver claiming for an unsalvageable car has to deliver the crashed vehicle to the insurer. The swaps become worthless if the bonds disappear.
The deal brokered by Cairn Capital with Experian is designed to avoid that situation. It introduces a new flavor of investor protection to the debt markets, reconciling the credit-checking company's funding needs with those of investors who had augmented their fixed-income investments with derivatives.
In the event of a takeover trashing Experian's credit rating to non-investment grade, bondholders can choose either full repayment or a higher interest rate -- the latter option crafted for investors who don't want to unravel their derivatives strategies by handing back their bonds.
``The technique of offering bondholders a coupon step-up as an alternative to the more traditional put at par is an important innovation,'' said Deniz Akgul, an analyst at Cairn. ``We hope and expect coupon step-ups will be used more widely to ensure stability in the credit-swap market.''
Chasing Debt
Default swaps on Rentokil Initial Plc, a London-based pest- control and washroom facilities company, lost 80 percent of their value earlier this year after a change in its capital structure erased the debt linked to those contracts. Delphi bonds were trading at about 57 percent of face value before the Troy, Michigan-based company filed for bankruptcy in October 2005. With $20 billion of credit swaps and only $2 billion of bonds, prices soared to about 70 percent as derivatives traders fought over the scarce securities.
``Corporate events can have unexpected effects on bonds, with the opposite happening to credit-default swaps,'' says Andrew Sutherland, who oversees about 13 billion pounds ($25 billion) of corporate bond investments at Standard Life Plc in Edinburgh. ``Treasurers have got to be aware of it.''
Unintended Consequences
Last month, default swaps on Englewood, Colorado-based Liberty doubled in 20 minutes after the company decided to replace an existing bond issue with new debt that could be transferred to its Dutch unit, rather than retiring the old notes. That prompted an offer from Blue Mountain Chief Executive Officer Andrew Feldstein, who manages the $3.6 billion hedge fund, to buy new bonds at a lower yield provided the obligations couldn't be switched.
``Advising a corporate client on a bond buyback that will extinguish the reference obligation on which credit derivatives are based generates market-sensitive information just as advising a client on a takeover does,'' Thomas Huertas, the banking- industry supervisor at the Financial Services Authority, which regulates U.K. financial markets, said in a Sept. 19 speech.
At the beginning of the month, an index that tracks the 30 most-volatile European default swaps jumped 6.5 basis points higher in a week, climbing to about 49 basis points after declining for six consecutive weeks.
Feedback Cycle
The moves were driven by speculation about a new strain of credit derivative called a constant proportion debt obligation, invented by ABN Amro Holding NV. Traders tried to anticipate whether ABN had found additional buyers for the new securities, which would have shifted the balance of buyers and sellers in the default-swap market. That sets up a feedback cycle; lower default-swap values make it harder to engineer derivative products at attractive yields for investors.
The credit-derivatives market is too big to ignore. It doubled in a year, surging to more than $20 trillion by the middle of this year, according to figures released last week by the Basel, Switzerland-based Bank for International Settlements.
Companies are typically fixated on their shareholders, reluctant to even acknowledge their bondholders. They are about to discover a whole new constituency of investors clamoring for attention -- the derivatives crowd.
(Mark Gilbert is a Bloomberg News columnist. The opinions expressed are his own.)
To contact the writer of this column: Mark Gilbert in London at magilbert@bloomberg.net .
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Yes the rating agencies were letting Triple BBB paper be repackaged and then given an AAA rating.
| To: John P who wrote (7448) | 11/8/2006 11:34:33 AM | | From: John P | Read Replies (3) of 18561 | | | Ratings Alchemy: Turning "BBB" into "AAA" (the new CPDO Structure)
riskchat.com
From: Lara
Affiliation: Consulting
Address: www_lara@yahoo.co.uk
Date: 29 Sep 2006
Time: 16:33:19
Comments
Has any one looked at the ABN's new "AAA" rated Structured Credit product, the CPDO 10-year note? It basically takes the DJ CDX index and iTRAXX index (made up of average A-BBB rated obligations), leverages it up by about 15 times, and issues it as "AAA" rated FRN (ratings issued by S&P and Moody's). Here are the details: from FinanceAsia.com "ABN AMRO continues to lead credit derivative innovation with its first-ever Constant Proportion Debt Obligation ABN AMRO this week launched its first public constant proportion debt obligation (CPDO). This new form of synthetic credit investment carries a full AAA rating from Standard & Poors on both principal and coupon. It uses elements from both CDO and CPPI technology to produce a new non-principal-protected, fixed-income, credit-investment tool. The CPDO generates returns through exposure to a portfolio of credit default swaps (CDS) which is linked to highly liquid CDS indices. The size of the portfolio is adjusted dynamically so that the CPDO only uses the leverage it needs in order to make the scheduled principal and interest payments. The structure of the CPDO is designed to have a stable rating with a high likelihood of “cashing-in” to a risk-free investment that pays the stated coupon and principal at maturity. "This is the most exciting development in the credit market for several years. The absence of a full rating has made it historically difficult for investors to assess the risks and appropriately place dynamically leveraged credit products into a portfolio. By creating the CPDO with a full rating for the timely payment of both principal and interest we have solved this issue for our institutional investors and broadened the asset choice available to managers of credit portfolios," says Steve Lobb, global head of credit and alternative derivative marketing at ABN AMRO. He adds that the new product allows a wide range of investors who are restricted from investing in unrated securities to access credit instruments that use dynamic leverage for the first time. "
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THESE CPDO's were not triple AAA worthy... they were so crazy in their structure that that as the market moves against the products..... the product is supposed to increase it's leverage to attempt to improve results and hit its NAV target? how is that for crazy world math.
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| o: John P who wrote (7446) | 11/8/2006 11:30:07 AM | | From: John P | Read Replies (1) of 18561 | | | Constant roportion debt obligation (CPDO) -- CDS spreads sink to lowest levels
By Paul J Davies and Gillian Tett
Published: November 1 2006 21:06 | Last updated: November 1 2006 21:06
The cost of buying credit protection in the derivatives market has pushed through its lowest ever levels as bullish views on debt markets mix with a heavy bout of protection selling related to the creation of new structured products.
Spreads, or protection premiums, on the indices of credit default swaps, which provide a kind of insurance against the non-payment of corporate debt, have been shrinking steadily since the latest index series were launched at the end of September.
Some traders attribute this tightening of spreads, which has accelerated in recent weeks, to a benign economic outlook and a widespread belief that Federal Reserve tightening has peaked. But others point to the sudden growth of a new type of complex derivative product.
The iTraxx Crossover index of junk-rated companies hit an intra-day low of 243 basis points, meaning it cost €243,000 per year to insure €10m worth of exposure to the names in the index. The Crossover closed a touch wider at 244.5bp, but was down 2.5bp on the day.
The main iTraxx Europe index of investment grade companies also closed tighter at just over 23.5bp.
ABN Amro launched the first of the new products, known as a constant proportion debt obligation (CPDO), towards the end of August and it has since been rapidly replicated by a number of other large investment banks, including Merrill Lynch, Lehman Brothers and Barclays Capital.
These deals make leveraged bets on the European and US CDS indices and aim to build up returns to hit a certain pre-determined net asset value that will cover all the promised fixed coupon payments to investors.
However, if the market moves against the deal and it makes losses, then it must increase the leverage it employs to try and improve returns and hit its NAV target.
In a report on the structures out on Wednesday, Standard & Poor’s warned that this strategy could be viewed as “chasing losses”.
It is difficult to track exactly how much influence these new structures are having on the opaque over-the-counter CDS markets, but traders say they are definitely a factor.
“CPDOs printing are certainly a factor and a big one, but not the only factor,” said Haider Ali, global co-head of integrated credit trading at ABN Amro. “The economic environment is still good, equities are doing well and there is very little reason for anyone to buy protection.”
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bottom line the rating agencies let all kinds of horrific things occur so that they could earn fees by placing ratings on all the derivative instruments that were being created.
John |
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