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Credit Derivatives:
Usage, Practice and Issues
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
Page 2
Outline of Presentation
• Introduction/General • Variants on Basic CDS
Background
• Big and Small Bang
• Basic Mechanics of a Credit Protocols
Default Swap
• Ongoing Industry Initiatives
• Synthetic CDOs/Basket and
• Interesting Legal and
Managed Trades
Documentation Issues
• Novation; Index
• CDS and the Financial Crisis
Transactions; Master
Confirmations/Matrix • Proposed Legislation
Supplement; NOLs
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Introduction/General Background
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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— Liquidity risk
— Credit risk
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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• Participants
— Commercial banks/investment banks (as portfolio managers and as
dealers)
— Insurers/reinsurers
— Hedge funds
— Collateralized debt obligation and other investment funds
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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— The annual growth for credit derivatives was 20% from $45.5
trillion at mid-year 2007
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Basic Mechanics of a
Credit Default Swap
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Fixed
Seller Buyer
Float ing
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Issu er Ho ld er
Repayment
Syn t h et ically Principal + Syn t h et ically
" Sh o rt " t h e Interest* " Lo n g " t h e
Cr ed it an d Cr ed it an d
" Lo n g " t h e " Sh o r t " t h e
Pr o t ect io n Pro t ect io n
6
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Appreciat ion
Payment s
Int erest or
Dist ribut ions on
Ref erence
Obligat ions
Seller Buyer
Cost of carry
(t ypically LIBOR +
spread)
Depreciat ion
Payment (s)
Synt het ically Synt het ically
" Short " all " Long" all
economic risks economic risks
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
AAA/
A aa Se l l e r ( s) - A A / A a R i sk
C Se l l e r ( s) - B a a 3 / B B B - R i sk
A A /A a
B
Baa3/
BBB A Se l l e r ( s) - U n r a t e d R i sk
U n rated
Bu yer Se l l e r s
A - C u m u l a t i v e l o sse s u p t o 4 % o f e n t i r e p o r t f o l i o
B - A d d i t i o n a l c u m u l a t i v e l o sse s u p t o 1 2 % o f e n t i r e p o r t f o l i o
C - A d d i o n a l c u m u l a t i v e l o sse s u p t o 4 0 % o f e n t i r e p o r t f o l i o
L o sse s u su a l l y m e a su r e d t h r o u g h c a sh se t t l e m e n t
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Physical Settlement
• The right of the Buyer upon occurrence of a Credit Event
to deliver Deliverable Obligations to the Seller and to
receive from the Seller the Notional Amount (usually "par")
Cash Settlement
• The right of the Buyer upon occurrence of a Credit Event
to receive cash in an amount equal to (a) the Notional
Amount minus (b) the current market value of a Reference
Obligation
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Documentation
• Based on 2003 ISDA Credit Derivatives Definitions published by
the International Swaps and Derivatives Association, Inc.
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Documentation
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Credit Derivatives
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• Reference Entity
• Reference Obligation(s)
• Credit Events
• Settlement
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Credit Derivatives
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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General Terms—Distinctions
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Credit Derivatives
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Credit Derivatives
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Succession Events
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Credit Derivatives
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Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
D id th e p a rtie s e le c t Page 30
R e s u lts L e ft to
to h a v e th e No
C o n tra c t L a w
S u p p le m e n t a p p ly ?
Yes
H a s a S u c c e s s io n
No N o C hange
E v e n t O c c u rre d ?
Yes
D id a n E n tity s u c c e e d
T h a t E n tity is th e
to 7 5 % o r m o re o f th e Yes
s o le S u c c e s s o r
R e le v a n t O b lig a tio n s ?
No
D id o n ly o n e E n tity s u c c e e d to
m o re th a n 2 5 % o f th e R e le v a n t
S u c c e e d in g E n tity is
O b lig a tio n s , b u t n o t m o re th a n Yes
th e s o le S u c c e s s o r
2 5 % re m a in s w ith th e o rig in a l
R e fe re n c e E n tity ?
No
D id m o re th a n o n e E n tity
E a c h s u c c e e d in g
s u c c e e d to m o re th a n 2 5 % o f th e
E n tity w ill b e a
R e le v a n t O b lig a tio n s , b u t n o t Yes
S u c c e s s o r (a n d
m o re th a n 2 5 % re m a in s w ith th e
2 .2 (d ) w ill a p p ly )
o rig in a l R e fe re n c e E n tity ?
No
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No
Did one or more Entities succeed Each succeeding
to more than 25% of the Entity and the original
Relevant Obligations, but more Yes Reference Entity will
than 25% remains with the be a Successor (and
original Reference Entity? 2.2(d) will apply)
No
Did one or more Entities succeed
to part of Bonds and Loans, but
no Entity succeeds to more than
Yes No Change
25% of Relevant Obligations, and
the Reference Entity continues to
exist?
No
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Reference Obligations
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Reference Obligations—Usage
Credit Derivatives
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*Note that Fixed Payment can be payment of floating amount (e.g., LIBOR)
Credit Derivatives
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Fixed Payments
No. Days
Fixed Rate * Fixed Rate Payer Calc Amount *
360
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Credit Derivatives
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Floating Payment
Credit Derivatives
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Credit Derivatives
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The period from and including the Effective Date to and including
the date that is 14 calendar days after:
• The Scheduled Termination Date
• The Grace Period Extension Date if (i) Grace Period Extension is
applicable, (ii) the Credit Event that is the subject of the Credit Event Notice is a
Failure to Pay that occurs after the Scheduled Termination Date and (iii) the
Potential Failure to Pay with respect to such Failure to Pay occurs on or prior to
the Scheduled Termination Date
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Credit Derivatives
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Generally speaking:
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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Bankruptcy (cont’d)
• Subjectivity of some aspects of the definition:
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— (b) becomes insolvent or is unable to pay its debts or fails or admits in writing in
a judicial, regulatory or administrative proceeding or filing its inability generally to
pay its debts as they become due;
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Practical Issues
— (e) has a resolution passed for its winding-up, official management or liquidation
(other than pursuant to a consolidation, amalgamation or merger);
— (g) has a secured party take possession of all or substantially all its assets or has
a distress, execution, attachment, sequestration or other legal process levied,
enforced or sued on or against all or substantially all its assets and such secured
party maintains possession, or any such process is not dismissed, discharged,
stayed or restrained, in each case within thirty calendar days thereafter; or
— (h) causes or is subject to any event with respect to it which, under the
applicable laws of any jurisdiction, has an analogous effect to any of the events
specified in clauses (a) to (g) (inclusive).
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Practicing Law Institute: Swaps and other Derivatives 2009
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Practical Issues
— Fannie/Freddie
— Tembec
— General Motors
Credit Derivatives
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Failure to Pay
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Credit Derivatives
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Restructuring
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Credit Derivatives
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Restructuring (cont’d)—Subordination
• “Subordination” defined as a contractual, trust or similar arrangement
providing that (i) upon the liquidation, dissolution, reorganization or
winding up of the Reference Entity, claims of the holders of the Senior
Obligation will be satisfied prior to the claims of the holders of the
Subordinated Obligation or (ii) the holders of the Subordinated
Obligation will not be entitled to receive or retain payments in respect of
their claims against the Reference Entity at any time that the Reference
Entity is in payment arrears or is otherwise in default under the Senior
Obligation. For purposes of determining whether Subordination exists
or whether an obligation is Subordinated with respect to another
obligation, the existence of preferred creditors arising by operation of
law or of collateral, credit support or other credit enhancement
arrangements shall not be taken into account, except that,
notwithstanding the foregoing, priorities arising by operation of law shall
be taken into account where the Reference Entity is a Sovereign.
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Credit Derivatives
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Restructuring—Some Examples
• Conseco
• Xerox
• Solutia
Credit Derivatives
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Conseco
• Background: Conseco’s decline began with the purchase of Greentree
Financial in April 1998 for $6.2 billion. The underperformance of this
subsidiary led, in the spring of 2000, to the resignation of CEO Steven
Hilbert and the June 2000 hiring of Gary Wendt, former CEO of GE
Capital. Wendt began a program of asset sales, but with over a billion
dollars of bank debt due in September, he needed to negotiate an
extension to provide time for the sale of the non-core assets.
• Triggering Event: In September 2000, Conseco announced agreement
providing for repayment of $650 million to banks and 15-month
extension of $571 million of bank debt to be financed by asset sales and
an acceleration of $300 million on $1.5 billon of bank debt due in
September 2003. Bank debt extension was accompanied by an
increase in the loan interest rate from L+50 bp to L+250 bp and receipt
by the lenders of additional collateral resulting in structural
subordination of the bonds.
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Credit Derivatives
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Xerox
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Solutia
Credit Derivatives
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Restructuring Alternatives
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Restructuring: Old-R
Credit Derivatives
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Restructuring Alternatives: Mod-R (used
primarily for North American credits)
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Credit Derivatives
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“Transferable”
Credit Derivatives
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“Eligible Transferee”
• Includes:
— Any bank or other financial institution, an insurance or reinsurance
company, a mutual fund, unit trust or similar collective investment
vehicle or a registered or licensed broker or dealer, in each case,
with total assets of at least $500 million
— An Affiliate of an entity specified above
— Any other entity that is an investment vehicle that (1) has total
assets of at least $100 million or (2) is one of a group of investment
vehicles under common control or management having, in the
aggregate, total assets of at least $100 million
— Any other entity that has total assets of at least $500 million
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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• Payment—Too Broad
• Bond—Too Narrow
• Loan—Too Narrow
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Guarantees
Credit Derivatives
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Qualifying Guarantee
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Credit Derivatives
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• “Voting Shares” are shares or other interests that have the power
to elect the board of directors or similar governing body of an
entity
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Credit Derivatives
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Settlement—Physical Settlement
Was Originally Preferred
• Originally, Cash Settlement was seldom used except in structured
transactions such as synthetic CDOs in which Physical Settlement is not
a viable option
• Buyer prefers Physical Settlement because it does not have to risk bad
price determination
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Cash Settlement
• The Floating Rate Payer must pay (a) the Floating Rate
Payer Calculation Amount multiplied by (b) the difference
between the Reference Price and the Final Price
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
Page 94
• Generally, the Quotations are firm Bids and the Highest Bid
obtained on a specified Valuation Date (or, less commonly,
the average of the Highest Bids obtained on each Valuation
Date) will represent the Final Price. Alternatively, the parties
may agree to determine the Final Price on a "Market" basis
where for each Valuation Date the high and low Quotations
are discarded and the remaining Quotations are averaged.
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Credit Derivatives
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Physical Settlement
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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Credit Derivatives
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Practical Issues
Credit Derivatives
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Practical Issues
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Practical Issues
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AAA/
A aa Se l l e r ( s) - A A / A a R i sk
C Se l l e r ( s) - B a a 3 / B B B - R i sk
A A /A a
B
Baa3/
BBB A Se l l e r ( s) - U n r a t e d R i sk
U n rated
Bu yer Se l l e r s
A - C u m u l a t i v e l o sse s u p t o 4 % o f e n t i r e p o r t f o l i o
B - A d d i t i o n a l c u m u l a t i v e l o sse s u p t o 1 2 % o f e n t i r e p o r t f o l i o
C - A d d i o n a l c u m u l a t i v e l o sse s u p t o 4 0 % o f e n t i r e p o r t f o l i o
L o sse s u su a l l y m e a su r e d t h r o u g h c a sh se t t l e m e n t
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
Novation
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Novation
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Novation—ISDA Protocol
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Novation
Credit Derivatives
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• Once the price has been agreed the Transferor will now
obtain consent from the Remaining Party as follows:
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Credit Derivatives
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• Novation Confirmations
— The Remaining Party agrees to dispatch the Novation Confirmation
as soon as practical after the Remaining Party’s consent has been
given.
— All adhering parties agree to sign the Novation Confirmation
promptly after receiving the Remaining Party’s Novation
Confirmation, taking due note of any agreed industry targets.
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Credit Derivatives
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Index Transactions
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Index Transactions
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Credit Derivatives
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Index Transactions
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Index Transactions
Credit Derivatives
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Index Transactions
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Credit Derivatives
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• When Collins and Aikman, the US auto parts supplier, filed for
bankruptcy, one of the tricky issues was settlement because
Collins was a part of the Dow Jones credit derivatives indexes
being traded in the market.
• Physical settlement would have been chaotic due to a limited
supply of Collins deliverable securities in the market.
• To resolve the problem, ISDA developed a new protocol, the
2005 CDS Index Protocol.
• Under the Protocol, the specific Collins Reference Obligation is
valued by an Auction Procedure
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Master Confirmations
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NOLs
• In recent bankruptcy cases, investors and broker-dealers have been left
with no choice but to engage attorneys to object to overly broad
bankruptcy court orders designed to limit trading in claims in order to
preserve net operating losses for U.S. Federal income tax purposes.
• The orders are typically imposed at the debtors’ initiative, resulting in
the expenditure of substantial time and effort in order to debate the
proposed breadth of the orders and put in place ad hoc procedures to
ensure compliance.
• Although the debt provisions of NOL orders vary, they frequently
prohibit large holders of debt from acquiring any additional claims. At
early stages of a bankruptcy, an NOL order may even prohibit all
purchases and sales of a corporation’s debt. These restrictions are very
disruptive to trading, and are often imposed without meaningful notice to
the markets.
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NOL Orders—Background
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NOL Orders—Background
• Under one of these special rules, a partial exemption from the Section 382 limitation is
available for an ownership change pursuant to a bankruptcy reorganization, so long as
the historic shareholders and “qualified creditors” of the debtor corporation own at
least 50% of the value and voting power of its stock after the change. In general, a
debtor corporation may treat a creditor as qualified if, immediately after the bankruptcy
reorganization, that person owns less than 5% of the debtor corporation’s equity.
• Pursuant to the basic Section 382 rule, normal trading in a debtor corporation’s equity
can directly result in significant limitations on future use of NOL carryovers, regardless
of the value of that equity. For this reason, NOL orders typically place significant
restrictions on equity trading during the course of a bankruptcy. Although trading in
debt cannot directly result in a limitation under Section 382, NOL orders also
frequently place restrictions on debt trading, in order to preserve the debtors’ ability to
benefit from the favorable qualified creditor presumption for less-than-5% holders. In
this regard, the emergence of a reorganized debtor from Chapter 11 frequently
constitutes a triggering ownership change for purposes of Section 382, and a large
portion of a reorganized debtor’s equity is frequently distributed to former creditors.
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• The goal of the Model NOL Order is to reduce the disruption and
expense resulting from NOL orders. The Model NOL Order aims to
reduce this burden for all parties, by creating a standard and less
restrictive mechanism for dealing with the tax issues raised by debt
trading during a bankruptcy.
• In producing the Model NOL Order, The Bond Market Association and
the Loan Syndications and Trading Association consulted extensively
with representatives of the debt trading community as well as leading
bankruptcy counsel for both debtors and creditors.
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The Participants
Protection Buyers
– Commercial and Investment Banks
Revolver exposure
Bridge loans
Non-tradeable loans
– Hedge funds
Until recently, arbitrage opportunities due to tight CDS spreads
Until recently, shorting 2nd lien market
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When a loan is trading at a premium, the Cheaper than Unsecured CDS Protection.
premium above par is lost upon a
Eliminate Basis Risk – hedge 1-for-1 with loan.
refinancing or default. CDS contracts
always reference par so at inception the Blind to the Issuer.
seller of protection is only exposed at par. No alternative way to short loans currently.
CDS will act like a fully funded position with Contract will terminate upon absence of Loans
a premium similar to a term loan spread. of the relevant priority of Issuer outstanding.
Can achieve leveraged loan position through
CDS.
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Trade Ideas:
There are many strategies that can be employed when
trading LCDS
Outright Long Sell Protection Get exposure synthetically to credit for relative value reasons; add
incremental exposure after primary market allocations
Outright Short Buy Protection No way to short loans in cash market; hedge positions; take
advantage of potential spread widening situations
Cap Arb Trade Sell Loan CDS, Buy Take advantage of perceived mispricing of unsecured (bond) vs.
Unsecured Bond CDS secured (loan) parts of capital structure for appreciation and carry
Replace Cash with Sell Loan, Sell Loan Sell/monetize call-constrained loan trading at premium; gain
Synthetic CDS exposure to par CDS instrument at comparable or better spreads
Refinancing Trade Buy Revolver, Buy Earn carry from Revolver commitment fees vs. paying for Loan CDS
Loan CDS Protection to short date that corresponds to expected refinancing date. Early
refinancing while CDS still has value – or additional funding (at a
higher spread) – will result in higher return on trade
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Reference Entity/Reference Depends on Issuer (Specify tranche/lien (Markit to Depends on Issuer (Specify bond)
Obligation maintain database))
3. Restructuring is NOT a credit event in the US and is 3. Restructuring is a credit event for IG and NOT
a credit event in Europe for HY issuers in the US. Restructuring is a
credit event in Europe
Settlement Cash settlement through auction methodology; physical Absent an auction-based cash settlement, physical
settlement is a fallback delivery generally used for single name (T+3 from
NOPs); Cash settlement protocols have been used
to settle index and single-name trades
Documentation issues — Par docs and distressed docs Standard Bond settlement mechanisms used for
single name
— Via assignments or via participations
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• Definition:
• “Syndicated Secured” means any obligation, including any
contingent obligation to pay or repay borrowed money resulting
from the funding of an unfunded commitment, (i) that arises under
a syndicated loan agreement and (ii) that, on the relevant day,
trades as a loan of the Designated Priority under the then-current
trading practices in the primary or secondary loan market, as the
case may be
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Settlement Mechanics: Bridging the Two
Markets (cont’d)
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Harmonization
• Among other things, these factors have made cash settlement through an auction
methodology the principal settlement method for LCDS
• Standard LCDS auction procedure is based on the precedent developed for bond CDS,
with appropriate changes to take account of the fact that the auction is in respect of loans
rather than bonds
• Starting Point: ISDA definition of Physical Settlement
• Streamline documentation choices and “hardwire” form of documentation
• LSTA distressed documentation, as of the NOPS Fixing Date
• Favor settlement by assignment, allow settlement by participation
• Harmonize conflicting conventions and risk allocations
• Settlement pricing
• Compensation for Delayed Settlement
• Borrow from ISDA when necessary: simplified form of Partial Cash Settlement
• In lieu of LSTA economic equivalent fallback
• Innovate: Market Standard Indemnity
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Paths to Settlement
• Assignment
• Fall-Back Participation
• Initial Participation (including Participation, Subparticipation and
Assignment of Participation)
• Cash Election Notice and Partial Cash Settlement
• Additional Termination Event
• Future Netting Protocols
• Avoiding Obstacles, including NOL Orders
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• LCDX consists of 100 Reference Entities determined by Markit and participating dealers to
be the most liquid in the single-name LCDS market
— Credit Event in respect of any Reference Entity triggers an auction and settlement for
that name for index and single-name trades
• Fixed Rate—Markit-published spread payable quarterly by the protection buyer on all LCDX
trades
• Maturity—For April rolls, June 20th of the fifth following year; for October rolls, December
20th of the fifth following year
— Only terms that are subject to election are: Trade Date, Effective Date (start paying
Fixed Amounts); Scheduled Termination Date, Original Notional Amount and Initial
Payment Amount (if any)
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• Initial Payment—Can be used to adjust for a spread that would otherwise be payable on a
trade on the 100 Reference Entities
• Credit Events—Bankruptcy and Failure to Pay with respect to Borrowed Money (includes
both Bonds and Loans)
• Conditions to Settlement must be satisfied for each trade (Credit Event Notice and Notice of
Publicly Available Information)
• If there is a Credit Event OR if the Relevant Secured List is withdrawn for any Reference
Entity, the trade terminates for that Reference Entity or Event Determination Date (for Credit
Event) or day withdrawal is announced—no further Fixed Amounts payable on that name
— Following a Credit Event, trades will be cash-settled through auction settlement
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• Once a credit event occurs and the notional is fixed based on the
then current value of the reference swap, the CCDS is settled in
the same way as a standard swap.
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• #
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• Customized Leverage
• New Trade Types
— Basis Trades (e.g., CDS vs. Cash Bonds)
— Capital Structure Trades (i.e., long BBs vs. short BBBs)
— Cross-sector arbitrage
— Single tranche bespoke synthetic CDOs; Hybrid CDOs
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Asset-Backed Securities
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Asset-Backed Securities
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Asset-Backed Securities
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Notional Amount Notional Amount will be reduced as a Notional Amount will be reduced as a result of
result of: Principal Payments, such as:
How is notional amount
affected by amortization - Principal Payment (scheduled or - Scheduled or accelerated amortization,
and write-downs of the unscheduled)
- Acceleration of payment obligations,
reference obligation?
- Failure to Pay Principal (FTP)
- Redemption
- Writedown (a decrease in principal
Does not take into account Writedowns / Writedown
other than scheduled/unscheduled
Reimbursements
payments; principal deficiency or
realized loss resulting in reduced
interest payable)
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Fixed payment (made Buyer pays a fixed rate premium to The buyer is obliged to pay the fixed rate premium
by the Buyer of Seller PLUS (if any): until a Credit Event is triggered.
protection to the Seller
- Writedown Reimbursement
of protection)
- Principal Shortfall
Reimbursement (payment toward
previously deferred or FTP principal)
or
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Treatment of the Step- If Step-Up occurs, the Fixed Rate will Fixed Rate payment (premium) paid by the buyer may
Up Coupon Feature increase by the same amount or be adjusted for any "step-up" feature of the Reference
alternatively Buyer may choose the Obligation.
Optional Step-up Early
Termination of the swap
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(ii) payment on any such day of an Actual (iii) Non-payment leads to Default for reference obligation.
Principal Amount that is less than the
- Loss Event - Principal Reduction when reference obligation:
Expected Principal Amount
(i) does not allow Principal Reduction reversal/reimbursement
Credit Events ("hard" credit events):
(ii) does not allow interest on Principal Reduction, or
- Failure to Pay Principal (note choice)
(iii) does not allow interest on interest, which would have accrued
- Writedown (note choice)
on Principal Reduction.
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Settlement Only Physical Settlement in whole or part at Cash Settlement unless Buyer chooses Physical Settlement. Only
Buyer’s option is allowed. Only Reference Reference Obligation is Deliverable.
Obligation is Deliverable.
- Cash Settlement N/A Three business days after final valuation, using the Highest Valuation
Method. Calculation based on a dealer poll valuation (2 dealers are
nominated by the Buyer, 2 dealers - by the Seller, for a total of at least 5
dealers). Poll is repeated every five days until two firm bids are received
or 60 days expire. The highest quotation determines settlement price: if
no quotations are received, then the price is zero.
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Reference obligation
Notional = $100
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EXAMPLE (continued)
(2) After $20 principal write-down
Fixed payment/
CDS premium 150 bp ($1.20)
Protection buyer or fixed-rate payer Protection seller/writer or floating-rate
(short credit risk) payer (long credit risk)
Floating payment/
Write-down amount $20
Reference obligation
Notional = $80
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EXAMPLE (continued)
(3) After $20 principal write-up
Fixed payment/
CDS premium 150 bp
Protection buyer or fixed-rate payer Protection seller/writer or floating-rate
(short credit risk) payer (long credit risk)
Additional fixed payment/
Write-up amount $20
Reference obligation
Notional = $100
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Underlying reference obligation reaches its cap Floating payment made from seller to buyer equal to the
amount of the shortfall, netted against the fixed payment
(CDS premium) paid by the buyer to the seller. If fixed cap
is applicable, then the floating payments in respect of
interest cannot exceed the CDS premium
Underlying reference obligation is below its cap after a Additional fixed payment made from buyer to seller equal to
period of being at its cap. Assume the obligation has paid any unreimbursed interest shortfalls (the protection buyer is
"catch up" interest first reimbursed for shortfalls)
Excess losses result in (a) an explicit writedown of principal Floating payment from seller to buyer equal to the
or (b) no explicit writedown of principal has occurred but an writedown amount + credit event: protection buyer has
implicit writedown has occurred based on pre-determined option to physically settle and deliver reference obligation to
variables (eg securities are under-collateralized, etc.) seller
Previously written down amounts have been written up due Additional fixed payment (reimbursement) from buyer to
to improvement in collateral pool seller equal to the write-up amount
Downgrade of reference obligation to a pre-agreed Credit event => protection buyer has option to physically
distressed level (triple-C, etc.) settle and deliver reference obligation to seller
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— 5 Buyside Members
— 2 non-voting Dealer members (one global, one regional), with one additional
non-voting global dealer for the first year
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Every DC member is required to vote in all binding votes with one excused
absence per year. All resolutions by a DC are published by ISDA. The
deliberations of a DC are confidential until relevant information is published.
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Credit Events
• Prior to the Big Bang Protocol and the 2003 Supplement,
credit derivative contracts were triggered by bilateral Credit
Event Notices exchanged between Buyer & Seller.
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Credit Events
• The determination of a DC in respect of a Credit Event applies
to all Covered Transactions. The steps for initiating
consideration of a Credit Event question by a DC are as
follows:
— Any ISDA Member may notify the DC Secretary asking that a DC consider whether
a Credit Event has occurred. This notice to the DC Secretary must include Publicly
Available Information (“PAI”).
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Succession Events
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• Benefits:
— Certainty--Enables settlement by auction following a
restructuring event
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The Maturity Bucket End Dates are the IMM Roll Dates occurring on
or immediately following the dates that are 2.5 years, 5 years. 7.5
years, 10 years, 12.5 years, 15 years, 20 years and 30 years after
the Restructuring Date.
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— Example: If the Scheduled Termination Date would occur 6 years after the
Restructuring Date and there is no Deliverable Obligation with a final
maturity date occurring between 5 and 6 years following the Restructuring
Date, then the CDS contract will be assigned to the 5-year Maturity Bucket,
even though based solely on its Scheduled Termination Date, it would
otherwise be assigned to the 7.5-year Maturity Bucket.
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• If Seller Triggers
— If Seller triggers, the CDS contract will be assigned to the 30-year Maturity
Bucket, regardless of the Scheduled Termination Date.
— (b) The Seller can move the CDS contract to the 30-year Maturity Bucket if
that Maturity Bucket is having an Auction.
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DC compiles Initial,
Supplemental and final Triggering Deadline Movement Option
lists of Deliverable (Use it or Lose it) deadline
Obligations for each
Maturity Bucket
5 business 3 business 2 business
Approximately 2 weeks days days days
1 business
day later
Earliest possible
Auction Date
DC publishes -latest date by which
-final list of Deliverable ISDA announces
Obligations auctions
-the range of Scheduled - announcement can be
Termination Dates for made earlier if the DC
Each Bucket learns from DTCC that
the 300/5 Criteria have
been satisfied
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• DC will determine whether each Bucket will have an Auction; ISDA announces
decision.
• The Auction Date will be set to occur no earlier than 2 Business Days following
the Movement Option Deadline.
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• Changes include:
— Adoption of full first coupon periods for all contracts;
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• In addition:
— Will issue performance metrics that address both new
transactions and the outstanding trade population on a
monthly basis.
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• Issues arising:
— Ability to exercise after Scheduled Termination Date
— Calculation of Premium
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• AIG and AIG FP did not have the liquidity to meet these posting
requirements, causing (a) further financial distress to AIG and
(b) risk to OTC derivatives counterparties of AIG FP that
accordingly faced serious mark-downs in the value of the credit
protection purchased (and other related consequences)
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Proposed Legislation
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Proposed Legislation
• On October 15, 2009, the House Financial Services Committee
approved legislation requiring the comprehensive regulation of
the market for OTC derivatives
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Proposed Legislation—Clearing
• Bill provides a mechanism to determine which swap transactions
are sufficiently standardized that they must be submitted to a
clearinghouse. For clearable transactions, clearing is a
requirement when both counterparties are either dealers or
major swap participants.
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• CFTC and SEC will set capital for non-banks at a level that
is “as strict or stricter” than that set by banking regulators
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• Issuing a guarantee
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Miscellaneous Legal/Regulatory/Tax
Issues
• Insurance
• Capital Adequacy
• Tax Treatment
• Insider Trading
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Insurance
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Insurance
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Insurance—Other Jurisdictions
• United Kingdom
• France
• Germany
• Italy
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Writer of policy subrogated to the rights of Provider of credit default swap not
the insured (i.e., writer can seek to subrogated. Once payment based upon
minimize loss by acquiring underlying asset decline in market value is made, no right to
and enforcing against obligor) proceed against underlying obligor
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Capital Adequacy
Credit Derivatives
Practicing Law Institute: Swaps and other Derivatives 2009
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Capital Adequacy
• Direct, irrevocable and unconditional claim on Seller
• Linked to specific exposures
• Credit Events must include, at a minimum, Failure to Pay, Bankruptcy and
Restructuring, although the inclusion of Restructuring is being discussed
• Cash Settlement permitted so long as there is a robust valuation process is in
place in order to estimate loss reliably and a clearly specified period for
obtaining post-Credit Event valuations, typically no more than 30 days
• Grace period in the Transaction must not be longer than the grace period agreed
upon under the loan agreement
• Buyer must have the right/ability to transfer the underlying exposure to the
Seller, if required in order to obtain payment
• Buyer must have the right/ability to inform the Seller of the occurrence of a
Credit Event
• Where there is an asset mismatch between the exposure and the Reference
Obligation, then the Reference Obligation and underlying assets must be issued
by the same obligor and the Reference Obligation must not be senior to the
underlying asset
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• Free transferability
• Non-Control
Credit Derivatives
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• Guarantee
• Insurance Contract
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• Bankruptcy Code
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• Changes to the U.S. Bankruptcy Code and FDIA that took effect
on October 17, 2005 will increase certainty of termination and
netting for credit derivatives.
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Insider Trading
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Contacts
• Don Bendernagel, Citigroup
— E: donald.bendernagel@citi.com
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