The Structured Credit Handbook

Acknowledgments xix

About the Authors xxi

About the Contributors xxiii

Introduction: A Roadmap of the New World of Structured Credit 1

How Structured Credit Completes Markets 2

Enabling Technology 3

Improved Liquidity, Transparency, and Customizability 3

Growth of Structured Credit Markets 4

Asset Classes 4

Products 4

Participants 7

Core Uses of Structured Credit 8

Nonrecourse Leverage 8

Diversification 8

Customization of Risk Profiles 9

Separating Legal from Beneficial Ownership 9

Separating Funding from Risk Transfer 9

Isolating and Hedging Risk 10

Representative Examples of Structured Credit Solutions 10

Who Should Read This Book? 11

How This Book Is Organized 11

PART ONE Index and Single-Name Products

CHAPTER 1 A Primer on Credit Default Swaps 17 
Arvind Rajan

The Market for Credit Default Swaps 17

Transaction Terminology and Mechanics 22

Prerequisites for Credit Derivatives Transactions 22

What Happens in Case of a Credit Event? 23

Unwinding Default Swap Transactions 25

The DV01 of a Credit Default Swap 25

The Default-Cash Basis 26

Some Uses of Default Swaps 26

Buying a Note versus Selling Default Protection 26

Freeing Up or Using Bank Credit Lines 27

Filling a Maturity Gap 28

Expressing Curve or Forward-Rate Views 28

Barbell-Bullet Trade 29

Taking Advantage of Tight Repo Levels without Financing 29

Case Study: Relative Value—Cashing In on the Curve Steepness in Telecoms 30

How to Blend CDs and Cash in Long-Maturity-Curve Trades 30

Implementing Credit Curve Flatteners—Two Basic Approaches 33

Appendix: Equivalence of a Bond Spread and Default Swap

Premium 35

Specialness of the Underlying 36

Effect of Accrued Default Swap Premium 36

Accrued Interest on the Underlying Risky Security 37

Accrued Interest on the Underlying Risk-Free

Security 37

CHAPTER 2 Credit Default Swaptions 39 
Arvind Rajan and Terry Benzschawel

Payer Options 40

Example—When to Buy a Payer 41

Example—When to Sell a Payer 42

Receiver Options 42

Example—When to Buy a Receiver 43

Effect of DV01 on Credit Swaption Payoffs 43

Example—When to Sell a Receiver 44

Credit Swaption Payoffs in Default 46

Credit Swaption Implied Volatility 47

Conclusion 47

Case Study: Are Tight Spreads Giving You Butterflies? 49

Introduction 49

Float Like a Butterfly, Sting Like a Bee 50

Butterfly versus Payer 50

Variations 54

Details of Butterfly Construction 54

Conclusion 54

CHAPTER 3 Constant Maturity Credit Default Swaps 57 
Olivier Renault and Ratul Roy

Basics of CMCDSs 57

Participation Rate 58

Behavior of CMCDSs 59

Impact of Spread Level 60

Impact of Spread Volatility 64

Capped CMCDS 66

Hedging CMCDSs 68

Trading Strategies with CMCDSs 69

Selling CMCDS Protection 69

Buying CMCDS Protection 70

Combination Trades and Index CMCDSs 70

Conclusion 72

Case Study: Taking Curve Views with CMCDSs 72

Features of CMCDSs 73

Trade Ideas 73

Appendix: Computing the Participation Rate 76

CHAPTER 4 Credit Derivatives Indexes 79 
Jure Skarabot and Gaurav Bansal

Introduction 79

Family of Credit Derivatives Indexes 80

Structure of the CDX/iTraxx Index Family 81

Administration of Indexes 83

Basket of Credit Default Swaps 83

Trading Example—The Index 84

Up-Front and Running Payments 84

Trading Example—Premium Payments 85

What Happens in Case of a Credit Event? 86

Trading Example—Credit Event 87

Settlement Process after Credit Event 87

Physical Settlement (Indexes and Tranche Products) 88

Cash Settlement (Tranche Product Only) 88

Recent Defaults in CDX Indexes 88

Index versus Intrinsics 90

Investment Strategies with Credit Derivatives Indexes 91

Investors 92

Index-Related Structured Credit Products 92

Issues and Concerns 93

Conclusion 93

Case Study: DJ CDX HY and DJ CDX EM—Conversion of Price Level into a Spread Level 94

Case Study: Using iTraxx to Replicate Bond Portfolios 94

Motivation 94

Typical Portfolio Risks 95

Replicating Interest Rate Risks 96

Using iTraxx to Replicate Broad Credit Market Risk 96

Adjusting for Single-Name Risk through Default Swaps 99

Performance 100

Conclusion 104

Appendix: Description of the Roll Process 106

Risky PV01 of a CDS Contract 106

Calculation of Intrinsic Spread of the Index 107

Risky PV01 of an Index 108

Mark-to-Market Estimation of an Index Position 108

CHAPTER 5 The Added Dimensions of Credit—A Guide to Relative Value Trading 111 
Matt King and Michael Sandigursky

Overview of Curve Trades 111

Learning Curves 112

Drivers of Curve Steepness 113

Putting on a Curve Trade 115

Cross-Currency Trades 116

Cross-Currency Opportunities in Bonds 117

Cross-Currency Trades in CDSs 117

Basis Trades 118

Back to Basis 118

Drivers of Basis 122

Why CDSs and Bonds Are Two Sides of the Same Coin 122

Trading the Basis 126

A New Spread Measure: C-Spread 129

Debt-Equity Trades 129

Meet the Models 129

The Debt-Equity Cycle 130

A Practical Hurdle or Two 131

Debt-Equity Trading in Practice—Arbitrage or Mirage? 132

Deciding What to Trade 133

A Recovery Trade 134

iTraxx Credit Indexes 134

Truly Global 135

You’ve Got to Roll with It 136

iTraxx Intrinsics 137

What Happens When a Name Defaults? 139

Equiweighted or Not 139

Second-Generation Products: iTraxx Tranches 139

Credit Options 140

It’s a Knockout 140

Effect of Convexity on Credit Option Payoffs 141

Delta-Exchange 143

Why Sell an Option (Riskier Strategy) Rather Than Buy One? 143

Option Strategies 144

PART TWO Portfolio Credit Derivatives

CHAPTER 6 Single-Tranche CDOs 149 
Jure Skarabot, Ratul Roy, and Ji-Hoon Ryu

Overview of Single-Tranche CDOs 149

Advantages of Single-Tranche CDOs 150

Key Features of Single-Tranche CDO Transaction 150

Description of the Product and Basic Structure 151

Main Decision Steps for Investors 153

Key Issues in Modeling and Valuation 155

Single-Tranche CDO Risk Measures and Hedging 158

Substitution of Credits 164

Single-Tranche CDO Market 166

Investment Strategies 167

Case Study: Dispersion Trades and Tranches 180

Traditional Bull-Bear Trade 180

Not Just Another Bull-Bear Tranche Trade 181

Who’s Afraid of Blowups? 181

Buy Protection on 10-Year 3 to 7 Percent CDX IG Tranche, Sell Protection on 5-Year 10 to 15 Percent CDX IG Tranche 183

Effect of Blowups in CDX IG on the Dispersion Trade 184

Trade Sensitivity Analysis 184

How to Choose the Most Efficient Tranches 187

Conclusions 190

Case Study: Attractions of Hedged Mezzanines 190

Motivation 191

The Trade 191

Comparing Delta-Hedged Equity and Mezzanines 192

Time-Decay Profile 194

Conclusion 195

CHAPTER 7 Trading Credit Tranches: Taking Default Correlation out of the Black Box 197 
Ratul Roy

The Credit Tranche Market 197

Importance of Default Correlation in Tranches 199

Problems with Traditional Correlation Measure 199

Skew in Default Correlation 201

Further Flaws in Tranche Correlation 201

Correlation Skew Is Like a Volatility Surface 201

Skew Is Market’s Risk Preference 204

Investor Risk Appetite May Scale Across Markets 207

Greeks: Managing Correlation and Delta Risk 209

In Summary: Why Skew Is a Better Model 213

Trading Opportunities for Investors 214

Tranche Correlation Can Still Provide Insight 214

Pricing Off-Market Tranches 217

Conclusion and Future Agenda 219

Case Study: Curve Trades in Tranche Markets 220

Curve Trades, Tranche Markets, and Technicals 220

Trade Recommendation 221

Market Drivers for the Tranche Curve Trades 221

Base Correlation Analysis and Market Technicals 223

Technicals Driving the Flattening of Tranche Curves 224

Analysis of Investment Strategy 225

CHAPTER 8 Understanding CDO-Squareds 229 
Ratul Roy and Matt King

CDOs versus CDO² 230

Value of CDO²s Derives Broadly from Inner CDOs 232

CDO² versus Inner CDO 234

Like Mezzanine, but with Tails 235

CDO² versus Master CDO 236

Economic Value versus Rating Quality 238

Uses of CDO²: Long, Short, and Correlation! 239

Structures: Good, Bad, and Ugly 239

Inner CDO Tranche Seniority and Thinness 240

Overlap of Credits 242

Nonuniformity of Portfolios 243

Fungible and Tradable Subordination 244

How Managers Can Add Value 246

Not Just Credit Selection 246

Manage to the Structure 248

Conclusion 249

Case Study: Term Sheet 249

CHAPTER 9 CPPI: Leveraging and Deleveraging Credit 253 
Olivier Renault

Product Mechanics 253

Managed CPPIs 256

When Is CPPI Suitable? 257

Choice of Trading Strategies 257

Case Study: Performance Comparison of Strategies 258

Baseline: Unlevered Strategies 258

Simulations 258

Results 259

Performance Comparison in CPPI Setup 263

Other Strategies 264

Appendix: Our Methodology 265

Our Estimations and Simulations 265

PART THREE Collateralized Debt Obligations

CHAPTER 10 Collateralized Loan Obligations 269 
Glen McDermott, William E. Deitrick, Alexei Kroujiline, and Robert Mandery

Leveraged Loan Market Overview 270

Strong Primary Market Growth 270

Broadening Investor Base 272

Increasing Secondary Market Liquidity 273

Continuing Challenges to Loan Market Liquidity 275

Key Loan Characteristics 276

Loan Structures 281

Revolving Credit Facilities 281

Amortizing Term Loans 281

Institutional Term Loans 282

Pro Rata Loans 282

Overview 282

Key Characteristics 283

Investment Opportunities 284

Middle-Market Loans 285

Overview 285

Key Characteristics 285

Investment Opportunities 288

European Leveraged Loans 289

Overview 289

European Mezzanine Bank Loans 290

Key Characteristics 292

Investment Opportunities 292

Collateralized Loan Obligations 293

Efficient Access to Loan Market Investment

Opportunities—Introducing CLOs 293

Basic CLO Structure 293

CLO Asset Manager 296

CLO Market Today 297

Key Drivers of CLO Outperformance 298

Conclusion 303

Middle-Market CLO Handbook 303

Middle-Market Size and Definition 304

Growing Investor Demand 305

Dominance of Institutional Term-Loan Debt 305

Second-Lien Loans Emerge 306

Investment Considerations for Middle-Market Investors 307

Legal Considerations 312

Middle-Market CLOs 312

CLO Investment Considerations 320

Conclusion 324

Appendix A: Middle-Market Loan Characteristics 325

Floating-Rate Coupon 325

Maturity 325

Callability 326

Covenants 326

Structure of a Middle-Market Loan 326

Appendix B: The Basic CLO Structure 327

Case Study: CDO Combination Securities—Tailoring Risk/Return Profiles 329

Introduction 329

Equally Rated CDO Combination Securities Are Not Equal 330

Value in Baa3-Rated CLO Combination Securities 332

Conclusion 334

CHAPTER 11 ABS CDOs 335 
Ratul Roy and Glen McDermott

Overview of the Structured Finance Market 335

Basic Structure 335

Roles of Multiple Parties in a Securitization 336

ABS Market Fundamentals 336

Major Characteristics of Structured Finance Securities 344

Relative Value 344

Structural Protection 346

Collateral Stability 346

Challenges 348

CDOs of Structured Finance Securities 350

Investor Motivation 350

A Customized Investment 350

Relative Value 351

Major Considerations in CDO Investing 351

Leveraging Stability—Performance of SF CDOs 354

CDOs of SFSs Take Many Forms 354

Conclusion 358

Case Study: Relative Value in High-Grade Structured Finance CDOs 358

Transaction Overview 359

High-Grade SF Securities: A Strong Track Record 361

Cash Flow Analysis 363

Conclusion 364

Case Study: Untangling Mezzanine and High-Grade Structured Finance CDOs 364

Collateral Composition 365

Collateral Risk 366

Expected Loss 366

Correlation Views 368

Other Differences 368

Conclusion 369

Appendix: Rating Transition Matrices of Common

Structured Finance Collateral 369

CHAPTER 12 CDO Equity 371 
Glen McDermott and Alexei Kroujiline

Cash Flow CDO Income Notes 373

Return Analysis 377

Defaults 378

Recoveries 380

Interest Rate Risk 382

Collateral Manager 384

Collateral Manager Review 384

Asset Selection 385

CDO Investment Guidelines 386

CDO Manager Types 388

Investment and Trading Philosophy 389

Asset Characteristics 391

Collateral Mix 391

Time Stamp or Cohort 392

Diversification 393

Structure 394

Trigger Levels 394

Senior Costs, Swaps, and Caps 395

Manager Fees and Equity Ownership 396

Credit-Improved Sales—Treatment of Premium 396

Conclusion 397

Case Study: Diversifying Credit Risk Using a CDO Equity Fund 397

Introduction 397

Modeling Assumptions and Analytical Techniques 398

Results 399

Conclusion 400

CHAPTER 13 Commercial Real Estate CDOs 403 
Darrell Wheeler and Ratul Roy

CRE CDOs by the Numbers 403

Slow Start, but Growth Now Strong 403

Relative Value: Spread Pickup Often Gives CRE CDOs an Edge 405

CRE CDO Performance Has Been Strong 406

Collateral Mix: Diverse and Evolving 407

Building Blocks of a CRE CDO 409

B-Notes and Rake Bonds 411

Second Lien Loans 412

Mezzanine Loans 412

Preferred Equity 413

Whole Loans 413

CMBS First Loss Positions or B-Pieces 413

CRE CDO Managers and Sponsors 415

Who’s Who 415

What to Look for in a CRE CDO Manager 415

CRE CDO Investors: A Diverse Group 416

Key Events in the CRE CDO Market 417

A Market Is Born 417

The Rise of CRE CDOs as a Source of Financing 418

The Push for Flexibility 420

The Current State of the CRE CDO Market 421

Investor Analysis of CRE CDOs 422

CRE CDO Analysis for Traditional

CDO Investors 423

CRE CDO Analysis for Traditional

Real Estate Investors 423

Additional Suggested Collateral Analysis 428

Analysis of CMBS Certificates 428

Analysis of Uncertificated Securities 429

Appendix: List of CRE CDOs 432

Glossary 437

Term Sheet 439

Notes 443

Index 457