The long and short of CDOs

The market for collateralized debt obligations based on equity default swaps has failed to ignite. But a new deal that references two portfolios—one long and one short—may shift the market dynamics. Christopher Jeffery reports

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A collateralized debt obligation (CDO) based on out-of-the-money barrier options was closed last month that may reshape the market for CDOs based on relative-value opportunities between equity and credit. The reason: its financial engineers have converted equity into triple-A rated credit that will pay investors 66 basis points over Euribor at a time when other dealers have struggled to achieve single-A rated tranches.

The structurers of the deal, Credit Suisse First Boston (CSFB), are not the first to use deep out-of-the-money put options, generically termed equity default swaps (EDS), to underpin a CDO. The first deals using Merton-based contingent claim model techniques to spot inefficiently priced implied equity volatilities compared with credit spreads emerged about two years ago in private transactions. Then, in January 2004, JPMorgan issued its Odysseus deal, which was referenced to a portfolio of 90% credit default swaps (CDSs) and 10% EDS. Daiwa Securities SMBC took the product a step further in February 2004 with its Zest Investments transaction, a CDO based purely on equity default swaps.

But with the notable exception of structures such as a euro-denominated CDO based on second-to-default baskets referenced on three CDS and one EDS by CDC-Ixis in September 2004, few transactions have emerged in the past 12 months. In part, this is because investors are wary about EDS in CDOs, as they believe the EDS component bears little resemblance to a CDS in distressed market environments.

Equity default swaps are exercised when a share price falls below the barrier—typically around 30–35% of the share’s initial value. When this happens, an ‘equity event’ takes place, meant to mimic a bankruptcy, failure to pay or restructuring credit event. Statistically, however, hitting an equity barrier is far more likely than a credit event.

“It is fair to say the EDS part in CDOs is not priced in the same way as a CDS, and that is why you get some of the yield enhancement,” says Nick James, deputy general manager of structured credit at Daiwa Securities SMBC in Tokyo, who structured the Zest deal. “It is more likely that a company’s stock will fall 70% than it is going to go bankrupt. That will be more expensive.”

As a result, the rating agencies—at least initially—were cautious when rating EDS. “If you look at the real probability of a loss on an EDS-based CDO and look at what the rating agency gives it, there is a normally about a one-notch difference between what it gets in reality and what it gets in theory,” says James.

Supply shortage

But there is a more fundamental issue: the inability of dealers to get a sizeable tranche of a CDO based on EDS with higher than a single-A rating. The Zest transaction, for example, contained A2-rated Japanese government bonds that helped it achieve a most senior tranche with an A3 rating. Daiwa Securities SMBC’s James says it was impossible to achieve a higher rating. The reason for this lies in Moody’s rating methodology, which analyses the performance of a portfolio in ‘normal’, ‘stress’ and ‘crash’ market scenarios.

As Gareth Levington, co-head of structured products and member of the European structured finance unit at Moody’s, says: “If you have a long portfolio, we are assuming that if a crash regime turns up, everything falls over.” This means the probability of the crash regime is the upper limit for a long-only portfolio. “If you want to get above a certain rating, probably somewhere in the single-A rated range, you must cover for that circumstance and hedge out that crash risk.”

So how has CSFB delivered a triple-A tranche? The bank’s co-head of equity derivatives structuring, Lionel Fournier, says CSFB resolved the dilemma by establishing two portfolios instead of the usual one to underpin its e250 million Collateralized Equity Debt Obligation (Cedo) transaction, which hit the market on May 17. The first portfolio was a diversified long investment portfolio of 60 names with an average rating of Baa2 and a bias towards the technology sector. But it is the second portfolio that represents the unique innovation in the transaction: it is a portfolio of short positions on 60 additional names with an average rating of Baa1 and a bias towards the energy sector. This portfolio was specifically included to act as insurance against a market collapse, and market participants say they have not seen such a structure before.

The 65% barrier options on US, European and Canadian names were selected using CSFB’s Credit Underlying Securities Pricing (Cusp) system, which assesses the relative value between debt and equity of a company. Cusp selected names with equity market implied volatilities higher than bond market implied volatilities for the risk portfolio and with equity market implied volatilities lower than bond market implied volatilities for the insurance portfolio.

Cedo’s structure not only provides investors with the ability to exploit relative-value arbitrage opportunities between debt and equity over its six-year maturity, but the inclusion of an insurance portfolio makes Moody’s assumption of near 100% losses in the event of a market crash redundant. If such an event took place, the short positions would then be in-the-money so investors would not be wiped out.

“The rating agencies loved the fact we were long and short with 60 names in each portfolio,” says Stephane Diederich, head of structured distribution to institutional clients in Europe at CSFB. “Each of the long and short portfolios are quite large and diversified, but they are correlated in between themselves.”

Following a year of dialogue with the rating agencies, CSFB issued its series of Cedo I notes in May. These included notes rated Aaa with 79% subordination paying 66bp above Euribor; notes rated Aa1with 54% subordination paying Euribor plus 121bp; notes rated A2 with 38% subordination paying 222bp above Euribor; notes rated Baa2 with 22% subordination paying 390bp above Euribor; and CSFB retained the equity tranche. “Getting an Aaa rating is quite an achievement,” says Daiwa Securities SMBC’s James. “And the 66bp payout on the Aaa tranche looks like a good payout for investors,” he adds.

Investors say they were impressed with the risk/return profile, although the widening of credit spreads in the past two months may have blunted take-up in the transaction, which attracted about €250 million in investment compared with an initial target of €1 billion.

“We’ve seen spreads come in dramatically in the CDO of asset-backed securities market in the past two years, and there are few good alternatives,” says one senior official at a small European private bank, which invested in the A2 and Baa2 tranches of Cedo. “This is one of the first deals to have much higher spreads and a better risk/reward profile. While credit spreads did go up before closing, generally Cedo spreads are higher by about 50bp.”

CSFB’s Diederich says the notes appealed to a number of investors concerned about uncertain equity markets, low interest rates and very tight credit spreads—although Cedo investors are exposed to a large increase in equity implied volatility. “People are focused on buying credit, but often mainly due to uncertain equity markets and a lack of alternatives,” says Diederich. “Investors often say they are not comfortable buying so much credit at 15-year lows in interest rates and credit spreads.”

And that could prove a major problem for credit investors that need to mark their positions to market. “Cedo is kind of a market-neutral situation as in the collateral we have a long side and a short side,” says the bank investor. “We feel much more comfortable with market-neutral collateral. The only other investment we have made recently was in a collateralized fund obligation largely investing in a market-neutral fund of funds.”

CSFB also tweaked the barrier options in the portfolios to better replicate a credit event. “We started with the EDS product, but modified it and enhanced it to make it more credit-like,” says Diederich. “We stuck to a barrier with a low strike, but instead of making the barrier active all the time, including intraday, we only take a weekly observation at Wednesday’s close. This eliminates intraday moves, but leaves the risk that the share price falls on Wednesday morning and moves up again on Thursday morning. So we spread the risk in time. Whenever the share price closes below the barrier on Wednesday, you lose just one-tenth of the amount at risk.”

While Moody’s Levington says it is impossible for an EDS to have all the characteristics of a credit default swap, the so-called ‘temporary dip’ protection was well received by investors as it means the share price must stay under the barrier for at least 10 weeks. “This is important as, to a certain extent, it avoids a high exposure to sudden irregular market behavior,” says an investor. “To just touch a barrier once is too digital.”

CSFB also offered an extra tweak that ensured no default was possible for the first three years of the transaction. “This was appealing as you have a fixed-income payout but exposure to equity risk,” says a senior official at a small European insurer.

Cedo is also attractive from a risk management perspective, says CSFB. Unlike most other cash or synthetic CDOs, where nothing stays on the structurer’s books, CSFB has to risk-manage what it sells to the outside world. So it prefers to sell higher-rated tranches. “It’s great for the salespeople as they would normally be asked to focus on selling lower-rated tranches,” says Jean-Manuel Dersy, CSFB’s head of equity derivatives sales in Europe. “From a risk management standpoint, we prefer selling above single-A rated tranches.”

CSFB will launch another European Cedo transaction in the next two months, and is looking at a potential US dollar issue. But while it may take other dealers several months to mimic the financial engineering required to convert equity into triple-A credit, it may not matter much if credit spreads continue to widen.

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