Features : Credit Where It’s Due


As global securitization markets continue to deteriorate, the credit derivatives space is a beacon of light in a relatively dark landscape.



Long: The key is to determine which structures have been hurt which have stability.

Most companies face some credit risks as a result of their business. This is one area of risk management that still eludes the skill set of many treasurers, although more and more are looking at it as something to examine. For corporates, credit risk comes in many forms, although it is most evident in any exposure to counterparties, where there is a risk they will default on obligations, particularly when a sale is made. Those with long-term fixed contracts can face considerable credit risk as a result of this. The credit portfolio also presents some credit risk, among other business activities.

Although credit derivatives have been primarily the domain of banks and insurance companies—using it to manage credit risk and to grow yield on loan portfolios—corporates are increasingly looking to the derivatives space to help manage credit risk. In the broader scheme of the credit derivatives market, corporate use continues to represent a very small piece of the market, but the strength of the product—even in dismal market conditions—demonstrates its potential value as a tool for risk transfer.

Credit derivative contracts offer protection against credit events occurring in the underlying paper. Credit events in the context of corporate contracts fall under three main categories: bankruptcy, failure to pay and restructuring. The details of what constitutes each event are defined in the derivative contract. If a credit event were to occur, it instigates a payment on the derivative contract.

Many structured product markets have suffered greatly as a result of the US mortgage market debacle, most immediately in the RMBS (residential mortgage-backed securities) space and consequently in all areas with direct or indirect exposure to RMBS. However, although most products in the derivatives space have been rocked by the downfall of CDOs (collateralized debt obligations) with RMBS exposure, the credit derivatives space has been somewhat of an anomaly.

Those products with complex contracts at their core, such as CPDOs (constant proportion debt obligations) and the like, have indeed been affected, and few such deals are now being done. But not all of the credit derivatives space has been shut down. In fact, some parts of the market continue to grow as though a slowdown had never occurred. Edmund Parker, a partner in the finance group at law firm Mayer Brown International, says, “The complex trades get the headlines, but by volume 83% of credit derivatives is still single-name CDSs [credit default swaps for a single company], so it seems that market is still increasing.”



Parker: Some of the concern arises out of the large amount of credit protection written on just one name.

Indeed, according to figures from the International Swaps and Derivatives Association (ISDA), the market grew 81.5% in 2007 to $62.2 trillion, from $34.5 trillion at the end of 2006. At mid-year 2007, when market news began to worsen, the credit derivatives market had volumes of $45.5 trillion. Richard Metcalfe, senior regulatory adviser and head of global policy at ISDA, says, “Recently released volume statistics show that over the course of the last six to 12 months, when credit repricing reached its height, CD volumes continued to grow.” This makes sense, according to Metcalfe, because at its heart a CDS is an instrument through which you can transfer risk, similar to insurance. “In an environment where there is palpable risk, what will you use to manage that if not credit risk transfer instruments?” he asks.

CDSs function in a way that is particularly accessible to wholesale market participants because they isolate credit risk components and strip them out. Also, they allow investors to get further away from the liquidity component that exists in the price of bonds, which is important in this credit environment, with asset-backed securities collateralized debt obligations (ABS CDOs) marking down in price as a result of the drying up of liquidity.

“With credit derivatives there is a minimal call on liquidity when you enter into a contract because settlement payment is contingent upon a credit event,” says Metcalfe. “Otherwise, the payment flows associated with credit derivatives are relatively small—a small premium payment paid quarterly. There is a focus solely on credit risk, which is why they have been consistently growing for the past 10 years, even in the more recent down market.”

However, there has been a push to increase control and clarity in settlement of over-the-counter (OTC) products, such as CDSs. Parker notes that some of the concern arises out of the large amount of credit protection written on just one name. “With single-name CDSs,” he says, “you have an awful lot of credit protection written on one name. The issue really started with [auto parts maker] Delphi. There was a lot of credit protection on the name without owning the asset. When the CDS was triggered as a result of default, suddenly everyone had to go out and get Delphi debt, so the debt went up far in excess of its worth after the default.”


One development that is helping to drive growth in the credit derivatives market is the advent of credit derivative product companies (CDPCs)—firms that focus on investment in the credit derivatives space, and, of late, particularly in single-name CDSs. Douglas Long, executive vice president of business strategy at structured finance software provider Principia Partners, says, “We are seeing a lot of new CDPCs over the last six to nine months that have been rated and a few that have progressed to launching.”



Metcalfe: With credit derivatives there is a minimal call on liquidity when you enter into a contract.

The growth in this space is really related to the capital structure and strength of such companies. They fill a unique need in the market: moving risk off balance sheet for banks. “Also, they allow banks to hedge out mark-to-market exposure and therefore reduce balance sheet volatility,” adds Long. “We are seeing growth in the CDS space still driving the market, and there are few people out there with the ability or willingness to fill that gap. This is where CDPCs come in.”

However, the ability of the market to grow is contingent upon increasing understanding of what exactly a CDPC does. “The big thing that people are discussing is increasing the level of understanding of what a CDPC is and how to get counterparties comfortable with the structure,” notes Long. “They have not been around for a long time, and it is important to broaden that understanding of the structure and risk and its strengths as a derivative counterparty.”

“The key thing that people are going through now—especially with a market where everyone is quite nervous—is differentiating between those structures that have been hurt versus those that have the stability to continue through the rough market,” says Long. As CDPCs continue to demonstrate their strength, the development of these companies will continue to help grow an already strong market.

Denise Bedell