The JP Morgan Chase deal, called Odysseus, comprised 90% CDS and 10% EDS and was rated by Moody’s. The Daiwa deal, however, consists entirely of EDS, referenced to 30 Japanese listed companies. Called Zest Investments V, the structure comprises ¥23.4 billion ($216 million) of rated notes – ¥6.3 billion of Class A notes provisionally rated A3 by Moody’s; ¥8.1 billion of Class B notes provisionally rated Baa2; and ¥9 billion of Class C notes provisionally rated Ba2. The notional amount of the portfolio is ¥45 billion.
“Being a new product, we had to work with the investors to make sure they understand the methodology, understand how the tranches are put together, and understand what the risks are,” says Nick James, deputy general manager, structured credit, at Daiwa Securities SMBC in Tokyo. “But with the Nikkei at 10,000, it will take a 70% fall before we reach the trigger level, so you’re talking about the Nikkei close to 3,000. So logically, it was something that was interesting for investors to look at.”
Equity default swaps are essentially equity put options, but investors can buy or sell protection on a particular company in a similar way to credit default swaps. The rationale behind the product is that a massive drop in a company’s equity price can almost be a proxy indicator of a company defaulting or being close to default. So, rather than being subject to a credit event, such as bankruptcy, failure to pay or restructuring, the protection seller pays out once the stock has fallen to a pre-defined trigger level, in this case 30% of the stocks’ initial value.
With credit spreads in Japan close to record tights – the CJ50, a multi-dealer index comprising the 50 most liquid credits in Japan, is currently at just 24.97 basis points – a CDO of equity default swaps can offer higher returns for investors. By basing the trigger on stock prices, it’s also easier to monitor when a trigger event has occurred.
A number of other dealers in Japan are looking to follow suit and launch rated CDOs of EDS, with around five or six houses currently in negotiations with the ratings agencies. However, some bankers have argued that the Moody’s ratings methodology currently makes it difficult to structure economically viable EDS transactions.
The ratings agency uses a similar methodology to its CDO ratings, relying on historical data and basing the probability of hitting the trigger level on the rating of the reference company. A market regime factor – normal, stress and crash – is also included, each regime requiring changes in the correlation assumptions and probability of hitting the trigger. It’s these assumptions (not publicly released) that have been criticised as being overly cautious by some dealers. “The initial indications are that these parameters, the correlation and regime probabilities, look to be very conservative,” says one Tokyo-based dealer.
Indeed, the Daiwa Securities SMBC deal requires high subordination levels of 56%, 38% and 18% respectively for the A3, Baa2 and Ba2 tranches, a factor that may dissuade some dealers from seeking ratings on EDS portfolios. “If the subordination is too high, in some cases, you’re better off not rated,” comments another banker.
Nonetheless, Moody’s has stressed that it intends to continually fine-tune its ratings methodology as the EDS market develops. “We have issued our rating methodology, but we will continue to refine the assumptions,” says Yusuke Seki, vice-president and senior credit officer, structured finance, at Moody’s in Tokyo.