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Debt Research 35

Credit Strategy

May 27, 2008

Glen Taksler Credit Default Swap Primer


646.855.7559
glen.taksler@bofasecurities.com Fourth Edition
Figure 1. Estimated Growth in Single-Name CDS Notional

21
18
$ Trillions 15
12
9
6
3
Additional Authors:
0
Jeffrey A. Rosenberg 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
646.855.7927
Sources: British Bankers Association; ISDA; Banc of America Securities LLC estimates.
jeffrey.rosenberg@bofasecurities.com

Ward Bortz X The credit crisis has changed the credit default swap (CDS) landscape.
646.855.8451
Riskier credits trade in points upfront, similar to a discount bond. Higher funding
ward.bortz@bofasecurities.com costs make it more expensive to take a leveraged position in cash bonds,
increasing the attractiveness of unfunded assets such as CDS.
X The CDS market has taken steps to reduce the risks associated with rapid
growth. Protocols have helped investors to cash settle contracts following recent
bankruptcies. Most CDS trades are processed electronically. Counterparties
exchange mark-to-market profit daily, and may use initial margin to further reduce
exposure.
X Credit default swaps have moved into the mainstream of credit portfolio
management. Hedge funds, banks and dealers, and insurers are the most active
participants. We discuss practical trading considerations, such as liquidity, trade
unwinds, and CDS rolls.
X Corporate bond investors and issuers are paying more attention to the CDS
market. CDS spreads provide a benchmark for new issue pricing. The CDS
markets influences—and is influenced by—corporate finance decisions such as
tender offer, guarantees, and spinoffs.

The author of this report is not acting in the capacity of an attorney, and the information contained herein is not intended to constitute
legal advice. You should consult with your legal adviser as to any issues of law relating to the subject matter of this report.
This report has been prepared by Banc of America Securities LLC (BAS), member FINRA, NYSE and SIPC. BAS is a
subsidiary of Bank of America Corporation. This report is intended for sophisticated institutional investors and equivalent
professionals in the fixed income market only.
Please see the analyst certification and important disclosures on page 194 of this report. BAS and its affiliates do and
seek to do business with companies mentioned in their research reports. As a result, investors should be aware that the
firm may have a conflict of interest that could affect the objectivity of this report. Should investors consider this report as
a factor in making an investment decision, it must be considered as a single factor only.
Credit Strategy Research 35
May 27, 2008

Table of Contents
This primer is organized by importance. Readers who want a basic overview of CDS may prefer to skip appendices.

Introduction............................................................................................................................................................................. 4
Chapter I – The Basics of Credit Default Swaps.................................................................................................................. 8
What Is a Credit Default Swap? ........................................................................................................................................ 8
The Credit Derivatives Market.......................................................................................................................................... 9
Beginners Guide to CDS Contract Jargon....................................................................................................................... 15
Appendix I – The Basics of Credit Default Swaps ............................................................................................................. 17
Details around CDS Contract Terminology .................................................................................................................... 17
Risk of a Short Squeeze .................................................................................................................................................. 22
CDS and Corporate Bond Market Surveys ..................................................................................................................... 23
Chapter II – Differences Between the CDS and Corporate Bond Markets..................................................................... 26
Pricing in the CDS Market .............................................................................................................................................. 26
The ABCs of Credit Spreads ........................................................................................................................................... 26
The Credit Default Swap Basis ....................................................................................................................................... 30
Appendix II – Differences Between the CDS and Corporate Bond Markets...................................................................... 34
More on The ABCs of Credit Spreads ............................................................................................................................ 34
Factors Driving the Basis ................................................................................................................................................ 43
Chapter III – CDX and iTraxx Indices............................................................................................................................... 48
Key Features of CDX Indices ......................................................................................................................................... 48
Basis Between Intrinsics and the Index........................................................................................................................... 51
Hedging Between Indices................................................................................................................................................ 53
Appendix III – CDX and iTraxx Indices............................................................................................................................. 53
DV01 Neutral Index Arbitrage........................................................................................................................................ 53
CDX Index Rolls............................................................................................................................................................. 57
Events and Reference Entities in the CDX Indices ......................................................................................................... 60
Chapter IV – CDS Operations Management...................................................................................................................... 65
CDS Operations............................................................................................................................................................... 65
Goals for CDS Operations Management......................................................................................................................... 67
Counterparty Risk and Leverage..................................................................................................................................... 68
Appendix IV – CDS Operations Management.................................................................................................................... 75
Sample Confirmations and Trade Recaps ....................................................................................................................... 75
Sample Credit Event Documentation .............................................................................................................................. 86
Chapter V – CDS Trading Management ............................................................................................................................ 90
Sample Trader Runs ........................................................................................................................................................ 90
CDS Rolls........................................................................................................................................................................ 94
Sample P&L Calculation................................................................................................................................................. 96
Implied Probability of Default ...................................................................................................................................... 100
Mind the Discount Factor.............................................................................................................................................. 102
CDS Duration and Curve Trades................................................................................................................................... 102
The Transition from Spread to Points Upfront.............................................................................................................. 108
Assignments, Unwinds, and Jump Risk ........................................................................................................................ 109
Interest Rate Sensitivity ................................................................................................................................................ 111
Appendix V – CDS Trading Management........................................................................................................................ 113
More on Single-Name CDS Rolls ................................................................................................................................. 113
More on Points Upfront................................................................................................................................................. 115
More on Jump to Default Risk – Take CDS Profit in Small Chunks ............................................................................ 123

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Credit Strategy Research 35
May 27, 2008

Chapter VI – CDS Case Studies and Legal Issues ........................................................................................................... 129


Case Studies .................................................................................................................................................................. 129
Succession—How Corporate Finance Affects Credit Derivatives................................................................................ 132
Operational Issues Surrounding Succession Events...................................................................................................... 142
CDS Settlement Protocols............................................................................................................................................. 143
Details Around Modified Restructuring........................................................................................................................ 152
Special Issues Pertaining to CDS on Monoline Insurers............................................................................................... 158
Chapter VII – Other Credit Derivatives Products........................................................................................................... 166
The Synthetic CDO Market........................................................................................................................................... 166
Leveraged Loan CDS (“LCDS”)................................................................................................................................... 167
Secured CDS ................................................................................................................................................................. 169
Recovery Locks............................................................................................................................................................. 170
CDS on ABS ................................................................................................................................................................. 172
CDS on CLOs ............................................................................................................................................................... 177
Preferred CDS (“PCDS”) .............................................................................................................................................. 177
Accounts Receivable CDS ............................................................................................................................................ 178
Private Institutional CDS .............................................................................................................................................. 179
Appendix VII – Other Credit Derivatives Products .......................................................................................................... 179
Structured Credit Market Basics ................................................................................................................................... 179
Chapter VIII – Glossary..................................................................................................................................................... 188

Credit Default Swap Primer 3


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Introduction
As this publication goes to press, credit derivatives have become a subject of
significant market and regulatory attention. The main theme is that rapid growth
involves risks, particularly in a volatile trading environment. Below, we comment on
some “hot topic” issues, along with the current state of the market. Throughout this
Credit Default Swap Primer, we address these topics in more detail.

CDS Market Size


Considerable concern has been raised over rapid growth in the credit derivatives
market. The International Swaps and Derivatives Association, Inc.’s (ISDA) 2007 year-
end market survey estimates that credit derivatives notional grew 81% in 2007, to $62
trillion. Of this, approximately $20 trillion is single-name CDS (globally), compared
1
with about $14 trillion in corporate bond notional.

The CDS market’s $62 Yet, headline market size estimates are drastically larger than the overall economic
trillion headline size is impact of the CDS market. There are two issues. First, CDS market surveys focus on
drastically larger than its gross, not net, credit exposure. Second, under many circumstances, the size of the CDS
overall economic impact market may grow without any change in overall risk.
Consider a trader at Bank A, who buys $10 million protection from Bank B. A week
later, spreads widen, and a different trader at Bank A sells $10 million protection to
Bank B. Both banks have zero net default exposure ($10 million – $10 million = zero).
But, because two different traders transacted, typically, the institution will record two
separate trades, with a total notional of $20 million, causing CDS market size to
increase. Through the ISDA trade association, the industry is developing netting
proposals to more accurately reflect net credit exposure.
Similarly, the CDS market is subject to double-counting of risk. For example, if an
investor buys protection in an index and sells protection in each of the underlying
constituents, reported CDS notional will grow, even though net credit exposure will be
unchanged.
As of December 2007, the Bank of International Settlements (BIS) estimates that the
gross market value of credit derivatives contracts was 3.5%. In cash market
terminology, if trades were implemented at $100, their market value as of December
2007 was $96.50.
Since that time, investment grade credit has lost about 1.2% in total return, and high
yield 1.5%. Roughly speaking, that suggests a current gross market value in credit
2
derivatives of $3 trillion. To be clear, this is a back-of-the-envelope estimate: If
spreads were to widen further, regardless of the reason, gross market value would
increase. Consequently, although the exact impact is unclear, the systemic risk of credit
derivatives is far less than the headline $62 trillion notional.

CDS Operational Concerns


CDS operational With rapid market growth comes increased attention to making sure that trades are
efficiency has improved confirmed shortly after execution. The goal is that, if an institution makes a mistake on
substantially in recent a trade, that error should be quickly discovered and corrected. In this light, CDS
years operational efficiency has improved substantially in recent years. In 2005, the majority

1
For more details, please see “The Credit Derivatives Market” on page 9.
2
For more details, please see “The $62 Trillion Question” on page 11.

4 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

of CDS trades were confirmed by facsimile, with quarterly coupon payments


reconciled by the manual exchange of spreadsheets. This resulted in a trade backlog,
where unsigned confirmations—those trades executed but not yet confirmed—piled up
in back and middle offices.
Now, according to Markit Group Ltd, about 95% of credit default swaps are eligible for
electronic settlement, through the Depository Trust & Clearing Corporation (DTCC).
Of those eligible trades, another nearly 95% (i.e., 90% of total trades) settle
3
electronically. For year-end 2007, ISDA estimates that 90% of electronic
confirmations are normally sent by T+1.

Although credit However, ISDA also estimates that unsigned credit derivatives confirmations rose to
derivatives face 6.6x the daily volume of new trades in 2007, from 4.9x in 2006. The 2007 estimate
4
challenges, they fare compares with 9.9x for interest rate derivatives and 13.3x for equity derivatives. As
favorably to other such, while credit derivatives fare favorably to other product areas from an operations
5
derivatives produts from perspective, they still face challenges in a growing market.
an operations
perspective Counterparty Risk
As an unfunded market, CDS market participants promise to exchange cash flows
following a potential Credit Event. There are no hard assets set aside to guarantee
payment, creating an issue of Counterparty risk.

To manage Counterparty Recognizing this risk, the CDS market requires parties to post collateral (margin).
risk, the CDS market has Although no one knows exactly how much collateral is required to effectively manage
increased collateral Counterparty risk, as of year-end 2007, ISDA estimates that there was approximately
requirements and is $2.1 trillion in collateral in circulation, up from $1.3 trillion in each of 2006 and 2005.
6
working on a These numbers are across all derivatives transactions, not just credit derivatives.
clearinghouse to Recently, the CDS market began work on a clearinghouse to guarantee selected trades.
guarantee selected Rather than face banks or broker-dealers as Counterparties, investors would face the
trades clearinghouse. Effectively, if a clearinghouse member were to default, all remaining
members would be responsible for a proportionate share of trades. To reduce
outstanding notional, trades would be netted across parties. In its early stages, this
proposal may take effect for a small number of trades, among a small number of
7
parties, toward the end of 2008.

CDS Contract Language


Standard CDS contracts are governed by the 2003 ISDA Credit Derivatives
Definitions. Now five years old, these Definitions did not fully anticipate the extent of
CDS market expansion and current market conditions. To preserve the spirit of CDS
contracts, the market continues to develop a series of voluntary solutions, called
“protocols.”
To mitigate potential risks
associated with rapid growth, When agreeing to a protocol, the immediate effect is that one party benefits, and the
the CDS market continues to other suffers. For example, if a protocol results in a lower recovery rate, the protection
develop a series of voluntary Buyer benefits. Yet, most investors seem to recognize that, for their overall portfolio,
solutions, called “protocols” the benefits of a highly functioning CDS market outweigh potential losses on

3
http://www.markit.com/information/products/metrics.html
4
Preliminary results of ISDA 2008 Operations Benchmarking Survey, and ISDA 2007 Operations Benchmarking Survey, available from
http://www.isda.org.
5
For more details, please see “Goals for CDS Operations Management” on page 67.
6
ISDA Margin Survey 2008, available from http://www.isda.org.
7
For more details, please see the section “Counterparty Risk and Leverage” on page 68.

Credit Default Swap Primer 5


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Credit Strategy Research 35
May 27, 2008

individual trades. If a credit default swap were, say, to recover par, few investors would
be willing to buy protection in the future, causing potential market disintegration.
Risk of a Short Squeeze
Following a Bankruptcy, standard CDS contracts require the protection Buyer to
deliver a bond or loan to the protection Seller. If the protection Buyer cannot do so, he
may (eventually) forfeit the right to receive par from the protection Seller. As a result,
in 2005, bond prices started to short squeeze considerably following bankruptcies—the
price of Delphi bonds rose from $58 to $72 after the company declared bankruptcy.

While not guaranteed, To accommodate these issues, the vast majority of investors have voluntarily agreed to
there are plans to cash settle CDS contracts following recent bankruptcies, thus reducing short squeezes
eventually hard-wire the as protection Buyers no longer have to locate bonds. While not guaranteed, there are
8
ability to cash settle CDS plans to eventually hard-wire such provisions into CDS contracts.
contracts Monoline Insurers

Uncertainty around CDS For CDS referencing monoline insurers, standard CDS contracts allow the protection
contracts referencing Buyer to deliver (by extension, the market to potentially cash settle to) any debt
monoline insurers obligation directly wrapped by the monoline. However, there may be wide disparity in
the price and liquidity of such obligations, making it particularly difficult to settle CDS
contracts should a monoline Credit Event ever occur. Similar uncertainty exists
surrounding the effect on CDS contracts from a potential split of monoline insurers into
separate municipal bond and structured finance businesses. There is some potential that
monoline CDS notional could be divided between the two businesses or move entirely
to the municipal bond business. Although the eventual outcome is unclear, an ISDA
9
working group has been formed to try to develop a solution.
Changes in Corporate Finance Structure

Corporate finance is The development of new, tax-efficient corporate finance structures sometimes has
becoming increasingly created uncertainty as to how CDS contracts should be treated following a spin-off,
important to CDS merger, or acquisition. For example, in 2006, Verizon spun off its directories business.
investors As part of the transaction, some existing Verizon bonds were exchanged for loans in
the new directories business (Idearc). A debate ensued as to whether this structure
would cause some existing Verizon CDS notional to succeed, or change Reference
Entity, to Idearc, with its wider high yield spreads. Currently, our best advice is for
10
investors to learn these sometimes overlooked clauses of CDS contract language.

Trade Unwinds in a Volatile Market


Managing risk associated As spreads gap wider, some protection Buyers have found it difficult to unwind single-
with trade unwinds when name CDS trades and realize profits. For example, consider a protection Buyer who
spreads gap wider looks to profit 15 points. In other words, the price of the CDS contract has fallen from
par to $85 ($100 – $15).
A bank or broker-dealer that accepts this trade must pay the investor 15 points, and
then hedge the transaction with a new trade at par. This setup leaves the bank or
broker-dealer with “jump risk”: If there is a Credit Event at the underlying Reference
Entity immediately after trade inception, the bank or broker-dealer will lose 15 points:

8
For more details, please see “CDS Settlement Protocols” on page 143.
9
For more details, please see “Special Issues Pertaining to CDS on Monoline Insurers” on page 158.
10
For more details, please see “Succession—How Corporate Finance Affects Credit Derivatives” on page 132.

6 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

X Bank or broker-dealer buys protection from investor, and pays 15 points:


P&L post-Credit Event = 100 – Recovery – 15
X Bank or broker-dealer hedges by selling protection in a new trade:
P&L post-Credit Event = – (100 – Recovery)
X Net P&L post-Credit Event = – 15
As such, buying protection on unwind or assignment becomes less valuable to the bank
or broker-dealer. Until the market develops a solution, “More on Jump to Default Risk
– Take CDS Profit in Small Chunks“ on page 123 discusses strategies for managing
unwind risk, such as rolling to on-the-run contracts and taking profits in small chunks.
This primer is organized by chapter, with appendices on more advanced topics. For
more current views on credit derivatives strategy, please see our daily Situation Room
and biweekly Credit Market Strategist publications.

Credit Default Swap Primer 7


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Chapter I – The Basics of Credit Default Swaps


What Is a Credit Default Swap?
A credit default swap is a Credit default swaps are bilateral contracts used to transfer risk among market
bilateral contract for participants. One party (the protection Buyer) agrees to pay another party (the
transferring credit risk protection Seller) periodic fixed payments, in exchange for receiving a payment should
a third party (the Reference Entity) or its obligations suffer one or more pre-agreed
adverse Credit Events. Figure 2 illustrates the mechanics of a credit default swap.
The protection Buyer Figure 2. Mechanics of a Credit Default Swap
pays the protection
Seller a quarterly Between trade initiation and the earlier of a Credit Event or maturity, the protection
premium for protection Buyer makes regular payments of default swap premium to the protection Seller:
against adverse Credit
Events on a third-party Periodic Fixed Payments
Reference Entity
Protection Buyer Protection
ProtectionSeller
Seller

Following a Credit Event, one of the following takes place:


Cash Settlement
Par - Final Price
Protection Buyer Protection
ProtectionSeller
Seller

Physical Settlement
Obligation
Protection Buyer Protection
ProtectionSeller
Seller
Par

Source: Banc of America Securities LLC estimates.

Flexibility to manage The financial innovation achieved by credit default swaps—and their primary
credit risk attraction—is flexibility to manage credit risk. Unlike other financial instruments,
credit default swaps allow users to take unfunded, customized credit risk positions.
Traditional cash instruments are inherently funding vehicles and, as such, represent
Limitations of cash inflexibly bundled market and credit risks. For example, investors in the cash markets
instruments for who are bullish on an issuer’s credit must fund the investment and express their view
expressing credit views among available loans and bonds in whichever maturities, seniority, etc. are available.
In addition, investment in bonds or term loans can subject investors to either undesired
interest rate risk or additional expense in hedging out this risk. These cash market
limitations are more accentuated when investors seek to express a bearish view. In this
instance, investors’ ability to short cash instruments is constrained by their ability to
borrow the cash instruments and by the rollover risk inherent in short-term repos.

8 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Application of credit By contrast, credit default swaps—as side agreements, so to speak, among two parties
default swaps for on a third entity—provide more flexibility for expressing investment views on credit
expressing credit views risk.
As unfunded products, credit default swaps allow investors to separate the credit
decision from the funding decision. As such, credit default swaps make the credit
markets more accessible to investors who have higher funding costs. The total cost of
funding, including initial and variation margin, reflects the credit rating of the
particular Counterparty. The sections “Counterparty Risk and Leverage“ (page 68) and
“CDS Operations“ (page 65) discuss Counterparty risk and procedures for setting up a
new Counterparty to CDS.

Credit derivatives are not The buyer of an insurance policy is required to own the underlying asset; for example,
insurance a house. Since credit derivatives have no such requirement, they are not considered
insurance. This distinction is intentional, because it allows the transfer of risk from a
single party—for example, a bank lending a large loan facility—to a wide group of
investors.
Credit default swaps also provide flexibility in expressing credit risk views on
maturities, seniority and Credit Events, without regard to the availability of a physical
market instrument. In this sense, a credit default swap allows protection Buyers to fix
protection costs for the life of the CDS, while rollover risk from an alternative cash-
based shorting strategy will either become very difficult or costly to execute precisely
when an issuer’s credit profile significantly deteriorates.
With few exceptions, the legal framework of CDS—that is, the documentation
evidencing the transaction—is based on definitions set forth by the International Swaps
and Derivatives Association, Inc. (ISDA), a trade association. In May 2003, the 2003
ISDA Credit Derivatives Definitions took effect, expanding and revising the 1999
Definitions and Supplements. The Definitions provide a basic framework for
documentation, but precise documentation remains the responsibility of the parties
involved, because credit default swaps are bilateral contracts. These Definitions build
on a substantial case history of the CDS market. For details, please see page 129.

The Credit Derivatives Market


While the precise size of the credit derivatives market is not known, it is clear that the
market has grown and gained significant strength in recent years. Figure 3 provides a
sense of the growth in notional volume of credit default swaps (CDS) since 1997,
relative to the corporate bond market.

Credit Default Swap Primer 9


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 3. Estimated Growth in Single-Name and Total CDS Notional, Globally

Single-Name CDS Notional-Estimates


Total CDS Notional-Estimates
Cash Notional-Estimates
64
56
48

$ Trillions
40
32
24
16
8
0
1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007
Single-Name CDS Notional-Estimates are for the single-name notional of the global credit derivatives market.
Total CDS Notional-Estimates are for total notional of the global credit derivatives market, including synthetic CDOs and index products.
Cash Notional—Estimates are for the total notional of the global corporate bond market.
For further details, please see the Chapter Appendix on page 23.
Sources: Bank of International Settlements; British Bankers Association; ISDA; Federal Reserve; Banc of America Securities LLC estimates.

ISDA estimates that CDS The International Swaps and Derivatives Association, Inc.’s (ISDA) 2007 year-end
notional grew by 81% in market survey estimates that CDS notional grew 81% in 2007, to $62 trillion.
2007, to $62 trillion Moreover, despite recent market conditions, ISDA estimates that CDS notional grew
37% during the second half of 2007, compared with 32% during the second half of
11
2006.
Single-name CDS has the greatest market share by product, but non-traditional
products have grown rapidly:

11
$62.2 trillion in year-end 2007 vs. $45.5 trillion in mid-year 2007, for a 37% growth rate, and $34.4 trillion in year-end 2006 vs. $26.0 trillion
in mid-year 2006, for a 32% growth rate. Sources: ISDA; Banc of America Securities LLC estimates.

10 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 4. CDS Product Usage, 2003 Figure 5. CDS Product Usage, Forecast 2008
Other
Basket Asset swaps Options Options
Basket 8%
Total return products 4% 3% Equity linked 3%
products
swaps 4% products Credit linked Single-name
1%
4% 1% notes CDS
3% 30%
Credit linked
notes Tranched
6% Index
Single-name
Tranched 10%
CDS
Index 51%
2%
Index (Excl. Synthetic
Tranches) CDOs
Synthetic Index (Excl.
9% 16%
CDOs Tranches)
16% 29%

Sources: British Bankers Association; Banc of America Securities LLC estimates. Other includes total return swaps, asset swaps, and equity linked products.
No survey was released in 2007, so this forecast is from before the onset of the credit
crunch. The next release is expected in 2008.
Sources: British Bankers Association; Banc of America Securities LLC estimates.

The single-name CDS Based on the overall CDS market size shown in Figure 3, the size of the single-name
market is estimated at CDS market is pegged at $20 trillion for 2007, compared to $2 trillion in 2003.
$20 trillion for 2007 Synthetic CDO market notional was an estimated $10 trillion in 2007, up from $570
12
billion in 2003. The index market expanded to an estimated $18 trillion in 2007, from
$319 billion in 2003. (The CDX credit derivatives indices began trading in October
2003.)

The $62 Trillion Question


Headline market size is drastically larger than the overall economic impact of the CDS
market. There are two issues. First, CDS market surveys focus on gross, not net, credit
exposure. Second, under many circumstances, the size of the CDS market may grow
without any change in overall risk.
Consider a trader at Bank A, who buys $10 million protection from Bank B. A week
later, spreads widen, and a different trader at Bank A sells $10 million protection to
Bank B. Both banks have zero net default exposure ($10 million – $10 million = zero).
But, because two different traders transacted, typically, the institution will record two
separate trades, with a total notional of $20 million, causing CDS market size to
increase. Through the ISDA trade association, the industry is developing netting
proposals to more accurately reflect net credit exposure.
Similarly, the CDS market is subject to double-counting of risk. For example, if an
investor buys protection in an index and sells protection in each of the underlying
constituents, reported CDS notional will grow, even though net credit exposure will be
unchanged.
As of December 2007, the Bank of International Settlements (BIS) estimates that the
gross market value of credit derivatives contracts was 3.5%. In cash market

12
Synthetic CDOs are debt obligations representing a pool of credit default swaps. To estimate the size of the synthetic CDO market, we
multiply the 2008 forecast market share from Figure 5 by the 2007 total CDS notional from Figure 3. We emphasize that the 2008 forecast
market share was made in 2006, before the onset of the credit crunch. Synthetic CDO volume declined substantially in the second half of
2007, as discussed in “The Synthetic CDO Market” on page 166.

Credit Default Swap Primer 11


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Credit Strategy Research 35
May 27, 2008

terminology, if trades were implemented at $100, their market value as of December


2007 was $96.50.
Since that time, investment grade credit has lost about 1.2% in total return, and high
yield 1.5%. Roughly speaking, that suggests a current gross market value in credit
13
derivatives of $3 trillion. Although the exact figure is unclear, the systemic risk of
14
credit derivatives is far less than the headline $62 trillion notional.

Breakdown of Buyers and Sellers of Protection


Banks and dealers are To date, banks and dealers have been the dominant CDS players as both Buyers and
both Buyers and Sellers Sellers of credit default protection. Banks’ prominence as protection Buyers is in part a
of protection natural outgrowth of their desire to hedge their substantial credit exposure, and as
Sellers, out of increased ROE focus and desire to diversify credit exposure. As market
makers, broker-dealers generally try to run more evenly balanced trading books, but are
becoming more active in managing their portfolios of credit risk, leading to increased
participation as Buyers of protection.
Hedge funds also have emerged as large Buyers and Sellers of protection, and are now
Hedge funds are the the fastest-growing participants in this rapidly expanding market. Their overall position
fastest-growing in the CDS market grew from about 15% in 2003 to 30% in 2006, with a focus on the
participants 15
riskiest parts of the capital structure. Moreover, hedge funds are typically total-return
investors, contributing to a general perception that CDS has higher volatility than the
corporate bond market. Hedge funds have two main motivations for participating in the
CDS market: the opportunity to use higher leverage than other markets allow, and
relative value between CDS and cash.

13
Total return estimates based on the CDX IG and CDX HY indices, which are discussed in “CDX and iTraxx Indices” on page 48. Using these
estimates, we assume a 70% investment-grade and 30% high-yield market share, following British Bankers Association estimates from 2006.
The total estimated CDS return is -1.3%, as of May 22, 2008 ( -1.2% investment grade return x 70% market share – 1.5% high yield return x
30% market share). Add the BIS estimate of -3.5% from December 2007, for a total CDS market value of -4.7%. Multiply the result by $62
trillion notional, for an estimate of $3 trillion gross market value.
14
We emphasize that this is a back-of-the-envelope estimate. A mass unwind of derivatives trades, should such a scenario ever occur, would
widen quotes—and therefore losses—drastically. Netting agreements between counterparties, which are excluded from our analysis, would
partially offset these losses. The CDS market is working to improve netting of trades, as discussed in the section “Counterparty Risk and
Leverage” on page 68.
15
The British Bankers Association releases surveys bi-annually, so estimates are not available for 2007. The next release is expected in 2008.

12 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 6. Sellers of Protection, 2006 Figure 7. Buyers of Protection, 2006


Pension funds Corps. Misc. Insurers Mutual funds Pension funds
5% 2% 1% 6% 2% 2% Misc.
Mutual funds 1%
Corps.
3% Banks and 2%
Dealers Banks and
(Trading Dealers
Portfolios) (Trading
33% Portfolios)
Hedge funds 39%
31%
Hedge funds
28%
Loan
Portfolios Loan
Insurers
7% Portfolios
18%
20%
No survey was released in 2007. The next release is expected in 2008. No survey was released in 2007. The next release is expected in 2008.
Sources: British Bankers Association; Banc of America Securities LLC estimates. Sources: British Bankers Association; Banc of America Securities LLC estimates.

Insurers tend to be net Insurers tend to be net Sellers of protection. The need for yield has led to participation
Sellers of protection in the credit derivatives market through selling protection on single-name and, to a
lesser extent, tranched CDS.

Credit Derivative Product Credit Derivative Product Companies (CDPCs) are a relatively new class of protection
Companies (CDPCs) are Sellers. CDPCs are triple-A rated investment vehicles that sell protection, primarily on
a relatively new class of investment grade credits. Owing to their high rating, CDPCs are exempt from initial
protection Sellers margin requirements, and therefore in principle are able to use leverage to seek high
returns. Equity, in the form of common stock, provides a cushion for potential loss of
16
principal on the credit portfolio.

CDS Issuer Composition


High Grade
In high grade, we estimate that there is an active market for credit default swaps
About 63% of high-grade referencing about 63% of issuers. Since these issuers are concentrated in the larger,
issuers trade actively in more liquid credits, they represent approximately 87% of the market value of high
the CDS market, grade debt. Volume is greatest at a five-year maturity, but also trades for other
accounting for 87% of maturities between one and ten years.
market debt
Figure 8 shows a more detailed breakdown of high grade CDS issuer representation by
sector:

16
In recent months, some Counterparties have expressed concern about trading with CDPCs, because CDPCs do not post initial margin.
According to Moody’s Investors Service, “Credit Derivative Product Companies 2007 Sector Review and 2008 Outlook,” March 11, 2008,
“Caution commensurate with uncertain times has made it more difficult for CDPCs to get prospective counterparties comfortable with
understanding and accepting model-based counterparty credit risk and counterparties who do not post collateral.” However, Moody’s also
writes that, “A record number of CDPCs launched in 2007 despite subprime turmoil and the pipeline for 2008 remains strong … When
liquidity in the CDS market improves, the newly launched CDPCs hope to become broadly accepted as trading partners.”

Credit Default Swap Primer 13


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Credit Strategy Research 35
May 27, 2008

Figure 8. High Grade Liquid CDS vs. High Grade Cash Issuers
Estimate as of April 2008

Count %
Sector Liquid CDS HG Issuers Issuer Market Value
Basic Materials 28 44 64% 70%
Capital Goods - Manufacturing 29 45 64% 76%
Consumer Cyclical 34 40 85% 95%
Consumer Non-Cyclical 37 43 86% 97%
Energy 42 64 66% 86%
Finance 52 121 43% 87%
Gaming, Lodging & Leisure 4 5 80% 96%
Health Care 25 33 76% 89%
Insurance 23 52 44% 71%
Media 16 19 84% 95%
Technology 11 18 61% 65%
Telecommunications 16 20 80% 97%
Transportation 10 13 77% 94%
Utilities 34 53 64% 88%
Total 361 570 63% 87%
Includes corporate issuers with investment grade ratings by at least two of Moody’s, S&P, and Fitch, with cash bonds outstanding of at least $250 million.
Finance includes Finance, Banks, Diversified Finance, and REITs.
Source: Banc of America Securities LLC Estimates.

High Yield
In high yield, we estimate that there is an active market for credit default swaps
About 16% of high-yield referencing approximately 16% of issuers. While not as large as in high grade, these
issuers trade actively in issuers represent approximately 44% of high yield market value. Figure 9 illustrates
the CDS market, this point.
accounting for 44% of
market debt

14 Credit Default Swap Primer


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May 27, 2008

Figure 9. High Yield Liquid CDS vs. High Yield Cash Issuers
Estimate as of April 2008

Count %
Sector Liquid CDS HY Issuers Issuer Market Value
Basic Materials 19 109 17% 34%
Capital Goods - Manufacturing 12 92 13% 50%
Consumer Cyclical 24 127 19% 36%
Consumer Non-Cyclical 8 57 14% 57%
Energy 8 85 9% 32%
Finance 8 61 13% 19%
Gaming, Lodging & Leisure 4 57 7% 52%
Health Care 5 49 10% 50%
Insurance 2 7 29% 42%
Media 13 67 19% 48%
Technology 11 35 31% 46%
Telecommunications 8 32 25% 60%
Transportation 1 17 6% 3%
Utilities 11 20 55% 90%
Total 134 815 16% 44%
Note: Includes corporate issuers with high yield ratings by at least two of Moody’s, S&P, and Fitch, with cash bonds outstanding of at least $100 million.
Source: Banc of America Securities LLC estimates.

Beginners Guide to CDS Contract Jargon


Investors new to the credit default swap market are sometimes thrown by a seemingly
endless list of terms and definitions. Below, we translate the most important points. For
a more detailed explanation, please see the Chapter Appendix on page 17.

Credit Events
A Credit Event is the A Credit Event is the “default” in “credit default swap.” It is a circumstance that allows
“default” in “credit parties to trigger a CDS contract. There are three types of Credit Events: Bankruptcy,
default swap” Failure to Pay, and for some contracts, Modified Restructuring.
17

Figure 10 outlines the basics around each type of Credit Event.

17
For Reference Entities located in Europe, the market uses a variant known as Modified-Modified Restructuring. For details, please see the
Chapter Appendix on page 17.

Credit Default Swap Primer 15


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 10. The Basics Around Credit Events


For
x more details, please see the Chapter Appendix on page 17 x
Credit Event Description
Bankruptcy A company files for bankruptcy or becomes insolvent.
A company's failure to make agreed upon payments on borrowed
Failure to Pay
money.
A company changes outstanding obligations such that it adversly affects
investors who own those securities. Examples include reduction in
Modified Restructuring
interest or principal, maturity extension, and subordination to other
x obligations. x
Source: ISDA; Banc of America Securities LLC estimates.

Reference Entity, Reference Obligation, and Deliverable Obligations


The Reference Entity The Reference Entity establishes which legal entity must suffer a Credit Event in order
establishes which legal to trigger a CDS contract. After the Reference Entity is selected, a Reference
entity must suffer a Obligation of that entity is chosen. The Reference Obligation is typically a large and
Credit Event in order to liquid bond issue, and establishes the seniority of CDS within the capital structure.
trigger a CDS contract Following a Credit Event, the protection Buyer must deliver an obligation to the
protection Seller, in exchange for the notional of the CDS contract (recall Figure 2 on
page 8). Only certain obligations, appropriately called Deliverable Obligations, are
deliverable into the CDS contract.
The Reference Entity and Reference Obligation establish the Deliverable Obligations.
Deliverable Obligations must be issued by, or in some cases, guaranteed by, the
Reference Entity. Importantly, the protection Buyer need not deliver the Reference
Obligation, simply an obligation of equal or better seniority. The Chapter Appendix on
page 19 discusses further Deliverable Obligation requirements, such as maturity
limitations.
Figure 11 shows how to often find the standard Reference Entity and Reference
Obligation in Bloomberg:

16 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 11. Finding the Reference Entity and Reference Obligation in Bloomberg
REDL <GO>
REDL is not always correct. Before entering into a trade, agree on a Reference Entity and Reference Obligation with your Counterparty.

Search field in
Bloomberg
Reference Entity Reference Obligation
(Specific legal (Establishes required
entity on which a seniority, not security,
CDS contract is of the Deliverable
written) Obligation)

Sources: Bloomberg; ISDA; Banc of America Securities LLC estimates.

Appendix I – The Basics of Credit Default Swaps


Details around CDS Contract Terminology
Below, we provide more explicit definitions of important CDS terms. Specifics of the
CDS contract are spelled out in the term sheet (see example on page 75).

Credit Events
Credit Events include Importantly, CDS contracts do not protect against all defaults. For example, if a
Bankruptcy, Failure to Reference Entity violates covenants, bonds may be in technical default, but protection
Pay, and for selected Buyers will be unable to trigger CDS contracts. Instead, CDS contracts protect against
credits, Modified specific Credit Events, the most common in North American corporates being
Restructuring Bankruptcy, Failure to Pay, and for selected credits, Modified Restructuring. The

Credit Default Swap Primer 17


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

European corporate market uses Bankruptcy, Failure to Pay, and Modified-Modified


Restructuring.
Figure 12 shows 2003 ISDA Defintions of Credit Events:
Figure 12. Credit Event Definitions
Credit Event Description
Bankruptcy A corporation’s insolvency or inability to pay its debts. Not relevant to sovereign issuers.

Additional criteria that do not involve an actual bankruptcy filing may trigger a Bankruptcy Credit Event. These criteria are
discussed in Chapter VI – CDS Case Studies and Legal Issues on page 158, and have been of particular concern to
monoline insurers.

Failure to Pay A Reference Entity’s failure to make due payments. Usually applies to borrowed money, a broader category than simply
bonds and loans. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days
in the U.S.—and usually sets a minimum threshold of USD 1 million.

Restructuring A reduction of interest or principal, or maturity extension. Or, a change in the priority of payment of an obligation, which
causes the subordination of such obligation to any other obligation. Must result from a deterioration in the
creditworthiness or financial condition of the Reference Entity, and not be expressly provided for under the terms of the
Obligation that were in effect as of the later of the Trade Date and the date the Obligation was issued or incurred.

Usually applies to borrowed money, a broader category than simply bonds and loans, and sets a minimum threshold of
USD 10 million. To prevent parties from profiting by triggering bilateral loans, the obligation triggering the Restructuring
must have at least 4 unaffiliated lenders, two-thirds of which consent to the Restructuring.

The US investment grade market generally uses Modified Restructuring. The US high yield market generally uses No
Restructuring (i.e., Restructuring does not constitute a Credit Event), but credits that were downgraded from investment
grade usually continue to use Modified Restructuring. The CDX indices use No Restructuring. Europe (investment grade
and high yield, single-name and iTraxx indices) uses Modified-Modified Restructuring.

Modified and Modified-Modified Restructuring generally limit the maturity of Deliverable Obligations to the front-end of the
curve. For details, please see Chapter VI – CDS Case Studies and Legal Issues on page 152.
Restructuring criteria may also be triggered if the date for payment or accrual of interest is extended, or currency is changed to a non-permitted currency (G7 plus OECD members with a triple-A local
currency long-term debt rating).
ISDA Definitions technically provide for three additional Credit Event triggers:
Obligation Acceleration: When an obligation has become due and payable earlier than normal because of a Reference Entity’s default or similar condition. Obligation Acceleration is subject to a
minimum dollar threshold amount. No longer used in G7 corporate contracts.
Repudiation/Moratorium: A Reference Entity’s rejection or challenge of the validity of its obligations. No longer used in G7 corporate contracts.
Obligation Default: Although rarely used, obligations may become capable of being declared due earlier than normal as a result of default.
Source: 2003 ISDA Credit Derivatives Definitions.

If no pre-specified Credit Event occurs during the life of the transaction, the protection
Seller keeps the periodic payment (quarterly payments calculated by notional x coupon
x actual/360, plus an up-front payment, if applicable) in compensation for assuming
18
credit risk on the Reference Entity. Conversely, should a Credit Event occur during
the life of the transaction, the protection Buyer receives a compensating payment
depending on the settlement of the contract (discussed below). The protection Seller
receives only the accrued periodic payment up to and including the Event
Determination Date (effectively, the date a Credit Event occurs).
The market standard is for CDS protection to begin at T+1 days. So, if a Credit Event
occurs on the same day that a trade is executed, the investor does not have protection.
Cash flows are settled at T+3 days.
Sample Credit Event documentation appears on page 86.

18
Upfront payments typically apply only to indices and Reference Entities with five-year CDS wider than approximately 700 bps. For details,
please see “The Transition from Spread to Points Upfront” on page 108.

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Deadline for a Credit Event

Credit Events must occur All Credit Events must occur by 11:59pm Greenwich Mean Time (GMT) on the
by 11:59pm Greenwich Scheduled Termination Date for the CDS Buyer to have protection.
Mean Time (GMT) on the For example, Calpine filed for Bankruptcy at 10:57pm New York time on December
maturity date 20, 2005, which was later than 11:59pm GMT. As such, for holders of CDS contract
with a December 20, 2005 maturity, there was no Credit Event.

Reference Entity, Reference Obligation, and Deliverable Obligations


The Reference Entity is The Reference Entity is the specific legal entity on which a CDS contract is written.
the specific legal entity After the Reference Entity is selected, a Reference Obligation of that entity is chosen.
on which a contract is The Reference Obligation is typically a large and liquid bond issue, and its selection
written establishes the seniority of the CDS within the capital structure. While there are some
exceptions, the market standard for Reference Entities and Reference Obligations is
often found on the REDL screen in Bloomberg.
It is important to note that the protection Buyer does not have to deliver the Reference
Obligation. Following a Bankruptcy or Failure to Pay Credit Event, the protection
Buyer may deliver a bond or loan that is pari passu in seniority with the Reference
19
Obligation, up to a 30-year maturity.
The Reference Obligation determines only the required seniority, not the security, of
the Deliverable Obligation. For example, if the Reference Obligation is a senior
secured bond, the protection Buyer may deliver a senior unsecured bond, following a
Credit Event.
If the Reference Obligation matures or is otherwise redeemed, its original seniority
20
continues to set the seniority of CDS. For plain-vanilla CDS trades without a
Reference Obligation, the priority is considered senior unsecured.

19
There are additional restrictions surrounding Deliverable Obligations following a Restructuring. For details, please see Chapter VI – CDS
Case Studies and Legal Issues on page 152.
20
By “original seniority,” we mean the seniority as of the later of the CDS trade date and the Reference Obligation issue date.

Credit Default Swap Primer 19


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Credit Strategy Research 35
May 27, 2008

Figure 13. CDS Essential Vocabulary List


Reference Entity The legal entity (not the instrument) on which a contract is written. Important because different entities within the same company
or organization may have different risk profiles and expected recoveries. Complicated by mergers, restructurings, etc.

Credit Event An event that triggers the contingent payment on a credit default swap. There are two Credit Events currently used across CDS
products (see Figure 12), Bankruptcy and Failure to Pay. Additionally, single-name CDS contracts on US investment grade and
fallen-angel Reference Entities typically include Modified Restructuring. Single-name and index CDS contracts on European
Reference Entities (investment grade and high yield) typically include Modified-Modified Restructuring.

Reference Obligation and Reference Obligation is cited in the CDS term sheet. Buyer does not have to deliver this exact obligation but must deliver a debt
Deliverable Obligations instrument that is pari passu in seniority with the Reference Obligation, up to a 30-year maturity (typically shorter for a Modified-
or Modified-Modified Restructuring). If no Reference Obligation is chosen, defaults to senior unsecured.
The Reference Obligation determines only the required seniority, not the security, of the Deliverable Obligation. For example, if the
Reference Obligation is a senior secured bond, the protection Buyer may deliver a senior unsecured bond following a Credit
Event.
Special language must be included for investors who wish to restrict the security of the Deliverable Obligation. Please see the
section “Secured CDS” on page 169, for details.

Settlement Can be Physical or Cash Settlement. Standard CDS documentation specifies Physical Settlement. Protection Seller buys
Deliverable Obligation from protection Buyer at par upon occurrence of a Credit Event. In Cash Settlement, protection Seller pays
protection Buyer the difference between the par and market values of a Reference Obligation.
In practice, market expectations are in the process of moving from Physical Settlement to Cash Settlement. Parties retain the
option to physically settle, provided that another market participant is willing to take the opposite position. Please see Chapter VI
– CDS Case Studies and Legal Issues on page 143 for details.
Note: For senior unsecured CDS, Deliverable Obligations typically are Bonds and Loans that meet the following criteria: Not Subordinated, Specified Currency (typically, USD, GBP, EUR, CAD, CHF, or
JPY), Not Contingent, Assignable Loan (if applicable), Consent Required Loan (if applicable), Transferable, Maximum Maturity: 30 years, and Not Bearer.
Maturity limitation is typically more restrictive following a Modified- or Modified-Modified Restructuring. For details, please see Chapter VI – CDS Case Studies and Legal Issues on page 152.
ISDA Definitions technically provide for additional Credit Event triggers, described in Figure 12.
Sources: ISDA; Banc of America Securities LLC estimates.

Guarantees
Under certain Naturally, the financial and risk profiles of different entities that fall under the same
circumstances, debt from organizational umbrella are not always the same. Consequently, the recovery values on
a subsidiary may be instruments of those different entities potentially will be very different following a
deliverable into CDS on a Credit Event. However, parties to a credit default swap should recognize that, under
parent company certain circumstances, debt from a subsidiary may be deliverable into CDS on a parent
company.
For Reference Entities located in North America, if a holding company (parent)
guarantees an operating company (subsidiary), that operating company’s debt is
deliverable into CDS on the holding company. See Figure 14. The guarantee must be
unconditional and irrevocable, where the holding company owns a majority of the
operating company.
Upstream guarantees (from subsidiary to parent) are not taken into account for
Reference Entities located in North America. That is, for CDS on an operating
company, under no circumstance is holding company debt deliverable.

20 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 14. Effect of Guarantees on CDS Contracts, Globally


Based on Location of Reference Entity, Regardless of Where Trade Is Executed
Globally, guarantees must be unconditional and irrevocable to be valid for CDS contracts

5 Indicates debt is deliverable


North America Europe
If Parent Guarantees Subsidiary
Is parent debt deliverable into subsidiary CDS? No No
Is subsidiary debt deliverable into parent CDS?
If parent owns majority of subsidiary 5 5
If parent owns minority of subsidiary No 5
If Subsidiary Guarantees Parent
Is parent debt deliverable into subsidiary CDS? No 5
Is subsidiary debt deliverable into parent CDS? No No
If Subsidiary A Sideways Guarantees Subsidiary B
Is subsidiary A debt deliverable into subsidiary B CDS? No No
Is subsidiary B debt deliverable into subsidiary A CDS? No 5
Globally, debt delivered must be pari passu or better than the Reference Obligation in seniority, regardless of security.
Also of note: If the parent (or subsidiary) guarantees a third-party, then third-party debt is deliverable into parent (or subsidiary) CDS, for Europe only.
If a third-party guarantees the parent (or subsidiary), then parent (or subsidiary) debt is deliverable into third-party CDS, for Europe only.
Sources: ISDA; Banc of America Securities LLC estimates.

For Reference Entities located in Europe, a broader class of guarantees applies to CDS
contracts, as illustrated in Figure 14.
Orphaned CDS (Lack of Deliverable Obligations)
A CDS contract on a company that has no Deliverable Obligation is sometimes called
“orphaned CDS.” For example, an orphaned CDS situation may occur when a
company’s debt is tendered for in connection with an LBO, and that company
subsequently becomes an operating company within the post-LBO entity. Unless the
operating company issues new debt, there will be no Deliverable Obligation into CDS
contracts, and CDS will become near-worthless.

Succession
Succession refers to What happens if a Reference Entity is merged, acquired, or some other change is made
changes in a CDS contract with respect to its corporate structure? This issue is one referred to as Succession in
after a Reference Entity is CDS terms, and may be summarized as follows:
merged, acquired, or
X If one entity succeeds to 75% or more of the Relevant Obligations (Bonds and
undergoes some other
Loans) of the Reference Entity, that entity will be the sole Successor. The original
change in its corporate
Reference Entity will be deleted from the contract, and replaced with the Successor
structure
Reference Entity.
X If one or more entities succeeds to more than 25% but less than 75% of the
Relevant Obligations, each such entity and the original Reference Entity will be a
Successor. The notional for each contract will be the original notional, divided
equally by the number of Successors. For example, an investor with a $10 million
CDS contract may now have a $5 million CDS contract in the original Reference
Entity, and a $5 million Reference Entity in the Successor Reference Entity.

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X If no one entity succeeds to more than 25% of the Relevant Obligations, and the
Reference Entity continues to exist, there will be no Successor. The Reference
Entity will not change.
For more details on Succession, including case studies on issues that have created
recent market uncertainty, please see Chapter VI – CDS Case Studies and Legal Issues
on pages 129 and 132.

Information and Confidentiality Provisions


Although credit default swaps usually are traded on the public side of the information
wall, the 2003 ISDA Credit Derivatives Definitions contain representations
surrounding information. Specifically, parties acknowledge that they may be in
possession of material information “that may or may not be publicly available or
known to the other party, and such Credit Derivative Transaction does not create any
obligation … to disclose to the other party any such relationship or information
(whether or not confidential).” Moreover, unless otherwise agreed, parties are not
21
subject to any obligation of confidentiality.

Risk of a Short Squeeze


Generally, it is the Standard confirms for flow CDS products (single-name, indices, and tranches) state
burden of the protection that Credit Events are physically settled. Generally, it is the burden of the protection
Buyer to find a Buyer to find a deliverable bond or loan. That is, according to standard confirms, the
deliverable bond or loan protection Buyer (generally) is only entitled to receive the notional value of protection
(e.g., $10 million) if he delivers a bond or loan to the Seller. As such, historically, there
has been a significant need for Buyers of protection to buy bonds post-Bankruptcy.
With rapid growth in the CDS market, the notional value of protection now exceeds the
This may drive the price notional of Deliverable Obligations for many Reference Entities. This has driven the
of bonds artificially high price of bonds artificially high following a Credit Event. For example, in Delphi, bonds
following a Credit Event traded up from $58 immediately post-default to a high of $72 three weeks later, on little
fundamental news.
As a partial solution to the risk of a short squeeze, the CDS market has voluntarily
As a partial solution, the adopted settlement protocols following all Credit Events since 2005. In regular CDS
CDS market has contracts, the standard is Physical Settlement, with an option to cash settle, provided
voluntarily adopted that both parties consent. The settlement protocols change the standard to Cash
settlement protocols Settlement, with an option to physically settle, provided that another market participant
22
is willing to take the opposite position.
Protocols originally allowed investors to cash settle only index and index tranche
transactions, but since the Dura Bankruptcy in October 2006, have allowed investors to
cash settle single-name transactions as well. For Delphi, the protocol helped to bring
23
bonds down from a peak of $72 to a cash settlement price of $63.375.
For more on CDS settlement protocols, please see Chapter VI – CDS Case Studies and
Legal Issues on page 143.

21
2003 ISDA Credit Derivatives Definitions, Section 9.1(b)(iv)–(v).
22
The other participant need not be the original Counterparty, just another participant in the settlement protocol.
23
Roughly speaking, cash settlement protocols have asked banks and broker-dealers to quote the cheapest-to-deliver bond on a defaulted credit.
After applying a filtering mechanism to eliminate off-market quotes, the protocol settles near an average of the dealer prices. Additionally,
although single-name CDS notional for Dura Operating Corp. was relatively low, the settlement protocol set a precedent for including single-
name CDS transactions.

22 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

CDS and Corporate Bond Market Surveys


We look at CDS surveys We agree that the CDS market is growing rapidly but believe that under many
from ISDA, the British circumstances, the size of the CDS market may grow without any change in overall risk
Bankers’ Association, exposure. For example, if an investor buys protection in an index and sells protection in
and the Bank of underlying intrinsics, reported CDS notional will grow, even though net credit
International Settlements exposure will be unchanged.
This section provides more details on the methodology of popular CDS and corporate
bond market surveys, emphasizing differences between market size and overall risk
exposure. We focus on three CDS market size surveys: the International Swaps and
Derivatives Association (ISDA), the British Bankers’ Association (BBA), and the Bank
of International Settlements (BIS). We then explain our methodology to estimate the
size of the global corporate bond market.

International Swaps and Derivatives Association (ISDA) Survey


ISDA conducts two surveys per year of its primary members. ISDA asks each
institution to estimate the size of its credit derivatives notional, and then aggregates the
results to obtain an overall estimate of market size. As described below, ISDA attempts
to adjust for potential double-counting, in which the trades of two survey respondents
offset each other. We show several examples that illustrate the methodology.
New Trades
An investor buys or sells $10 million in protection:
X Reported size of the CDS market grows $10 million
Unwinds/Assignments/Offsets:
An investor sells $10 million in protection, and immediately unwinds with the same
dealer:
X Reported size of the CDS market is unchanged
An investor sells $10 million protection, and assigns the trade to another dealer:
X Reported size of the CDS market grows $20 million ($10 million initial trade + $10
million assignment). This is an overstatement, because the CDS market should
grow only $10 million (the amount of the remaining trade between the original
dealer and the new dealer to whom the trade was assigned).
X ISDA attempts to adjust for the error by multiplying the $20 million by a BIS-
estimated adjustment factor for dealer-to-dealer trades. That is, each dealer will
report a $10 million trade with another dealer, leading to double-counting. The
adjustment factor estimates the extent of this double-counting. In principle, the
adjustment factor should bring the reported growth in the CDS market back to $10
million.
An investor sells $10 million in protection, and subsequently offsets the trade by
buying $10 million in new protection (rather than an unwind or an assignment):
X If the offset is with the original dealer and has the same maturity date as the
original trade, reported size of the CDS market is likely to be unchanged ($10
million in initial trade – $10 million offset). This is because the original dealer is
likely to consolidate the two trades, similar to an unwind, to show a net zero
position. This result accurately reflects net credit risk.

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X However, if the offset is with the original dealer but has a different maturity date
(for instance, an investor partially offsets an off-the-run CDS contract with an on-
the-run CDS contract, but keeps the tail risk between the maturity dates), the
reported size of the CDS market grows $20 million ($10 million in initial trade +
$10 million in offset). Even though the offset causes net credit risk to substantially
decline, reported CDS notional increases.
X If the offset is with another dealer, regardless of maturity date, reported size of the
CDS market grows $20 million ($10 million in initial trade + $10 million in
offset). Unlike an assignment, each dealer faces the client, rather than another
dealer. As such, there is no adjustment for the offsetting position.
Index vs. Intrinsics Arbitrage
An investor sells $125 million in index protection and buys $1 million single-name
protection on each of the 125 underlying constituents:
X Even though there is no net credit exposure, the reported size of the CDS market
grows $250 million ($125 million index trade + 125 single-name trades of $1
million each)
CDS—Cash Basis Trades
An investor buys $10 million of a cash (corporate) bond and buys $10 million single-
name protection.
X Even though there is no net credit exposure, the reported size of the CDS market
grows $10 million
Structured Credit (Correlation)
An investor sells $10 million of 20x leveraged equity tranche protection, unhedged:
X Reported size of the CDS market grows $10 million. However, one might argue
that the reported size of the CDS market should grow $200 million ($10 million
tranche notional x 20x leverage = $200 million single-name equivalent risk).
An investor sells $10 million of 20x leveraged equity tranche protection, delta-hedged
with protection in the underlying constituents:
X Reported size of the CDS market grows $210 million ($10 million tranche notional
+ $200 million of protection for the hedge). The result is the same if the investor
hedges with single-name CDS or an index.

British Bankers’ Association (BBA) Survey


The bi-annual BBA survey does not use a standardized methodology to estimate the
size of the CDS market. Instead, the BBA survey simply asks one question of each of
its members:
“What do you estimate the size of the GLOBAL market in credit derivatives to be?
Please provide estimates in aggregate notional value outstanding in USD mns.”
BBA then reports the average of these estimates.

Bank of International Settlements (BIS) Survey


The Bank of International Settlements (BIS) conducts a semiannual survey on the
derivatives markets, across approximately 60 institutions in the G10 countries and
Switzerland. Every third year, the last time in June 2007, the survey is conducted
across approximately 1,500 institutions worldwide.

24 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

In addition to credit, the survey includes data on derivative contracts in foreign


exchange, interest rates, equities, and commodities. While the survey began in June
1998, credit default swap reporting began in December 2004.
BIS surveys dealers, banks, insurance and financial firms, as well as non-financial
institutions. To reduce double-counting, dealers are asked to report both their total
notional and their notional with other dealers. The BIS then calculates total notional
amount outstanding as the sum of contracts bought and sold, minus one-half the sum of
contracts bought and sold between reporting dealers. Otherwise, BIS’ methodology is
similar to the ISDA survey.

Corporate Bond Market Size


We use the following methodology to estimate global corporate bond market size:
1. Estimate the size of the portion of the global corporate bond market held by U.S.
residents, based on Federal Reserve Flow of Funds data. These estimates include
bonds issued by U.S. corporations, anywhere in the world, plus bonds issued by
non-U.S. entities, which are purchased by U.S. residents through U.S. dealers.
2. Adjust these estimates to reflect the approximate size of the global, relative to the
U.S., corporate bond market. We look at BIS estimates of debt securities for
corporate and financial issuers, international and domestic. For the numerator, we
look at the global market. For the denominator, we look at the U.S. market. We
then multiply the results in step one by this adjustment factor. In recent years, this
methodology suggests that the global market is approximately twice the size of the
U.S. market.

Credit Default Swap Primer 25


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Chapter II – Differences Between the CDS and Corporate


Bond Markets
Pricing in the CDS Market
Quoting conventions have Credit default swap market pricing convention can be counterintuitive to cash investors
opposite economic because bids and offers in the cash and CDS markets have opposite economic meaning.
meanings in the cash and The bid side in the CDS market reflects what CDS dealers will pay for protection, or
CDS markets the fixed payment an investor would receive for providing protection: meaning going
long credit risk. In contrast, the bid side in the cash market reflects what cash dealers
will pay for an asset, so that the investor would be short credit risk.
Similarly, the offered side in the CDS market reflects the fixed payment CDS dealers
demand to provide protection, or the fixed payment an investor must pay to purchase
protection: meaning, to short credit risk. In contrast, the offered side in the cash market
reflects the price at which cash dealers will sell an asset, so that the investor would be
long credit risk.
Figure 15. CDS vs Cash Market Pricing Convention
Credit Default Swap Cash Market
Market Bid for Credit Default Protection Market Bid for Cash Instrument
Investor’s Economic Position Long credit risk Short credit and interest rate risk
Investor’s Cash Flows Receive coupon Pay yield
Funding Unfunded Funded
The reverse logic applies for market offer-side.
Investor’s Economic Position: Although relatively small, credit default swaps have some exposure to interest rates, because of the inclusion of LIBOR in the discount factor. For details, please see
Interest Rate Sensitivity on page 111.
Source: Banc of America Securities LLC.

Though the form of CDS fixed payment quotations may be unfamiliar to some cash
market participants, CDS payments in most instances are tied to the underlying cash
instrument through no-arbitrage relationships. In this sense, a bond’s spread to LIBOR,
discussed below, often provides a good indication—but not an exact metric—of credit
default swap levels.

The ABCs of Credit Spreads


Below, we summarize various ways to compare relative value between CDS and
corporate bonds. The Chapter Appendix on page 34 provides more complete details.
The most important difference between the corporate bond (“cash”) and CDS markets is
While investment-grade the benchmark spread curve. While investment grade cash bonds are typically quoted as a
cash bonds are typically spread to Treasury, credit default swaps are thought of as a spread to LIBOR.
quoted as a spread to
Treasury, credit default The reason has to do with the cost of funding. Consider a single-name CDS trade at
swaps are thought of as 380 bps, on a $10 million notional. The quoted spread will be 380 bps, and the
a spread to LIBOR protection Buyer will pay $380,000 per annum ($95,000 per quarter) to the protection
Seller. Notice the payment is 380 bps, not LIBOR + 380 bps. However, in CDS, the
Buyer is assumed to fund at LIBOR. That is, for the protection Buyer to pay 380 bps

26 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

annually, he must borrow that money at LIBOR, effectively creating a spread of


24
LIBOR + 380 bps.
Alternatively, spread to LIBOR may be thought of as compensation for Counterparty
risk. If a cash bond investor purchases a Verizon bond, payment for that transaction is
solely a matter between the investor and Verizon. While a bank or broker-dealer
Counterparty may facilitate that trade by locating the bonds, once the bonds have been
delivered, the investor has no further exposure to the bank or broker-dealer.
However, in a credit default swap, payment for the transaction also depends on the
Should the Counterparty creditworthiness of the Counterparty. Should the Counterparty fail to make a coupon
fail to make a payment, payment (or appropriate payments following a Credit Event), the investor has no
the investor has no recourse against Verizon, only against the CDS Counterparty. Typically, major CDS
recourse against the Counterparties fund at approximately LIBOR; that is, they would issue a bond at about
Reference Entity, only
the Treasury rate + swap spread. Hence, the market generally views CDS as a LIBOR-
against the CDS
based market. Hedge funds are a natural exception, and they view CDS as a LIBOR +
Counterparty
funding spread market.
Figure 16 shows how to (theoretically) reconstruct a corporate bond from a credit
default swap:

24
This gives an important lesson: Different counterparties should view the benchmark CDS spread differently. For example, a protection Buyer
who funds at LIBOR + 3/8 should view the same credit spread as LIBOR + 3/8 + 380 bps, not just LIBOR + 380 bps.

Credit Default Swap Primer 27


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 16. Reconstructing a Cash Bond out of a Credit Default Swap

Par

L+380

Swap
Spread +
380

380 bps

Assumes semiannual coupon for both corporate bond and CDS. A quarterly CDS coupon (still with a semiannual corporate bond coupon) would widen the Z-spread by approximately 3 bps.
Sources: Bloomberg; Banc of America Securities LLC estimates.

For a five-year credit default swap trading at 380 bps, the relevant comparison is a
corporate bond trading at five-year LIBOR + 380 bps; in this case, a yield of 7.582%.
Since single-name CDS trades usually begin at par, 7.582% is also the comparable cash
25
bond coupon. The equivalent cash bond spread is 463.7 bps over the five-year
Treasury. The difference between the 463.7-bp spread to Treasury and the 380-bp CDS
spread is the five-year swap spread (83 bps). The “Z-spread,” one of the spread to
LIBOR measures we will discuss in this section, is 380 bps, the same as the credit
26
default swap spread.
In practice, investors do not often replicate cash bonds out of CDS contracts. This is
To reconstruct a cash because most corporate bond buyers hedge with Treasuries, leaving them exposed only
bond out of a Credit to the credit spread component of risk. However, investors who want to reconstruct a
Default Swap, buy a AAA- cash bond out of a credit default swap may in principle buy a triple-A rated bond that
rated bond that yields yields roughly LIBOR—such instruments do not generally exist as of May 2008—and
roughly LIBOR and sell
sell CDS protection. This yields the investor LIBOR (from buying the bond) plus the
CDS protection
CDS spread (from selling protection).
25
Since the credit default indices trade with a fixed coupon, these trades often begin away from par. In addition, single-name CDS trades often
begin away from par for wide-spread Reference Entities. See the section, “The Transition from Spread to Points Upfront” on page 108 for
details.
26
For simplicity, we assume a semiannual coupon and 30/360 day count for both the corporate bond and CDS. In reality, CDS trades with a
quarterly coupon and ACT/360 day count, while US corporate bonds pay a semiannual coupon and have a 30/360 day count. Relaxing the
coupon assumption would widen the Z-spread by approximately 3 bps, while relaxing the day count assumption would tighten the Z-spread
by approximately 3.5 bps.

28 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Which Spread to LIBOR?


Below, we summarize popular spread to LIBOR measures. The Chapter Appendix on
page 34 provides more details.
CDS Spread
X CDS Spread is a pure and simple credit risk premium that a protection Seller is
paid to take on credit risk in the credit default swap market. It is a percentage of the
notional amount (expressed in terms of bps) that the investor is paid per annum. If
there is a Credit Event during the life of the transaction, this payment stops and the
investor pays the Buyer of protection a onetime credit loss equal to par minus
recovery.
Preferred Spread to LIBOR Measure for Bullet Bonds
X Par CDS Equivalent Spread is the spread level calculated for a cash bond that
makes an investor indifferent between buying the cash instrument and selling CDS
protection. Par CDS equivalent spread assumes a recovery value to keep total
credit risk equal between the cash and CDS markets. I-spread, asset swap spread,
and Z-spread, discussed below, understate the actual level of spread when the cash
bond is trading at a discount. Par CDS equivalent spread more accurately reflects
compensation for credit risk. Par CDS equivalent spread does not adjust for
optionality and therefore should be used only for bullet bonds.
Preferred Spread to LIBOR Measure for Non-Bullet Bonds
X OAS to LIBOR is the option-adjusted spread to LIBOR, without an assumption of
zero volatility. This measure estimates the value of call or put provisions, making it
particularly appropriate for high yield bonds. For bullet bonds, OAS to LIBOR is
the same as Z-spread. For non-bullet bonds, OAS to LIBOR is an approximate
relative value measure, but does not take into account that single-name CDS trades
at par, while cash may trade away from par.
Other Popular Spread to LIBOR Measures
X I-Spread, or interpolated spread to swap, is the yield difference between a cash
corporate bond and a matched-maturity swap yield. The economics of I-Spread for
a par bond are identical to those of CDS Spread, except that there is no funding
requirement under the credit default swap contract. I-spread is based solely on the
yield and maturity of a bond, not cash flows.
X Asset Swap Spread is the incremental spread above LIBOR that an investor earns
to swap a fixed-rate corporate bond to LIBOR-based floating payments. It is
calculated by discounting the premium or discount portion of cash flows at LIBOR
flat, unlike Z-spread, which uses a higher discount factor to more accurately reflect
credit risk. For par asset swaps, any premium or discount is settled upfront in cash.
The key difference between asset swap spread and other spread measures is the
way that asset swap spread breaks up the discounting of coupon flows (at the risky
rate) versus premium or discount flows (at LIBOR).
X Z-Spread is the option-adjusted spread to LIBOR under an assumption of zero
volatility. It incorporates the shape of the yield curve in its calculation and uses the
timing of cash flows of the bond. If the yield curve is completely flat, Z-spread is
the same as I-spread. For a coupon bond, the Z-spread is higher than the I-spread,
assuming an upward sloping yield curve. For bonds trading away from par, Z-
spread does not adjust for the dollar difference in recovery between cash bonds and
credit default swaps.

Credit Default Swap Primer 29


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Example: Z-Spread vs. Par CDS Equivalent Spread


Figure 17 and Figure 18 illustrate the difference between Z-spread and Par CDS
equivalent spread for the Toys “R” Us, Inc. 7.875 % of 2013, between October 2003 and
April 2008. This date range incorporates periods in which the bond traded at both a
premium (high of $110) and a deep discount (low of $69):
Figure 17. As a Bond Moves Further Away from Par… Figure 18. …Be Careful About Your Spread Measure
Par CDS – Z-Spread, versus Price Par CDS – Z-Spread, versus Price
TOY 7.875% July April 15, 2013 TOY 7.875 % July April 15, 2013

Par CDS - Z-Spread Price 250


250 120

Par CDS - Z-Spread (bps)


200
Par CDS - Z-Spread (bps)

200 110
150
150 100
Price ($) 100
100 90
50
50 80
0
0 70
-50
-50 60 65 75 85 95 105 115
Oct-03 Oct-04 Oct-05 Oct-06 Oct-07 Price ($)
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

The further a bond moves Notice that the error introduced by Z-spread is closely related to the dollar price of the
away from par, the more bond. When the bond was trading at about $80, Z-spread understated Par CDS
Z-spread and Par CDS equivalent spread by about 45 bps (Figure 18). By contrast, when the bond was trading
equivalent spread will around par, Z-spread and Par CDS equivalent spread were within 10 bps of each other.
differ Moreover, this relationship is nonlinear. The further the bond moves away from par,
the more Z-spread and Par CDS equivalent spread will differ.

The Credit Default Swap Basis


If CDS trades tighter After converting a cash bond to spread to LIBOR, an investor might expect that the
than cash (a “negative CDS spread for a Reference Entity should equal the spread to LIBOR on an identical-
basis”), an investor may maturity par bond. This is due to a no-arbitrage relationship:
consider buying If CDS trades tighter than cash (a “negative basis”), an investor may consider buying
protection and buying the protection and buying the cash bond. Provided that the basis widens, the investor
cash bond profits from widening of CDS, tightening of the cash spread, or both. If a Credit Event
occurs, the investor may deliver the cash bond to settle the CDS contract, and receive
par. Negative-basis trades require attractive funding rates (to pay the CDS premium)
and balance sheet availability (to buy the cash bond).
If CDS trades wider than If CDS trades wider than cash (a “positive basis”), an investor may consider selling
cash (a “positive basis”), protection and selling the cash bond. Provided that the basis tightens, the investor
an investor may consider profits from tightening of CDS, widening of the cash spread, or both. If a Credit Event
selling protection and occurs, the investor may use the bond received from physically settling the CDS
selling the cash bond contract, to cover the short position in the bond. Positive basis trades require either
having the bond in inventory (and available for sale), or borrowing the bond in the repo
market.

30 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

In reality, a number of factors cause differences in CDS and the cash spread to LIBOR,
Historically (less since even for par bonds. We define this difference (CDS – cash) as the “basis.”
summer 2007), the Historically—but less since summer 2007—one of the most important factors
CDS—cash basis tended determining the basis has been the level of credit risk (or spreads). When credit risk has
to widen with the level of risen, demand for buying protection also rose, and the basis became more positive.
credit spreads
When credit risk has declined, the opposite occurred, and the basis tended to narrow or
even become negative. In this sense, CDS spreads have often traded with a higher beta
than their cash bond equivalent. That is, if the cash bond widens 10 bps, CDS has
27
tended to widen, say, 13 bps (and the basis has increased 3 bps), and vice-versa.
For example, Figure 19 illustrates the historical relationship between CDS and cash for
General Motors Corp. Notice that CDS almost always traded wider than cash during
this approximately two-year period. As Figure 20 shows, the basis widened with the
level of credit spreads. This means that, even after adjusting for maturity differences,
CDS spreads reached particularly wide levels versus cash, as credit quality
deteriorated. For example, in mid-May 2005, an investor could earn roughly 750 bps in
cash, but 1000 bps in CDS.
Figure 19. CDS Is More Risky than Cash… Figure 20. …Particularly in Wide Spread Environments
Interpolated CDS versus Cash Spread Cash Spread versus CDS-Cash Basis
GM 7.125% July 2013 GM 7.125% July 2013

Matched-Maturity CDS 1,600 y = 1.3128x + 1.1708


1,400 Spread to LIBOR 1,400 R2 = 0.9607
Interpolated CDS (bps)

1,200 1,200
1,000 1,000
Spread (bps)

800 800
600 600
400
400
200
200 0
0 0 500 1,000 1,500
Oct-03 Oct-04 Oct-05 Oct-06 Cash (Par CDS Equivalent Spread, bps)
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

CDS versus Cash in a Volatile Market


Since summer 2007, CDS has aggressively outperformed cash, particularly in tighter
Recently, CDS has spread credits. Figure 21 shows cash versus matched maturity CDS spreads in the five-
outperformed cash, driving the year sector, for credits where five-year CDS spread is tighter than the CDX IG index.
average CDS – cash basis to We note that, in early 2008, most basis package volume has been in the ten-year sector;
roughly -80 bps (CDS 80 bps however, we focus our graphs on the five-year sector due to better data availability.
rich to cash bonds)
Most recently, as CDS spreads have tightened, cash spreads actually moved wider. In
wider spread credits (Figure 22), both CDS and cash have rallied, with CDS tightening
more than cash.

27
Also, at wide credit spreads, the repo market often dries up, making it difficult or expensive to find a bond to borrow. This makes it more
difficult to sell bonds and sell protection. For details, please see the Chapter Appendix on page 44.

Credit Default Swap Primer 31


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 21. Cash and Matched Maturity CDS Spread Figure 22. Cash and Matched Maturity CDS Spread
For Credits with Five-Year CDS < CDX IG Index For Credits with Five-Year CDS > CDX IG Index
January 2005 to April 2008 January 2005 to April 2008

160 600
Cash Cash
140
Matched Maturity CDS 500 Matched Maturity CDS
120

Spread (bps)
400
Spread (bps)

100
80 300
60 200
40
20 100
0 0
Jan-05 Jan-06 Jan-07 Jan-08 Jan-05 Jan-06 Jan-07 Jan-08
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate.
The number of bonds analyzed each day depends on the availability of pricing data. The number of bonds analyzed each day depends on the availability of pricing data.
Currently, we look at a portfolio of 66 bonds. Currently, we look at a portfolio of 66 bonds.
Source: Banc of America Securities estimates. Source: Banc of America Securities estimates.

Figure 23 illustrates the relationship between cash and CDS spreads more directly by
taking the difference between the two spreads. Notice the gap tighter:

Figure 24. CDS – Cash Basis Volatility Increases Steadily Since


Figure 23. CDS Outperforms Cash Spread to LIBOR Summer 2007
CDS – Cash Basis (bps) For Credits with 5y CDS < CDX IG Index
January 2005 to April 2008 January 2005 to April 2008

Tighter Spread Credits


Volatility of CDS -Cash Basis (bps)

6
100 Wider Spread Credits
5
CDS - Cash Basis (bps)

50
6m Rolling Daily

4
0
3
-50 2
-100 1
-150 0
Jan-05 Sep-05 May-06 Jan-07 Sep-07 Apr-05 Feb-06 Dec-06 Oct-07
The number of bonds analyzed each day depends on the availability of pricing data. Currently,
The number of bonds analyzed each day depends on the availability of pricing data. Currently, we look at a portfolio of 82 bonds: 39 with five-year CDS wider than the CDX IG index and
we look at a portfolio of 82 bonds: 39 with five-year CDS wider than the CDX IG index and 42 tighter than the CDX IG index. This figure is restricted to credits with five-year CDS
42 tighter than the CDX IG index. tighter than the IG index.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

32 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

The heightened volatility in the CDS–cash basis is as striking as the record negative
levels. Figure 24 shows that the volatility in the basis has grown steadily since summer
2007. To calculate volatility, we take a rolling six-month standard deviation of daily
changes in the CDS–cash basis.
Funding Costs
As it becomes more expensive for financial institutions to fund, they tend to prefer
synthetic risk, like CDS, relative to funded risk, like cash bonds. Alternatively, if
funding costs rise, say, 50 bps, the relevant metric for cash bonds becomes a spread to
L+50 bps rather than a spread to LIBOR flat. Figure 25 shows three-year AAA credit
card spreads and the CDS cash basis. Notice that as the credit card spreads have
widened (gray line is inverted), the basis has tightened.

Figure 25. CDS – Cash Basis and Funding Cost Moving Figure 26. CDS- Cash Basis and the Effective Basis after
Together Adding Funding Cost
CDS – Cash Basis and AAA Credit Card Spreads Effective Basis = CDS – Cash Basis + Funding Cost
For credits with 5y CDS tighter than the CDX IG index spread For credits with 5y CDS tighter than the CDX IG index spread

CDS - Cash Basis CDS - Cash Basis


20 AAA Credit Cards -20 100 Effective Basis
10 80
0 CDS - Cash Basis (bps)
AAA Credit Cards Spread
CDS - Cash Basis (bps)

0 60
-10 20
(Inverted) (bps)

40
-20 40 20
-30
60 0
-40
-50 -20
80
-60 -40
100 -60
-70
-80 120 -80
Jan-05 Jan-06 Jan-07 Jan-08 Jan-05 Jan-06 Jan-07 Jan-08
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

2006: The Year of Swap Spreads


Tighter swap spreads may In summer 2006, the CDS—cash basis moved almost in lockstep with tightening swap
cause CDS to outperform spreads. The reason is a different investor base between cash and CDS. Cash bond
investors, who typically are benchmarked versus Treasuries, paid little attention to the
move in swap spreads. By contrast, CDS investors, who typically fund versus LIBOR,
viewed cash bonds as cheapening to CDS, because their spread to LIBOR had widened.
See Figure 27 and Figure 28.

Credit Default Swap Primer 33


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 27. 2006: Cash Spread to Treasury Tightening, but Figure 28. 2006: CDS-Cash Basis On Top of Swap Spreads
Spread to LIBOR Widening Interpolated CDS—Cash Basis, versus Five-Year Swap Spread
Shown for BAS Broad Market Index of Investment Grade Cash Bonds 3 Jan 06—5 Jan 07
3 Jan 06—5 Jan 07

Spread to Treasury Spread to LIBOR Basis 5y Swap Spread


Cash Spread to Treasury (bps)

Cash Spread to LIBOR (bps)


96 50 8

5y CDS - Cash Basis (bps)


56
48 5

5y Swap Spread (bps)


94 54
92 46 2 52
44 -1 50
90
42 48
88 -4
40 46
86 -7
38 44
84 36 -10 42
82 34 -13 40
Jan- Mar- May- Jul- Sep- Nov- Jan- -16 38
06 06 06 06 06 06 07 Jan-06 May-06 Sep-06 Jan-07

Based on approximately 145 investment grade and crossover credits. Based on approximately 145 investment grade and crossover credits.
Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate. Cash spread reflects par CDS equivalent spread to LIBOR, assuming a 40% recovery rate.
Sources: Bloomberg; Banc of America Securities LLC estimates. Sources: Bloomberg; Banc of America Securities LLC estimates.

Appendix II – Differences Between the CDS and Corporate


Bond Markets
More on The ABCs of Credit Spreads
Particularly when a bond For relative value comparisons between cash and CDS, investors should convert the
is trading away from par, cash bond spread to LIBOR. Popular measures of spread to LIBOR include I-spread,
various spread to LIBOR asset swap spread, Z-spread, and par CDS equivalent spread. Particularly when a
measures can be quite corporate bond is trading away from par, these measures can be quite different. For
different example, as illustrated in Figure 29 for a $68.50 bond, the asset swap spread (“ASW,”
in red) is 576.7 bps, while the Z-spread (“ZSPR,” also in red) is 758.2 bps. To clear up
the concepts, we now explain the various spread measures.

34 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 29. YAS Screen on Bloomberg

Source: Bloomberg.

I-Spread
I-spread is the simplest way to define and understand spread to LIBOR. I-spread simply
I-spread compares the compares the yield of a bond with a matched maturity swap yield. For the sample bond
yield of a bond with a in Figure 29, the yield to maturity of a 10.3-year (August 2018) bond is 11.889%. The
matched maturity swap corresponding 10.3-year swap yield is 4.38%. (To calculate the 10.3-year swap yield,
yield we interpolate the 10- and 15-year swap yields.) As illustrated in Figure 30, the
corresponding I-spread is 7.51%. This matches up with the 751-bp I-spread from
Figure 29 (“ISPRD,” in white toward the bottom-left of the circled area).

Credit Default Swap Primer 35


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 30. Calculating I-Spread

11.889% Yield –
4.38% Swap Yield
(at 10.275 years)
= 7.51% I-Spread

Sources: Bloomberg; Banc of America Securities LLC estimates.

That is, assuming no default, a credit investor earns 751 bps more per annum on the
corporate bond than on a matched-maturity swap. The reason for the 751 bps extra
yield is the risk that the corporate bond issuer may fail to pay.
It is important to note that I-spread only considers the yield of the bond, not the timing
I-spread only considers of its cash flows. That is, for the same yield and maturity, a 4.5% coupon bond has the
the yield of the bond, not same I-spread as a 6.5% coupon bond, whose cash flows are more front-loaded. In
the timing of its cash reality, investors usually prefer the lower dollar-priced bond (4.5% coupon), because
flows they will lose less of a premium following a Credit Event.
Asset Swap Spread
Most investment grade corporate bonds are structured as fixed-rate bullets, with a flat
coupon payment plus par at maturity. For leveraged investors who fund the purchase of
corporate bonds with a floating rate liability, there is an interest-rate mismatch. Asset
Asset swap spread is the swap transactions are designed to solve this problem. That is, the investor buys the
annual spread over fixed-rate corporate bond and swaps the fixed-rate payment into floating LIBOR-based
floating-rate LIBOR that payments, to meet cash flow requirements on the funding side.
an investor earns, in
Asset swap spread is the annual spread over floating-rate LIBOR that an investor earns
exchange for selling the
in exchange for selling the fixed cash flows of the bond. A par asset swap is based on
fixed cash flows of the
bond

36 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

par, with any premium or discount settled up-front in cash when the investor enters into
a transaction. Asset swaps have a quarterly day-count convention, so in practice, the
fixed-rate cash flows are exchanged semiannually, while the floating-rate cash flows
(floating-rate LIBOR plus the asset swap spread) are exchanged quarterly. An asset
swap is a separate agreement between two parties, so if the underlying issuer defaults,
an asset swap continues.
Figure 31. Calculating Asset Swap Spread
F6.5 2018 Corp ASW <GO>

Discounted
at LIBOR

$31.5
Discount
(Plus
Accrued
Interest)

Sources: Bloomberg; Banc of America Securities LLC estimates.

Consider Figure 31. In this case, the investor pays out fixed cash flows of 3.25%
semiannually (second column, calculated as a 6.5% coupon divided by two). In
exchange, the investor receives LIBOR + 579 bps quarterly (circled area in the third
column). Notice that 579 bps roughly corresponds to the asset swap spread (“ASW,” in
28
red) from Figure 29. The net cash flows (floating minus fixed) are shown in the fourth
column. Net cash flows, which represent the premium or discount portion of the bond,
are discounted at LIBOR, to arrive at the present value in the far right column.
The key difference between asset swap spread and other spread measures is the way
In ASW, the par portion of that asset swap spread breaks up the cash flows. The par portion of the bond is
the bond is discounted at the discounted at the risky rate (the bond coupon), while the premium or discount portion
risky rate, while the premium is discounted at LIBOR.
or discount portion is
discounted at LIBOR In this case, the investor is expected to receive a present value of $1 million in floating-
rate LIBOR over the life of the asset swap, but will only pay out fixed-rate cash flows

28
Intraday movement in the swap curve may cause slight differentials in spreads between screens.

Credit Default Swap Primer 37


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

worth $68.5. In exchange, the investor also pays 31.5 points upfront ($100 par – $68.5
bond price).
The bond yield is 11.889% and the coupon is 6.5%. The par portion of the bond is
discounted at 6.5%, while the discount portion of the bond is discounted at LIBOR.
With the exception of cross-currency trades, where an investor may actually want to
swap US dollars for euros, CDS—cash investors do not usually institute asset swaps.
Instead, they use asset swap spread as a relative value tool to estimate the appropriate
spread to LIBOR against which to compare a CDS spread. The most important point to
remember is that, while I-spread ignores the timing of a bond’s cash flows, asset swap
spread incorporates the timing of coupon payments.
Z-Spread
Another often-used but easily misunderstood spread terminology is the Z-spread. While
Z-spread is the OAS to I-spread is the incremental yield over a matched maturity swap, Z-spread is the
LIBOR under an incremental yield over the entire LIBOR spot curve (or zero curve). For readers
assumption of zero familiar with option-adjusted spreads (OAS), Z-spread is the OAS to the LIBOR curve
volatility under an assumption of zero volatility. The origin of Z-spread is the mortgage market.
Z-spread may be interpreted as spread income on a corporate bond, when the investor
Each cash flow is finances his purchase with a series of zero-coupon bonds. Each cash flow is discounted
discounted at the zero- at the zero-coupon LIBOR rate plus a fixed spread on the cash flow payment dates.
coupon LIBOR rate plus a This fixed spread is called the Z-spread. The Z-spread is chosen to make the present
fixed spread on the cash discounted value of the cash flows equal to the price of the bond. For bonds at par, Z-
flow payment dates. This
spread, I-spread, and asset swap spread are relatively close to each other.
fixed spread is called the
Z-spread

38 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 32. Calculating Z-Spread


F6.5 2018 Corp OAS1 <GO>

Zero Volatility
Assumption
(Valid for USD Swap Curve
Bullet Bonds) (Semiannual, 30/360)

Sources: Bloomberg; Banc of America Securities LLC estimates.

For our example bond, Figure 32 illustrates the calculation of Z-spread, using the
OAS1 screen in Bloomberg. We use a $68.5 bond price and add in a zero (the “Z” in Z-
spread) volatility assumption, which is valid for a bullet bond. We also use the USD
swap curve because Z-spread is a spread to LIBOR. This gives a Z-spread of 763 bps,
29
roughly the same as that from Figure 29 (“ZSPR,” in red).
The Z-spread (763 bps) is wider than the asset swap spread (579 bps) because of a
difference in discounting methodology. An asset swap assumes that the premium or
discount portion of a bond bears very little risk, with a discount rate of LIBOR. So, the
discount rate on the premium or discount portion of a AAA-rated bond, and a BBB-
rated bond, is the same under asset swap spread. By contrast, Z-spread discounts the
premium or discount portion of a BBB-rated bond at a higher (LIBOR + Z-spread) rate,
recognizing the incremental default risk of a less creditworthy bond. So while both Z-
spread and asset swap spread take into account cash flows, Z-spread discounts the
premium or discount portion at a more realistic rate.
Recall that I-spread ignores the timing of cash flows entirely. If the LIBOR yield curve
is flat, then Z-Spread is exactly the same as I-Spread. This is because all the zero-
29
Intraday movement in the swap curve may cause slight differentials in spreads between screens.

Credit Default Swap Primer 39


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

coupon LIBOR rates coincide with the LIBOR swap rates. However, when the LIBOR
When the LIBOR yield yield curve is upward sloping, Z-Spread tends to be higher than I-Spread. This is
curve is upward sloping, because on balance, zero rates are lower than the yield-to-maturity used in I-spread. For
Z-Spread tends to be example, Z-spread may discount the coupon due in six months at 3.10% plus the Z-
higher than I-Spread spread, and the coupon due in one year at 3.25% plus the Z-spread. Ordinarily, the
lower discount rate on the coupon due in six months would cause the present value of
the cash flows to rise. To keep the present value equal to the bond price, the Z-spread
widens; i.e., Z-Spread adjusts upward to keep the present value of the cash flows equal
to the price of the bond. The opposite is true when the yield curve is downward sloping.
A Note of Caution: Callable/Puttable Bonds
The preceding analysis has looked solely at bullet bonds. For bonds with options, an
investor should relax Z-spread’s assumption of zero volatility and look at OAS to
LIBOR. Figure 33 shows why it is important to relax the zero volatility assumption, for
a 2015-maturity bond that is callable in 2011:
Figure 33. Comparing OAS to LIBOR with Z-Spread for a Callable Bond
Bond is Callable November 1, 2011 at $105.125

Source: Bloomberg.

40 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

The Z-spread is 495 bps. Although Z-spread does adjust for the shape of the LIBOR
For bonds with options, curve, it ignores the value of the call option completely. Calculating OAS to LIBOR
relax Z-spread’s assumption with a volatility of 22.6% gives an OAS to LIBOR of 557.5 bps. As another way to
of zero volatility, and look at think of this, the value of the call option is the 557.5-bp OAS to LIBOR minus the
OAS to LIBOR 495.2-bp Z-spread, or 62 bps. For relative value purposes, the 557-bp OAS to LIBOR
should be compared with the CDS spread.
Par CDS Equivalent Spread
All of the measures illustrated above ignore the value of a bond’s premium or discount.
For example, consider an underlying cash bond that trades at a premium, say $120.
Should there be a Credit Event with a 40% recovery rate, the bond investor’s actual
recovery rate will be lower. In this case, the investor will recover $40 on an initial $120
investment, or 33%. By contrast, in a single-name credit default swap, the investor will
Par CDS equivalent recover $40 on an initial par ($100) investment, or 40%.
spread adjusts the Z-
spread for a bond’s The Par CDS equivalent spread adjusts the Z-spread for a bond’s premium or discount.
premium or discount For example, adjusting for the difference in recovery rates between cash and CDS for
the $120 bond, 150 bps of Z-spread in the cash bond may provide just as much
compensation for risk as, say, 143 bps of CDS spread. So in reality, the investor is
indifferent between the 150 bps of Z-spread for the cash bond and the 143 bps of CDS
spread. A spread of 143 bps for the cash bond is therefore called the Par CDS
equivalent spread.
For bonds trading at a For bonds trading at a premium, Par CDS equivalent spread is the Z-spread minus a
premium, Par CDS recovery adjustment. Namely, Par CDS equivalent spread adjusts the Z-spread
equivalent spread is the downward for a premium bond to more accurately reflect the recovery rate in the event
Z-spread minus a of default. Similarly, for cash bonds trading at discount (say an $80 price), Par CDS
recovery adjustment equivalent spread is higher than the Z-spread.
If the underlying cash bond is trading at par ($100 price), the difference in recovery
rate becomes a non-issue, because both cash and CDS are based on par. Consequently,
for cash bonds trading at par, Par CDS equivalent spread is the same as the Z-Spread,
ignoring day count and other operational conventions.
Par CDS equivalent Par CDS equivalent spread does not adjust for optionality, and therefore should be used
spread should be used only for bullet bonds.
only for bullet bonds Details on Par CDS Equivalent Spreads
In this section, we show how to calculate par CDS equivalent spread to LIBOR, from
the pricing of a cash bond. We look at the General Motors Corporation 7.7% 2016 as
an example. In April 2008, the bond was bid at $78, for a spread of 874 bps over the 10
year Treasury and a Z-spread of 802 bps over Swaps. To calculate the par CDS
equivalent spread, we look for the spread for which the present value of expected cash
flows equals the bond price. Figure 34 illustrates the mechanics:

Credit Default Swap Primer 41


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 34. How to Calculate Par CDS Equivalent Spread


Solve for Par CDS Equivalent Spread, Such that the Present Value of Expected Cash Flows Equals Bond
Price ($78)
GM 7.7% 2016. Assumes a 40% Recovery Rate.
Par CDS Probability Marginal Bond Expected PV of
Equivalent of Not Probability Cash Cash Discount Expected
Years Spread Defaulting of Default Flow Flow LIBOR Factor Cash Flow
exp( -[ Spread ] / Probability of ( Probability of Not ( 1 + LIBOR )^ Expected Cashflow *
[ 1 - Recovery ] * Not Defaulting Defaulting ) * ( -Years ) Discount Factor
Years ) in Prior Bond Cash Flow +
Coupon Period - Marginal Prob
Probability of of Default *
Not Defaulting ( Recovery +
in Current 1/2 * Coupon )
Coupon Period
0.5 902 bps 92.76% 7.24% $3.85 $6.61 3.04% 98.50% $6.51
1.0 902 bps 86.04% 6.72% $3.85 $6.13 3.11% 96.96% $5.94
1.5 902 bps 79.82% 6.23% $3.85 $5.68 3.11% 95.48% $5.43

7.0 902 bps 34.92% 2.73% $3.85 $2.49 4.08% 75.39% $1.88
7.5 902 bps 32.39% 2.53% $3.85 $2.31 4.13% 73.59% $1.70
8.0 902 bps 30.05% 2.35% $103.85 $32.19 4.18% 71.80% $23.11

Sum of PV of Expected Cash Flows = Bond Price $78.00


Settlement on April 22, 2008.
By market convention, we assume that default occurs halfway through a coupon period, so that half the coupon is accrued upon default.
Probability of Not Defaulting, sometimes also called Survival Probability: exp( -[ Spread ] / [ 1 – Recovery ] * Years ). For details, see the
section “Implied Probability of Default” on page 100.
Marginal Probability of Default: Probability of Not Defaulting in Current Coupon Period – Probability of Not Defaulting in Prior Coupon
Period
Expected Cash Flow: (Probability of Not Defaulting ) * Coupon + Marginal Probability of Default * ( Recovery + ½ * Coupon )
Discount Factor: (1+LIBOR) ^ (-Years)
PV of Expected Cash Flow: Expected Cash Flow * Discount Factor
Sources: Bloomberg; Banc of America Securities LLC estimates.

For each coupon period, calculate the present value of the expected cash flow as
follows. First, look at the marginal probability of default; that is, the probability that an
issuer defaults during a particular coupon period. This probability rises as par CDS
equivalent spread widens. Mathematically, the marginal probability of default is the
probability that the issuer does not default in the prior coupon period (i.e., survives the
prior period), minus the probability that the issuer does not default in the current
30
coupon period.
Second, look at the expected cash flow during a particular coupon period. Provided the
issuer does not default, the investor receives the bond coupon, or at maturity, par plus
the coupon. However, if the issuer defaults, the investor receives recovery plus half the
coupon. The reason for including half the coupon is that, by market convention, we
31
assume that default occurs halfway through a coupon period. Since we are looking at
the spread that makes a bond equivalent to a CDS contract, we include accrued interest.
Mathematically, expected cash flow is ( Probability of Not Defaulting ) x Coupon +
Marginal Probability of Default x ( Recovery + ½ x Coupon ).
Third, discount the cash flow by LIBOR. Add up the present value of expected cash
flows across coupon periods. Then solve for the spread for which the present value of
expected cash flows equals the bond price. This is the par CDS equivalent spread.

30
The one-year probability of default is the spread, divided by one minus the expected recovery rate. For details, see the section “Implied
Probability of Default” on page 100 of the main text.
31
More realistically, we would expect an issuer to default shortly before (or after) the end of a coupon period, because there is little incentive for
to default well before a coupon payment or principal is due. In this case, approximately all of the coupon would be missed.

42 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

In this case, the par CDS equivalent spread is 902 bps, versus the Z-spread of 802 bps.
Figure 35 illustrates the problem with Z-spread. Notice that, using the Z-spread, the
present value of expected cash flows equals $81.13, versus an actual bond price of $78.
As a bond moves further from par, the difference between Z-spread and par CDS
equivalent spread grows; see Figure 18 on page 30 of the main text.
Figure 35. Why Z-Spread Fails to Account for Bond Premium or Discount
Present Value of Expected Cash Flows ($81.13) Does Not Sum to Bond Price ($78)
GM 7.7% 2016. Assumes a 40% Recovery Rate.
Probability Marginal Bond Expected PV of
of Not Probability Cash Cash Discount Expected
Years Z-Spread Defaulting of Default Flow Flow LIBOR Factor Cash Flow
exp( -[ Spread ] / Probability of ( Probability of Not ( 1 + LIBOR )^ Expected Cashflow *
[ 1 - Recovery ] * Not Defaulting Defaulting ) * ( -Years ) Discount Factor
Years ) in Prior Bond Cash Flow +
Coupon Period - Marginal Prob
Probability of of Default *
Not Defaulting ( Recovery +
in Current 1/2 * Coupon )
Coupon Period
0.5 802 bps 93.54% 6.46% $3.85 $6.31 3.04% 98.50% $6.22
1.0 802 bps 87.49% 6.05% $3.85 $5.90 3.11% 96.96% $5.72
1.5 802 bps 81.83% 5.66% $3.85 $5.52 3.11% 95.48% $5.27

7.0 802 bps 39.23% 2.71% $3.85 $2.65 4.08% 75.39% $2.00
7.5 802 bps 36.70% 2.54% $3.85 $2.48 4.13% 73.59% $1.82
8.0 802 bps 34.32% 2.37% $103.85 $36.64 4.18% 71.80% $26.31
Sum of PV of Expected Cash Flows ≠ Bond Price $81.13
Settlement on April 22, 2008.
By market convention, we assume that default occurs halfway through a coupon period, so that half the coupon is accrued upon default.
Probability of Not Defaulting, sometimes also called Survival Probability: exp( -[ Spread ] / [ 1 – Recovery ] * Years ). For details, see the
section “Implied Probability of Default” on page 100.
Marginal Probability of Default: Probability of Not Defaulting in Current Coupon Period – Probability of Not Defaulting in Prior Coupon Period
Expected Cash Flow: ( Probability of Not Defaulting ) * Coupon + Marginal Probability of Default * ( Recovery + ½ * Coupon )
Discount Factor: (1+LIBOR) ^ (-Years)
PV of Expected Cash Flow: Expected Cash Flow * Discount Factor
Sources: Bloomberg; Banc of America Securities LLC estimates.

Factors Driving the Basis


A number of factors cause differences in CDS and the cash spread to LIBOR, even for
par bonds. The main text discussed the impact of the level of credit spreads on the
CDS—cash basis. We now discuss other major factors that influence the credit default
swap basis:

Maturity Differences
It is rare that the maturity of a cash bond and CDS contract match exactly. For
example, the most liquid point on the CDS curve is usually the five-year. For a
company that has not issued a five-year bond for one year, the benchmark five-year
bond actually has a four-year maturity.
For relative value comparisons, an investor often will look at the interpolated CDS
Matched-maturity versus spread (average of 3- and 5-year CDS quotes) versus the cash-bond quote. To keep the
benchmark relative value trade as liquid as possible, historically basis trades usually were executed with five-
year CDS. This left the investor exposed to credit risk between years four and five of
the trade. More recently, investors have shifted to matched maturity CDS, where CDS

Credit Default Swap Primer 43


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

expires on the quarterly roll date (March, June, September, or December 20) following
32
the maturity of the cash bond.

The Repo Market


If the repo rate exceeds Assuming an investor has favorable funding rates and balance sheet availability—as
the positive basis was the case historically—arbitraging a negative basis is straightforward. An investor
between CDS and cash, it simply buys protection and buys a cash bond. In principle, this should prevent negative
becomes unprofitable to basis opportunities from persisting for extended periods. However, arbitraging a
sell protection and sell positive basis is significantly more difficult. As credit spreads widen, the repo market
the cash bond often dries up, so that an investor may be unable to find the bond to borrow. Even when
the bond is available, it is often expensive, due to significant demand to borrow the
security. This makes the “effective basis” equal to the CDS spread, minus the cash
spread, minus the repo rate. If the repo rate exceeds the positive basis between CDS
and cash, it becomes unprofitable to sell protection and sell the cash bond.
Moreover, borrowing the bond may be dangerous. Even when the investor is able to
borrow a bond in the repo market, it is frequently for a relatively short term. Consider the
case where an investor is only able to borrow a bond overnight, and a Credit Event occurs
the following day. The investor sold protection, so he receives a bond from the protection
Buyer. The investor expects to use this bond to cover his short position (i.e., the investor
sold the bond), but there is a timing mismatch. The protection Buyer has at least 30 days
to deliver a bond, but the investor only has the bond overnight from the repo market.
The cash bond is also issue-specific, instead of issuer-specific as in the credit default
swap. This leaves the investor exposed to the difference in price between the bond he
borrows in repo and the bond delivered into the CDS contract following a Credit
33
Event.
CDS underperformance Despite the difficulty in arbitraging a positive CDS—cash basis, it is not surprising that
may signal a high a wide basis may signal a high probability of default. Enron in 2001 clearly illustrates
probability of default this case:

32
Generally, it is best for CDS to mature at least 30 calendar days after a cash bond. If a Reference Entity misses its last scheduled coupon or
principal payment, an investor may only trigger a CDS Failure to Pay Credit Event upon the expiry of the grace period specified in the
relevant bond indenture, often 30 days. The protection Buyer has no recourse should CDS mature before the end of that grace period. This
assumes that the Reference Entity does not file for Bankruptcy or undergo a Modified Restructuring Credit Event—if so, the protection Buyer
may trigger CDS immediately. See Figure 12 on page 18 for details.
33
That is, the investor sold CDS protection. Following a Credit Event, the investor should receive a bond from the Buyer of protection. The
price of this bond may not equal the price of the bond the investor borrowed in the repo market, exposing the investor to basis risk.

44 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 36. The Evidence of Things Unseen: Enron Basis Trades Perpetually Wide in 2001

Enron SRAC AT&T Ford Motor Credit


60%
50%
40%

Relative Basis
30%
20%
10%
0%
-10%
-20%
18-May-01 25-May-01 1-Jun-01 8-Jun-01
Source: Banc of America Securities LLC estimates.

In Figure 36, we show the relationship of the relative CDS basis (defined as the CDS-
cash basis as a percentage of the asset swap spread) on several dates in 2001. Notice
that Enron’s basis is clearly wider than other credits. This trend persisted throughout
much of 2001, preceding Enron’s financial restatement and subsequent default.
The relatively wide level of Enron’s basis was due to a large demand for protection. In
hindsight, the wider level was signaling credit risk that was not apparent from cash
market pricing alone.

Differential Liquidity
As the CDS market evolves, perceptions of liquidity often tend to favor CDS over cash,
helping to compress the CDS-cash basis. However, for less liquid credits and maturities,
the reverse can be true, causing CDS to trade wide to cash.

Recovery Rate Risk Between Cash and CDS


The risk of a short As we discussed in the section, “Risk of a Short Squeeze” on page 22, the rapid growth
squeeze could cause CDS in the credit derivatives market may result in a short squeeze following a Credit Event.
to tighten, relative to In turn, the value of credit default protection may decline relative to cash. Consider an
cash bonds investor who buys $10 million notional protection and expects the same recovery rate
as cash, say 40%. That is, the investor expects to recover $6 million ($10 million – $4
million recovery). If a short squeeze causes CDS to settle at, say, 50% recovery, then
the value of protection becomes just $5 million ($10 million – $5 million recovery).
Should a series of short squeezes cause investors to expect permanently lower recovery
rates in CDS, they should become less willing to pay for protection. This would cause
CDS spreads to tighten relative to cash, compressing the basis.
However, recent CDS settlement protocols have reduced the risk of a short squeeze, so
this factor may decline in importance over time.
Even without a short squeeze, “recovery rate” has a different meaning in cash and
Even without a short CDS. Typically, CDS contracts settle 30 calendar days after a Credit Event. At that
squeeze, “recovery rate” time, the market price of the cheapest-to-deliver obligation becomes the CDS recovery
has a different meaning rate. By contrast, in cash, an investor may continue to hold a bond until the end of (e.g.,
in cash and CDS bankruptcy) proceedings. Not until that time, which potentially could be years after
CDS contracts settle, is the cash recovery rate determined.

Credit Default Swap Primer 45


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Succession Language—The Corporate Finance Factor


Succession risk can Since leveraged buyout (LBO) and spinoff activity increased in 2006 and early 2007,
widen or tighten the CDS market participants have become more aware of issues surrounding Succession
basis Events. Consider a case where one or more entities succeed to more than 25% of bonds
or loans outstanding for a Reference Entity. Then CDS language (2003 ISDA Credit
Derivatives Definitions) allows a change in the Reference Entity of the CDS contract.
Under these rules, it is possible for an investor to end up with CDS protection that does
not exactly replicate the LBO’d, or spun-off, entity.
Moreover, for corporate finance activity accompanied by a tender offer, all senior
unsecured debt at the Reference Entity may go away; i.e., there may become no
Reference Obligation for the CDS contract. For more details, please see Chapter VI –
CDS Case Studies and Legal Issues on page 132. Also see several case studies in the
same appendix.
Succession risk often causes CDS to widen relative to cash, because it is uncertain what
entity a CDS contract will eventually reference. Additionally, cash bonds—particularly
in high yield—may have covenant protection that prevents bond spreads from widening
significantly. CDS has no such protection and often widens to reflect expectations of
the new capital structure.
However, Succession risk may cause CDS to tighten, as happened with monoline
insurers in February 2008. A proposed “good bank” / “bad bank” split led to concern
that CDS contracts may succeed to a “good bank” business of primarily municipal
bonds and tighter credit spreads. For details, please see Chapter VI – CDS Case Studies
and Legal Issues on page 158.

Demand for Structured Portfolio Investments


Synthetic transactions Although structured transaction volumes plummeted in 2007, it is important to
tended to compress the understand their effect, for historical perspective, in case volume eventually returns,
CDS—cash basis. A and in case existing structures ever unwind en masse. Structured transactions
potential unwind should embedding credit default swaps provided a vehicle for investors to sell protection (go
widen the basis. long credit risk). Perceived advantages for the investor included higher risk-adjusted
returns, less complexity relative to cash flow CDO waterfall rules, and favorable
regulatory capital treatment. Historically, demand for structured portfolio investments
caused dealers to hedge by selling protection, resulting in tightening pressure on CDS
spreads. Similarly, if a potential unwind of such structures were to occur, it could cause
wider CDS spreads, particularly at popular seven- and ten-year maturities. For details
on structured credit, please see Structured Credit Market Basics on page 179.

Changes in the Cost of Funding


Higher funding costs As financial institutions’ funding costs rise, protection Sellers (who are long credit risk)
cause CDS to outperform are increasingly attracted to the CDS market, which does not require funding. In this
case, the influx of protection Sellers tends to drive CDS spreads tighter, making a
34
synthetic short position relatively cheaper to a cash short position.

34
This general observation may not apply to a specific user of CDS, as individual counterparty risks determine each user’s effective funding
costs (both direct funding costs embedded in the CDS spread and implicit funding costs from haircut and margin agreements).

46 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Cheapest-to-Deliver Option
Less relevant in today’s Less relevant in today’s CDS market, the delivery option may impact the CDS—cash
CDS market, the basis. The protection Buyer in a CDS transaction has an option to deliver the cheapest
cheapest-to-deliver option deliverable instrument he can find in the cash market. In the US, Modified
may cause CDS to Restructuring terminology has greatly limited, although not completely eliminated, the
underperform cheapest-to-deliver option. In certain cases, this may cause CDS spreads to widen
relative to cash.

Technical Conditions
CDS settles with accrued CDS trades on an Actual/360 day-count convention, while cash trades on a 30/360
interest following a convention. Additionally, CDS settles with accrued interest following a Credit Event
Credit Event, while cash (up to and including the Event Determination Date), while cash settles without accrued
settles without accrued interest.
interest
Convertible Bonds
CDS spreads may widen CDS spreads may widen after the announcement of a new convertible issue, driving the
after the announcement CDS—cash basis wider. There are two main reasons.
of a new convertible
The first reason is temporary supply and demand imbalance. In 2001, the rapidly
issue
expanding convertible market was driven primarily by issuers tapping an alternative
source of low-cost financing (in a deteriorating equity market), and the demand created
from convertible arbitrage funds’ purchase of cheap equity options. To strip the
perceived cheap equity option from convertible issues, convertible arbitrage traders
needed to buy credit protection in the CDS market. This pushed CDS spreads wider.
The second reason is a perception of lower recovery rates on convertibles. According to
35
a 2001 study conducted by Moody’s, there is a 7% price difference between straight
and convertible bond issues, with the same seniority, after Credit Events. To account
for the greater potential loss following a Credit Event, protection Sellers demand a
wider spread.

35
For more details, please see BAS research report, “Impact of Convertible Bond Issuance on the Credit Default Swap Market,” October 19,
2001 and Moody’s Investors Service, “Default and Recovery Rates of Convertible Bond Issuers: 1970—2000,” July 2001.

Credit Default Swap Primer 47


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Chapter III – CDX and iTraxx Indices


In the CDS market, it is possible to gain direct exposure to an index of liquid credits.
The CDX and iTraxx The CDX indices are static portfolios of equally weighted credit default swaps,
indices are portfolios of designed to provide diversified North American credit exposure in the CDS market.
equally weighted credit Overseas versions also exist under the brand name “iTraxx.” These indices represent
default swaps, designed the evolution of the market toward a benchmark index recognized by the market.
to provide diversified
credit exposure The North American Investment Grade index (CDX.NA.IG index) consists of CDS on
125 North American Reference Entities. The North American Crossover index
(CDX.NA.XO) consists of CDS on 35 North American four- and five-B rated
Reference Entities. The North American High Yield index (CDX.NA.HY) consists of
100 North American high yield Reference Entities. The North American Leveraged
Loan index (LCDX.NA) references CDS on 100 North American Reference Entities, at
the secured (first-lien) loan level.

Key Features of CDX Indices


X CDX provides liquid exposure to the corporate CDS market.
X The index represents a portfolio of individual CDS contracts purchased
simultaneously at the same spread.
X Underlying CDS contracts based on “No Restructuring” Credit Event definitions.
Only Bankruptcy and Failure to Pay trigger Credit Events.
X Trades in an unfunded/CDS format.
X Facilitates relative value trades.

How the Indices Are Constructed


Reference Entities in the X The Reference Entities included in the CDS indices are selected by a consortium of
CDS indices are selected market makers. The indices roll every six months, in March (to a June maturity)
36
by a consortium of and September (to a December maturity).
market makers. The
X Each of the Reference Entities is equally weighted:
indices roll every six
months X In the Investment Grade (IG) index, each entity is weighted at 0.8% (1 / 125
members). HVOL is a subindex of IG, intended to reflect the 30 most volatile
credits. The weighting for each HVOL entity is 3.333% (1 / 30 members).
X In the Crossover (XO) index—whose members are rated double-B by all three
agencies, or double-B by two agencies and triple-B by one agency—each entity is
weighted at 2.857%. XO volume has declined substantially since mid-2007.
X In the High Yield (HY) index, each entity is weighted at 1.0% (1 / 100 members).
37
BB and B subindices also exist.
X In the Leveraged Loan (LCDX) index, each entity is weighted at 1.0% (1 / 100
members). Currently, 38 Reference Entities overlap between CDX HY and LCDX,

36
CDX IG, HVOL, and XO roll on March 20th and September 20th. CDX HY rolls on March 27th and September 27th. LCDX rolls on April 3rd
and October 3rd.
37
For eligibility in the investment grade index, at least 2 out of 3 ratings (Moody’s, S&P, and Fitch) must be investment grade, at index
inception. For the high yield index, at least 2 out of 3 ratings must be high yield, at index inception. For the crossover index, ratings must be
either double-B by all three agencies, or triple-B by one agency and double-B by the other two agencies, at index inception.

48 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

plus 8 Reference Entities at different levels of the capital structure (operating vs.
38
holding company).
X The corresponding European indices are iTraxx Main (investment grade), iTraxx
HVOL (HVOL), iTraxx Financials (two indices, one senior and one subordinated),
iTraxx XO (high yield, not to be confused with the North American definition of
39
XO), and LevX (leveraged loans).
Please see the Chapter Appendix on page 57 for more detail on the construction of the
indices and index rolls.

How Index Payments are Determined


Unlike most single-name Unlike most single-name CDS, the credit default indices may trade away from par. For
CDS, the credit default example, consider a credit default swap at 102 bps. In single-name CDS, the Buyer of
indices may trade away protection pays 102 bps running coupon, and there is no accrued interest at trade
from par inception. However, in the investment grade index (CDX IG, Series 10), the coupon is
fixed at 155 bps, as illustrated in Figure 37:
Figure 37. Indices Trade Away from Par

Current
Index
Spread

Index
Coupon

Up Front
Payment
Made By
Seller of
Index
Protection

Source: Bloomberg.

38
Eight Reference Entities trade at different parts of the organizational structure in LCDX vs. CDX HY Series 10 (current on-the-run index):
Alltel Corp is in CDX HY and ALLTEL Communications Inc is in LCDX; Charter Communications Holdings LLC is in CDX HY and
Charter Communications Operating LLC is in LCDX; Intelsat Ltd is in CDX HY and Intelsat Corp is in LCDX; RH Donnelley Corp is in
CDX HY and RH Donnelley Inc is in LCDX; Sabre Holdings Corp is in CDX HY and Sabre Inc is in LCDX; Six Flags Inc is in CDX HY
and SIX Flags Theme Parks is in LCDX; Toys R US Inc is in CDX HY and Toys R US – Delaware Inc is in LCDX; Owens-Illinois Inc is in
CDX HY and Owens-Illinois Group Inc is in LCDX. See the Chapter Appendix on page 60 for a full list of Reference Entities.
39
Technically, a North American IG Financials subindex exists, but the iTraxx version is far more liquid.

Credit Default Swap Primer 49


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

The index trades at 155 bps (right hand side of the screen), but the coupon is fixed at
102 bps running (“deal spread”). In this case, the Buyer of protection pays 155 bps
running (the fixed coupon) and receives the present value of 53 bps upfront (the
difference between the 102 bps traded spread and the 155 bps fixed coupon). The
upfront payment equals $242,654 (“market value”) per $10 million notional, plus
$13,778 accrued interest, for a total payment of $256,432 (“total value”). Note that this
is equivalent to a price of $102.43 (“price”).
Note that, while the investment grade indices are quoted in spread (“102 bps”), the high
yield indices are quoted in dollar price (“$96.50”). This syncs the high yield indices
with the traditional price- (not spread-) based high yield cash market.

Ratings
Although the indices are not rated, we estimate the credit quality of IG10 (investment
grade index, Series 10) at Baa2. HVOL10 (high volatility index, Series 10) is estimated
at Baa3, XOVER10 (crossover index, Series 10) at Ba2, HY10 (high yield index,
Series 10) at B3 and LCDX10 (leveraged loan index, Series 10) at B2.

Members of the CDX Consortium


The consortium currently comprises ABN AMRO, Bank of America, Barclays Capital,
Bear Stearns, BNP Paribas, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs,
HSBC, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and
Wachovia.

Credit Linked Notes – DJCDX <CORP> <GO> Funded versions of the High Yield CDX Index
The CDX high-yield index Although not as liquid, the CDX.NA.HY index is also available in funded form, using a
is also available in Special Purpose Vehicle structure. These investment vehicles are a type of Credit
funded form Linked Note. Investors who would not otherwise invest in derivatives can gain
exposure to the credit default swap market, because they require no ISDA contracts and
operationally work in the same manner as trading in cash bonds. Since the notes
incorporate an interest-rate swap, they effectively add interest rate exposure (through
the swap rate) to the CDS spread, to replicate the price movement of a fixed rate bond.
40
Liquidity is significantly lower in funded indices versus their unfunded counterparts.

40
Although the definition of a Credit Event is the same for the CDX HY unfunded and funded products, there is a difference in settlement
mechanics. The unfunded index is technically physically settled, although in practice most counterparties have agreed to cash settle. By
contrast, the funded note settles through a three-part dealer auction. Investors in the funded note receive a cash settlement price based on the
auction results. This leaves the investor exposed to basis risk between the funded and unfunded versions of the indices.

50 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 38. CDX.NA.HY Series 10 Trades in Both Funded and Unfunded From
Version Issuer CUSIP Coupon (%) Maturity Price Movements
Unfunded - - 5 20-Jun-13 Spread Only
Funded CDX HY 10 T 12514TAA8 8.875 20-Jun-13 Spread + Swap Rate
To view details regarding the unfunded CDX HY index on Bloomberg, type CDX10 CDS <Corp> <Go>, then select the corresponding index.
To view details regarding the funded CDX HY index on Bloomberg, type DJCDX <Corp> <GO>, then select the corresponding issuer,.
Sources: Bloomberg; Banc of America Securities LLC estimates.

Credit Event Example: Counterparty Owns $10 Million CDX.NA.IG Protection


Assume that a Credit Event occurs on one of the index’s Reference Entities. The
Reference Entity weighting is 0.8% (that is, each entity makes up 0.8% of the
CDX.NA.IG index).
The market maker pays to the Counterparty $80,000 (0.8% x $10 million notional), and
the Counterparty delivers to the market maker $80,000 of Deliverable Obligations of
the Reference Entity.
The notional amount on which premium is paid from that point forward is consequently
reduced 0.8%, to $9.92 million. By convention, the index trades with a factor of 99.2%,
so that a notional quote of $10 million results in cash flows being exchanged on $9.92
million.
Following the Credit Event, the Counterparty pays the fixed coupon of 155 bps on
$9.92 million until maturity.
Standard confirms state that Credit Events in CDX.NA.IG are physically settled.
However, historically, Counterparties have had an option to cash settle the indices.
Please see the section “Risk of a Short Squeeze” on page 22 and Chapter VI – CDS
Case Studies and Legal Issues on page 143 for details.
Credit Events in the CDX indices include Bankruptcy and Failure to Pay. Modified
Restructuring is not a Credit Event. Please see the section “Credit Events” on page 17
for more details.

Basis Between Intrinsics and the Index


A popular analytic in A popular analytic in index trading is the basis between intrinsics and the actual index
index trading is the basis spread. For example, IG is a 125-name equally weighted index. If the average spread of
between intrinsics and the 125 names, adjusted for convexity and Modified Restructuring, trades tighter than
the actual index spread the index spread, the index is cheap to intrinsics. Trading the spread differential
between the index and its underlying intrinsics is known as “index arbitrage.”
Figure 39 shows that the intrinsic spread is less than the simple average spread of
The intrinsic spread is
underlying index components:
less than the simple
average spread of
underlying index
components

Credit Default Swap Primer 51


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Credit Strategy Research 35
May 27, 2008

Figure 39. Actual Present Value of Single-Name CDS Versus Estimated Present Value
Ignoring Convexity
Based on a notional of $10 million

Estimated Present Value, Ignoring Convexity


Actual Present Value ($ Thousand)

Present Value ($ Thousand)


5,000
4,000
3,000
2,000
1,000
0
0 200 400 600 800 1000
5y Spread (bps)
Sources: Bloomberg; Banc of America Securities LLC estimates.

Taking the average spread of underlying index components is analogous to looking at


the gray line, which shows the present value of a single-name credit default swap.
Instead of considering convexity, the investor implicitly assumes the same DV01 for all
of the underlying intrinsics.
What the investor should be using is the red line, which shows the actual present value
of a single-name credit default swap. This line takes into account that a 1 bp move at 20
bps is more significant—hence, a higher DV01—than a 1 bp move at 300 bps.
Figure 40 shows an example for a portfolio composed of just two CDX HY (Series 10)
credits, Beazer Homes USA Inc and The Goodyear Tire & Rubber Co.:
Figure 40. Intrinsic Spread Determined by Average Present Value, Not Average Spread
April 2008
Based on a notional of $10 million
x x

Reference Spread Spread DV01 Present Value


Entity Rating (bps) ($) ($)
Beazer Homes USA Inc B2/B 1075 3,149 3,385,186
The Goodyear Tire & Rubber Co Ba3/BB- 330 4,169 1,375,912
Average 703 3,659 2,380,549
Implied Spread 651
Sources: Bloomberg; Banc of America Securities LLC estimates.

For five-year CDS, the spread on Goodyear is 330 bps and the spread on Beazer Homes
is 1075 bps. This produces an average spread of 703 bps. Notice, however, that the
average present value is $2,380,549. Converting this back to spread gives an implied
41
spread for the portfolio (intrinsic spread) of just 651 bps. The difference (703 bps
minus 651 bps) is the distance between the gray estimated line and the red actual line in

41
To obtain the intrinsic spread, take a DV01 weighted-average of the underlying spreads. In this example, the DV01-weighted average is ( 330
x 4169 + 1075 x 3149 ) / (4169 + 3149 ), or 650 bps. Also, note that Beazer Homes trades as 18 points upfront + 500 bps running. We show
the equivalent running spread of 1075 bps for illustrative purposes.

52 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 40. Including convexity reduces the actual intrinsic spread to 651 bps. The
greater the dispersion of credit spreads within an index, the greater the effect of
convexity.

Hedging Between Indices


Like single-name pairs trades, an investor may hedge between indices by going long
risk in one index and short risk in another. When determining a hedge ratio, it is
important to look not just at the average hedge ratio (or beta from a regression), but
also the shape of the distribution.
Figure 41. Amount of CDX IG Protection Needed to Offset $10 Million of CDX HY Exposure
Weekly, January 2006—April 2008

20 Average: $47mm
Standard Deviation: $120mm
Percent of days (%)

15

10

0
-70 -50 -30 -10 10 30 50 70 90 110 130 150 170
Actual IG Hedge ($mm) to offset $10mm CDX HY
On-the-run indices.
Source: Banc of America Securities LLC estimates.

For example, Figure 41 illustrates the realized hedge ratio between CDX IG
(investment grade) and CDX HY (high yield), using weekly data between January 2006
and April 2008. On average, $47 million of investment grade protection was needed to
offset $10 million of high yield index exposure. However, on any given day, the hedge
ratio ranged from –$60 million to $180 million. As such, investors should understand
that P&L between two indices is unlikely to be fully hedged on any particular day.
Instead, look for P&L to average out over time. Indeed, in 2007, some investors were
stop-lossed out of CDX IG—HVOL pair trades amid substantial mark-to-market
42
losses.

Appendix III – CDX and iTraxx Indices


DV01 Neutral Index Arbitrage
As discussed in the main text, some investors attempt to arbitrage the difference
between the index and underlying intrinsic spread. If the intrinsic spread is tighter than
the index spread, the investor would buy intrinsic protection and sell index protection,
and vice-versa.

42
Moreover, just because a particular hedge ratio was realized historically does not mean it will be realized in the future. Past performance is not
indicative of future results.

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Credit Strategy Research 35
May 27, 2008

A complicating factor in index vs. intrinsics relative value is that single-name CDS and
the indices have different durations. To adjust for this risk, in 2008, index arbitrage
investors have begun to adjust the notionals of single-name CDS, to keep them DV01-
neutral to the overall index.
Consider an investor who bought protection on an index and sold protection on each
underlying constituent in single-name CDS, notional-neutral. Although the investor
43
would be hedged against Credit Events, he would be exposed to some duration risk,
because the coupons of single-name CDS differ from the fixed coupon of the index.
For the CDX HVOL Series 10 index, Figure 42 shows the difference in DV01 of
single-name CDS, relative to the DV01 of the single-name using the index coupon, as
44
of April 2008. Consider Radian, which trades at 16 points upfront + 500 bps running
in single-name CDS, and has a DV01 of $3,180 per $10mm notional. But at the index
strike of 350 bps (a deeper discount), the DV01 would fall to $2,999 per $10mm
notional.
In general, for wide-spread credits, single-name CDS has a higher DV01, because it
trades at a higher dollar price than the same single name struck at the index coupon.
For tight-spread credits, the single name struck at the index coupon has a higher DV01,
because it trades at a premium.

43
Assuming a Bankruptcy or Failure to Pay. In the event of a Modified Restructuring (“MR”), the investor would lose money if he sold single-
name CDS or make money if he bought single-name CDS. The reason is that Modified Restructuring is a Credit Event in single-name CDS
(for selected Reference Entities), but not in the CDX indices. For iTraxx, Modified-Modified Restructuring (“MMR”) is a Credit Event for
both single-name CDS and the indices, so payments would cancel out, similar to a Bankruptcy or Failure to Pay in CDX. For more on
Restructuring clauses, please see “Restructuring Alternatives” on page 153.
44
For our analysis, we assume that all single names where 5y CDS trades wider than 700 bps trade in points upfront + 500 bps running. We
assume that all other single names trade at par (all running spread).

54 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 42. DV01 Calculated Using Single Name Strike, Less DV01 Using Index Strike
Tight Spread Name Have Higher DV01s When Using Index Strike
Wide Spread Names Have a Higher DV01 When Using the Single Name Strike
5 Widest 5 Tightest

DV01 Differential ($ Thousands per $10mm)


Single Name Strikes Index Strike
0.6 Have Higher DV01s Has Higher DV01
0.4

0.2

0.0

-0.2

-0.4

-0.6
MBIA

SFI

DRI
WY

CTL
RDN

FON

MDC

FO
CIT

As of April 11, 2008.


Among the five widest credits, only FON trades in running spread.
RDN and MBIA have a lower differential than CIT because the former trade in points upfront + 500 bps running coupon, while CIT trades
at 690 bps running.
Source: Banc of America Securities LLC estimates.

The DV01 differential from Figure 42 suggests that notional-neutral index arbitrage
leaves an investor exposed to mark-to-market risk. For example, consider an investor
who sells single-name protection and buys index protection, and then Fortune Brands
(FO) widens, sending the overall index wider. For Fortune Brands, the CDS at the
index strike has a higher DV01 than at the single-name strike. As such, the investor
would profit more from the index position—which would be positive because the
investor buys index protection—than he would lose from the single-name position.
Hedging the DV01 Mismatch
In 2008, investors have been hedging DV01 mismatch between the index and
underlying single names, by adjusting the single-name notional. Based on Figure 42,
Figure 43 shows the adjusted notional for single names, to give them the same DV01 as
the single name struck at the index coupon (350 bps for HVOL10).

Credit Default Swap Primer 55


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 43. Notional for DV01 Neutral Index Arbitrage


Notionals Vary Inversely With Spread
For wide spread credits, single name CDS has a higher DV01 than the single name struck at the index coupon.
To make the DV01s the same, reduce the single name CDS notional.

5 Widest 5 Tightest
11.5
11.0
Notional ($ Millions) 10.5
10.0
9.5
9.0
8.5
8.0

MBIA

CTL
KSS

DRI
SFI

CIT

FON

MWV
RDN

FO
As of April 11, 2008.
Source: Banc of America Securities LLC estimates.

For wide spread credits, single-name CDS has a higher DV01 than the single name
struck at the index coupon. To make the DV01s the same, the investor sells protection
on a lower single-name CDS notional.
After applying the DV01 neutral notionals to each name, calculate the underlying
intrinsics. Since the whole point of index arbitrage is that the intrinsics differ from the
index, the overall intrinsics (even after applying the DV01 neutral notionals) will have
a different duration from the index. For example, if the intrinsics are 295 bps versus the
index at 280 bps, Figure 44 shows the difference in overall DV01s. As such, Figure 45
scales the total notional of intrinsic protection (in the same proportions as Figure 43), to
keep the overall DV01s the same between intrinsics and the index.

56 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 45. Total Notional of Index vs Intrinsics


Different Notional for Each Underlying Intrinsic, To Keep the Overall
Figure 44. Index DV01 vs Intrinsics DV01 Index Arbitrage Trade DV01 Neutral

133 312
310
($ Thousands Per $300mm)
Index or Intrinsics DV01

132 308

Notional ($ Millions)
306
131 304
302
130 300
298
129 296
CDX HVOL Index CDX HVOL Intrinsics Index Notional Total Intrinsics Notional

As of April 11, 2008. As of April 11, 2008.


Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

Jump-to-Default Risk
After hedging out DV01 risk, the investor is left with potential risk following a Credit
Event. Recall that, in DV01 neutral index arbitrage, an investor uses less notional on
wide-spread single names. As such, if an investor sells protection on single-name CDS,
and buys protection on the index, he will have net bought protection on the credit. This
will leave him with positive P&L for a wide-spread credit post-Credit Event.
Figure 46 shows a more complete jump-to-default payoff profile:

Figure 46. Post-Credit Event P&L in DV01 Neutral Index Arbitrage


Wide or Tight Spread is Relative to the Index Coupon (350 Bps for HVOL10)
Wide Spread Credits Tight Spread Credits
Intrinsics Index Notional Credit Event P&L Notional Credit Event P&L
Sell Protection Buy Protection Lower Positive Higher Negative
Buy Protection Sell Protection Lower Negative Higher Positive
Source: Banc of America Securities LLC estimates.

CDX Index Rolls

Index Rolls
Approximately every six Approximately every six months (March and September), the indices roll to a new on-
months, the indices roll the-run version. This results in a “roll,” or difference in spread between the old and
to a new on-the-run new on-the-run indices. We estimate the roll in three parts: (1) the change in credit
version quality, (2) an adjustment for intrinsics trading with Modified Restructuring, but the
index trading with No Restructuring, and (3) a six-month maturity extension.
For example, consider the roll between IG9 and IG10 in March 2008. Eight credits
dropped out of the on-the-run CDX IG index. Figure 47 shows the details. Notice that
credits being added to the index traded at a tighter spread than credits being deleted,
which should reduce the overall IG10 index spread:

Credit Default Swap Primer 57


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Credit Strategy Research 35
May 27, 2008

Figure 47. Changes to On-the-Run IG Index, from Series 9 to Series 10


As of March 17, 2008

Mid Mid
Deletions (bps) Additions (bps)
Comcast Cable Communications LLC 200 Black & Decker Corp 207
IAC/InterActiveCorp 275 MDC Holdings Inc 210
Belo Corp 400 Comcast Corp 210
Pulte Homes Inc 435 Viacom Inc 220
Jones Apparel Group Inc 460 Kohl's Corp 220
Centex Corp 570 Brunswick Corp/DE 326
Countrywide Home Loans Inc 730 Masco Corp 340
Lennar Corp 740 New York Times Co/The 390
Sources: CDX; Bloomberg; Banc of America Securities LLC estimates.

When performing this analysis, we assumed the same basis between intrinsics
(underlying single-name CDS components) and the index, for IG9 and IG10. More
realistically, we expected that a portion of index shorts (with buy protection positions)
would want to roll to the Series 10 (new) index, as a way to both reduce carry and,
perhaps more importantly, maintain maximum liquidity. To execute the roll, these
investors needed to sell protection on Series 9 indices (driving spreads tighter), and buy
protection on Series 10 indices (driving spreads wider). This would tend to reduce the
roll versus the estimate in Figure 48.

Figure 48. Estimate of IG Roll from Series 9 to Series 10


As of March 17, 2008

Mid
Description (bps)
IG9 Intrinsics to 20 Dec 12 198
IG10 Intrinsics to 20 Dec 12 187
Credit Quality Roll -10.8

Credit Quality Roll with 2% Haircut Adjustment: MR vs No-R -10.6


6-month Maturity Roll 0
Total Estimated Roll -10.6
Source: Banc of America Securities LLC estimates.

To December 20, 2012, the maturity date of the five-year IG9 index, IG9 intrinsics
were 198 bps, compared to IG10 intrinsics at 187 bps. That is, solely due to improved
credit quality, the IG10 index should trade 10.8 bps tighter than IG9. However, single-
name CDS trades with Modified Restructuring, while the CDX indices trade without
Restructuring. To assess this factor, we used a 2% haircut, bringing the roll to –11 bps.

58 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

That is, based solely on credit quality, our estimate was that Series 10 IG should trade
11 bps tighter than Series 9.
Next, there is a six-month maturity extension for rolling from December 2012 to June
2013. Since investment grade credit curves were flat around the roll date, the effect of
the maturity extension was negligible.
Adding up the credit quality, Modified Restructuring vs. No Restructuring, and
maturity extension components suggested that Series 10 IG should trade 11 bps tighter
than Series 9. We also thought that a short base in IG9, rolling to IG10, would result in
IG10 trading cheaper to intrinsics, reducing the roll. The actual roll was IG10 trading 5
bps tighter than IG9.
Special Issues for HY Index Rolls
Since the high yield index trades in dollar price, an investor also must consider the
In high yield, also coupon differential between the old and new indices, to estimate the roll. For example,
consider the coupon suppose that a new on-the-run high yield index should trade 40 bps wider than the old
differential between the index. If the old index trades at par and the coupon on the new index is set 40 bps wider
old and new indices than the old index, the roll should be $0. This is because, with both indices trading at
par, the spread differential will be 40 bps.
For most HY rolls, the roll trades cheap to the methodology in Figure 48. For example,
we estimated a fair value roll of 40 bps ($2 5/16) from HY8 to HY9, versus an actual
roll of 60 bps ($1 1/2). We think this difference is largely due to lower liquidity of HY
underlyings, as compared to IG.

Mechanics of CDX Index Rolls


Approximately two weeks prior to the roll date, each market maker submits to the
Administrator (currently Markit Group Ltd) a list of Reference Entities from the current
index that, in its judgment, should no longer be included, based on the following
criteria: (1) entities downgraded below investment grade by at least two of S&P,
Moody’s, and Fitch (2) entities for which a merger or other similar corporate action has
occurred or has been announced, and (3) entities whose credit default swaps have
become materially less liquid. (This is for the investment grade index. For the high
yield index, the first criteria changes to entities upgraded to investment grade by at
least two of S&P, Moody’s, and Fitch. For the crossover index, the first criteria
changes to entities that are no longer rated double-B by all three ratings agencies, or
triple-B by one ratings agency and double-B by the other two ratings agencies.)
Each market maker then submits to the Administrator a list of entities that, in its
judgment, should be added to the new index. Affiliates of entities that are guaranteed
by entities already in the index are ineligible. Non-guaranteed affiliates are eligible for
inclusion.
The Administrator will add to the new index those entities receiving the greatest
number of votes, until the new index totals 125 entities (100 entities for the high yield
index, or 35 entities for the crossover index).
HVOL is a subindex of IG. After the composition of IG is established, market makers
submit a list of entities for inclusion in HVOL. There are no formal deletion/addition
criteria; any entity in the new series of IG is eligible for inclusion in HVOL.
Shortly before the roll date, the Administrator releases the composition of the new
index. Then, each market maker submits to the Administrator a suggested fixed rate for

Credit Default Swap Primer 59


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Credit Strategy Research 35
May 27, 2008

the index coupons at various maturities. The median of these spreads rounded up to the
nearest 5 bps will be the fixed rate for the new index.

Events and Reference Entities in the CDX Indices

Credit Events in the CDX Indices


Figure 49. Credit Events in the CDX Indices
Date Reference Entity Indices Recovery
22 Jan 08 Quebecor World Inc. HY 6-9; BB 6-7; B 8-9; HB 8-9; XO 6-7 41.250%
19 Sep 07 Movie Gallery, Inc. LCDX8 91.500%
30 Oct 06 Dura Operating Corp. HY 1-6; B 1-3; HB 3-6 3.500%
06 Mar 06 Dana Corporation HY 1,2,3,4,5; BB 1,2,3,4,5; XO 5 75.000%
21 Dec 05 Calpine Corporation HY 1,2,3,4,5; HB 3,4,5 19.125%
08 Oct 05 Delphi Corporation IG1,2,3; HV 1,2,3; HY4,5; BB4; HB4,5 63.375%
14 Sep 05 Delta Air Lines, Inc. HY 1,2 18.000%
14 Sep 05 Northwest Airlines, Inc. Trac-X 28.000%
17 May 05 Collins & Aikman Products Co. HY 1,2,3,4 43.625%
Trac-X is an index that traded before the inception of CDX.
Source: CreditEx; ISDA; Markit Group Ltd; Banc of America Securities LLC estimates.

Succession Events in the CDX Indices


Figure 50. Succession Events in the CDX Indices
Date Original Reference Entity Indices New Reference Entities
17 Nov 06 Verizon Communications Inc. IG 1,2,3,4,5,6,7 50% Verizon Communications Inc., 50% Idearc Inc.
17 Jul 06 Alltel Corporation IG 2,3,4,5,6 50% Alltel Corporation, 50% Windstream Corporation
Only shows 50% / 50% CDS splits, not 100% Succession Events.
Source: CreditEx; ISDA; Markit Group Ltd; Banc of America Securities LLC estimates.

Prepayment Events in the LCDX Indices


Figure 51. Prepayment Events in the LCDX Index
Event Reference Entity Index Prepaid Removed
WLT Walter Industries Inc. LCDX8 11 Dec 07 28 Jan 07
AMD Advanced Micro Devices, Inc. LCDX8 28 Aug 07 10 Oct 07
BLUEGR Altivity Packaging, LLC LCDX8 20 Mar 08 06 May 08
A Reference Entity may be removed from the LCDX index if it cancels its entire Syndicated Secured facility, including any revolver, and does not replace it within 30 Business Days. By “removed,” we mean
the weight of that entity is reduced to zero, without changing the weight on any other Reference Entity.
Sources: Markit Group Ltd; Banc of America Securities LLC estimates.

60 Credit Default Swap Primer


Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Reference Entities in the CDX Indices


Investment Grade: CDX.NA.IG, Series 10
Figure 52. Reference Entities in CDX.NA.IG, Series 10
Reference Entities Reference Entities Reference Entities
ACE Ltd Dominion Resources Inc/VA Motorola Inc
Aetna Inc Dow Chemical Co/The National Rural Utilities Cooperative Finance Corp
Alcan Inc Duke Energy Carolinas LLC New York Times Co/The
Alcoa Inc Eastman Chemical Co Newell Rubbermaid Inc
Allstate Corp/The EI Du Pont de Nemours & Co News America Inc
Altria Group Inc Embarq Corp Nordstrom Inc
American Electric Power Co Inc Federal National Mortgage Association Norfolk Southern Corp
American Express Co FirstEnergy Corp Northrop Grumman Corp
American International Group Inc Fortune Brands Inc Omnicom Group Inc
Amgen Inc Freddie Mac Progress Energy Inc
Anadarko Petroleum Corp Gannett Co Inc Quest Diagnostics Inc
Arrow Electronics Inc General Electric Capital Corp Radian Group Inc
AT&T Inc General Mills Inc Raytheon Co
AT&T Mobility LLC Goodrich Corp Rohm & Haas Co
Autozone Inc Halliburton Co RR Donnelley & Sons Co
Baxter International Inc Hartford Financial Services Group Inc Safeway Inc
Black & Decker Corp Hewlett-Packard Co Sara Lee Corp
Boeing Capital Corp Home Depot Inc Sempra Energy
Bristol-Myers Squibb Co Honeywell International Inc Sherwin-Williams Co/The
Brunswick Corp/DE Ingersoll-Rand Co Ltd Simon Property Group LP
Burlington Northern Santa Fe Corp International Business Machines Corp Southwest Airlines Co
Campbell Soup Co International Lease Finance Corp Sprint Nextel Corp
Capital One Bank USA NA International Paper Co Starwood Hotels & Resorts Worldwide Inc
Cardinal Health Inc iStar Financial Inc Target Corp
Carnival Corp JC Penney Co Inc Textron Financial Corp
Caterpillar Inc Kohl's Corp Time Warner Inc
CBS Corp/Old Kraft Foods Inc Toll Brothers Inc
CenturyTel Inc Kroger Co/The Transocean Inc
Chubb Corp Liz Claiborne Inc Union Pacific Corp
Cigna Corp Lockheed Martin Corp Universal Health Services Inc
CIT Group Inc Loews Corp Valero Energy Corp
Comcast Corp Ltd Brands Inc Verizon Communications Inc
Computer Sciences Corp Macy's Inc Viacom Inc
ConAgra Foods Inc Marriott International Inc/DE Wal-Mart Stores Inc
ConocoPhillips Marsh & McLennan Cos Inc Walt Disney Co/The
Constellation Energy Group Inc Masco Corp Washington Mutual Inc
COX Communications Inc MBIA Insurance Corp Wells Fargo & Co
CSX Corp McDonald's Corp Weyerhaeuser Co
CVS Caremark Corp McKesson Corp Whirlpool Corp
Darden Restaurants Inc MDC Holdings Inc Wyeth
Deere & Co MeadWestvaco Corp XL Capital Ltd
Devon Energy Corp MetLife Inc
Source: Bloomberg.

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Credit Strategy Research 35
May 27, 2008

Crossover: CDX.NA.XO, Series 10

Figure 53. Reference Entities in CDX.NA.XO, Series 10


Reference Entities
American Axle & Manufacturing Inc
Belo Corp
Bombardier Inc
Boston Scientific Corp
CA Inc
Centex Corp
Chemtura Corp
Chesapeake Energy Corp
Citizens Communications Co
Echostar DBS Corp
El Paso Corp
Expedia Inc
Flextronics International Ltd
Gap Inc/The
Host Hotels & Resorts LP
Jones Apparel Group Inc
KB Home
L-3 Communications Corp
Lennar Corp
Liberty Media LLC
MGM Mirage
Mosaic Co/The
Olin Corp
Pioneer Natural Resources Co
Pulte Homes Inc
RadioShack Corp
Royal Caribbean Cruises Ltd
Sears Roebuck Acceptance
Smithfield Foods Inc
Sun Microsystems Inc
Temple-Inland Inc
Tyson Foods Inc
Unum Group
Wendy's International Inc
Windstream Corp
Source: Bloomberg.

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Credit Strategy Research 35
May 27, 2008

High Yield: CDX.NA.HY, Series 10


Figure 54. Reference Entities in CDX.NA.HY, Series 10
Reference Entities Reference Entities Reference Entities
Abitibi-Consolidated Inc El Paso Corp Neiman-Marcus Group Inc
Advanced Micro Devices Inc Energy Future Holdings Corp Nortel Networks Corp
AES Corp/The Fairfax Financial Holdings Ltd Nova Chemicals Corp
AK Steel Corp First Data Corp NRG Energy Inc
Allegheny Energy Supply Co LLC Flextronics International Ltd Owens-Illinois Inc
Allied Waste North America Inc Ford Motor Co PolyOne Corp
Alltel Corp Forest Oil Corp Pride International Inc
American Axle & Manufacturing Inc Freeport-McMoRan Copper & Gold Inc Qwest Capital Funding Inc
Amkor Technology Inc Freescale Semiconductor Inc RadioShack Corp
AMR Corp General Motors Corp Realogy Corp
Aramark Corp/Old Georgia-Pacific LLC Reliant Energy Inc
ArvinMeritor Inc Goodyear Tire & Rubber Co/The Residential Capital LLC
Avis Budget Car Rental LLC/Avis Budget Finance Inc Harrah's Operating Co Inc RH Donnelley Corp
Beazer Homes USA Inc HCA Inc/DE Rite Aid Corp
Bombardier Inc Hertz Corp/The Royal Caribbean Cruises Ltd
Celestica Inc Host Hotels & Resorts LP Sabre Holdings Corp
Charter Communications Holdings LLC Idearc Inc Saks Inc
Chemtura Corp IKON Office Solutions Inc Sanmina-SCI Corp
Chesapeake Energy Corp Intelsat Ltd Six Flags Inc
Citizens Communications Co Iron Mountain Inc Smithfield Foods Inc
Clear Channel Communications Inc K Hovnanian Enterprises Inc Smurfit-Stone Container Enterprises Inc
CMS Energy Corp KB Home Standard Pacific Corp
Community Health Systems/Old L-3 Communications Corp Station Casinos Inc
Constellation Brands Inc Lear Corp Sungard Data Systems Inc
Cooper Tire & Rubber Co Level 3 Communications Inc Tenet Healthcare Corp
CSC Holdings Inc Levi Strauss & Co Tesoro Corp
Dillard's Inc Liberty Media LLC Toys R US Inc
DIRECTV Holdings LLC Massey Energy Co Tribune Co
Dole Food Co Inc Mediacom LLC TRW Automotive Inc
Domtar Inc MGM Mirage Unisys Corp
Dynegy Holdings Inc Mirant North America LLC United Rentals North America Inc
Eastman Kodak Co Mosaic Co/The Univision Communications Inc
Echostar DBS Corp Nalco Co Visteon Corp
Windstream Corp
Source: Bloomberg.

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May 27, 2008

Leveraged Loans: CDX.NA.LCDX, Series 10


Figure 55. Reference Entities in CDX.NA.LCDX, Series 10
Reference Entities Reference Entities Reference Entities
Affiliated Computer Services Inc First Data Corp Mylan Inc
Aleris International Inc Ford Motor Co Nalco Co
Allied Waste North America Inc Freescale Semiconductor Inc Neiman-Marcus Group Inc
ALLTEL Communications Inc Fresenius Medical Care AG & Co KGaA NewPage Corp
AMC Entertainment Inc General Growth Properties Inc Nielson & Associates Inc
American Airlines Inc General Motors Corp NRG Energy Inc
Aramark Corp/Old Georgia Gulf Corp Oshkosh Corp
ArvinMeritor Inc Georgia-Pacific LLC Owens-Illinois Group Inc
Avis Budget Car Rental LLC/Avis Budget Finance Inc Goodyear Tire & Rubber Co/The PENN NATIONAL GAMING, INC. -LCDS
Bausch & Lomb Inc Graham Packaging Co Inc Realogy Corp
Berry Plastics Holding Corp Graphic Packaging International Corp Regal Cinemas Corp
Biomet Inc Harrah's Operating Co Inc Reliant Energy Inc
Blockbuster Inc Hawaiian Telcom Communications Inc RH Donnelley Inc
Boston Generating LLC HBI Branded Apparel Ltd Inc Rite Aid Corp
Boyd Gaming Corp HCA Inc/DE Rockwood Specialties Ltd
Burger King Corp Health Management Associates Inc Sabre Inc
Calpine Corp Healthsouth Corp Sensata Technologies BV
Capital Automotive LP Hertz Corp/The SIX Flags Theme Parks
Cedar Fair -LP Hexion Specialty Chemicals Inc Smurfit-Stone Container Enterprises Inc
Celanese US Holdings LLC Idearc Inc Sungard Data Systems Inc
Cequel Communications LLC Intelsat Corp SUPERVALU Inc
Charter Communications Operating LLC Jarden Corp Swift Transportation Co Inc
Community Health Systems Inc Las Vegas Sands LLC Texas Competitive Electric Holdings Co LLC
Constellation Brands Inc Lear Corp Toys R US - Delaware Inc
CSC Holdings Inc Level 3 Financing Inc Travelport Inc
DaimlerChrysler Financial Services North America LLC Lyondell Chemical Co Tribune Co
DaVita Inc Masonite International Corp TRW Automotive Inc
Dean Foods Co Mediacom LLC United Air Lines Inc/Old
Del Monte Corp Metro-Goldwyn-Mayer Inc United Rentals North America Inc
DIRECTV Holdings LLC MetroPCS Wireless Inc Univision Communications Inc
Dole Food Co Inc Michaels Stores Inc US Airways Group Inc
Domtar Corp Mirant North America LLC Visteon Corp
El Paso Corp Momentive Performance Materials Inc Warner Chilcott Co Inc
Windstream Corp
Source: Bloomberg.

64 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Chapter IV – CDS Operations Management


The rapid growth of the CDS market has brought operational issues to the attention of
investors, banks and broker-dealers, and even regulators. Below, we highlight some of
the most important details around CDS operations that are essential for investors who
would like to add CDS to their portfolio.

CDS Operations
In general, to trade in credit derivatives, an investor must have an ISDA Master
Agreement in place, and a Bank of America, N.A. (for illustrative purposes only) credit
officer must approve a credit line. Credit exposure is granted in a risk equivalent. For
example, a $10 million credit line refers to the total allowable risk of a Counterparty,
not a notional number.

Main Documents
The new credit derivatives investor should be familiar with five main documents:
1. 2003 ISDA Credit Derivatives Definitions, which form the standard language for
CDS transactions.
2. ISDA Master Agreement. This agreement is negotiated between Bank of America,
N.A. (in this example) and a Counterparty to ensure enforcement of the CDS
confirmation document. It is negotiated only after Credit approves a Counterparty.
3. Schedule, which may replace part of the language on the ISDA Master Agreement.
The schedule has several parts:
X Termination provisions
X Tax representations
X Agreement to deliver documents
X Miscellaneous (such as addresses for correspondence)
X Other provisions (waiver of right to trial by jury, disclosure)
X Additional terms for foreign exchange
4. Credit Support Annex. This document is optional. Its main purpose is to pre-
determine when, and in what increments, margin requirements are due (initial
margin, variation margin, and threshold amounts). The text is much more account-
specific than the ISDA Master Agreement and Schedule.
5. Confirmation (Master and Long formats). The “Master” confirm is also called the
“Short” form. Confirms may note a CUSIP, which refer to the Reference
Obligation of the Reference Entity. Language is relatively standard.

Required Documentation
A hedge fund typically must submit the following documentation to begin the ISDA
process:
X Two years of audited financial statements
X Fund offering memorandum
X Monthly NAV (returns) since inception

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X Marketing materials / pitch book


X Authority documentation (Investment Management Agreement / Limited
Partnership Agreements)
X Certificate of incorporation or other formation documents
X Other documents that may help the credit process
For non-hedge funds, BAS Portfolio Management may obtain information on publicly
traded companies and regulated depository institutions. However, a privately owned or
a non-guaranteed subsidiary of a public company typically must submit the following
documentation:
X Two years of audited financial statements and most recent quarterly statements
X Industry specific requirements:
• Regulated broker-dealers: FOCUS reports for the last four fiscal quarters and
the most recent month
• Non-leveraged mutual funds and pension funds: Prospectus and Statement of
Additional Information
• Insurance subsidiaries: Statutory statements
X Other documents that may help the credit process:
• New clients: Articles of incorporation, Partnership or LLC agreement, or other
foundation documents
• Investment advisers: Form ADX
• Registered broker-dealer: Form BD
• Marketing materials, biographies, and other available information

Electronic Settlement of Trades (DTCC) and CDS Operations Management


About 95% of credit According to Markit Group Ltd, about 95% of credit default swaps are eligible for
default swaps are eligible electronic settlement, through the Depository Trust & Clearing Corporation (DTCC).
for electronic settlement. Of those eligible trades, another nearly 95% (i.e., 90% of total trades) settle
45
electronically. For Counterparties not already established on DTCC, a bank or broker-
dealer may facilitate the process, which involves a Membership Package of legal
documents. Once the Counterparty submits the package and DTCC accepts it, the
Counterparty receives a membership number and may begin using electronic
settlement.
To confirm trades, Counterparties use one of two methods. First, Counterparties may
manually submit trades to DTCC and allow DTCC to match them with the relevant
bank or broker-dealer. Alternatively, the Counterparty may allow the relevant bank or
broker-dealer to submit trades DTCC and either accept (called “know”) or decline
(called “DK,” or “don’t know”) each trade.
Currently, banks and broker-dealers absorb the costs of DTCC registration and
settlement. While non-banks and broker-dealers must supply personnel to confirm
trades, there is no charge to use the service itself. DTCC is web-based, so the
Counterparty need not purchase software.

45
http://www.markit.com/information/products/metrics.html

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Goals for CDS Operations Management


Goals for CDS operations In a March 2008 letter to the Federal Reserve, dealers noted the following goals for
management electronically eligible trades, excluding novations. By July 2008:
X “90% T+1 submission;
X 90% submitted accurately, matching without amendment;
X 92% match by T+5;
X RED subscribers are to accurately submit 9-digit RED codes, standard
identifiers that greatly improve matching, on 100% of index trades and 90% of
single name trades;
X Exceptions to the above to be escalated internally and externally as
46
appropriate.”
For year-end 2007, ISDA already estimates that 90% of electronic confirmations are
normally sent by T+1. However, ISDA also estimates that unsigned credit derivatives
confirmations rose to 6.6x the daily volume of new trades in 2007, from 4.9x in 2006.
The 2007 estimate compares with 9.9x for interest rate derivatives and 13.3x for equity
47
derivatives.

Give-Ups
“Give-ups” allow a It is sometimes possible for a Counterparty to trade in credit derivatives without an
Counterparty to trade in ISDA Master Agreement. This process is called a “give-up” and requires that (1) a
CDS without an ISDA Counterparty have prime brokerage service and (2) the Counterparty’s prime broker
Master Agreement has an ISDA Master Agreement with Bank of America, N.A. (for illustrative purposes
only).
In a give-up, Bank of America, N.A. and the Counterparty’s prime broker negotiate an
agreement that allows a client to trade. After a client states that he would like to
execute a trade, Bank of America, N.A. sends a request to the client’s prime broker. If
In a give-up, Bank of approved, Bank of America, N.A. faces the client’s prime broker as a Counterparty.
America, N.A. faces the The prime broker then faces the client in a separate trade. Figure 56 and Figure 57
client’s prime broker (not the compare a normal trade with a give-up:
client) as a Counterparty

46
http://www.newyorkfed.org/newsevents/news/markets/2008/an080327.pdf. “RED” denotes Reference Entity Database, which comprises a list
of standardized Reference Entities for CDS transactions.
47
Preliminary results of ISDA 2008 Operations Benchmarking Survey, and ISDA 2007 Operations Benchmarking Survey, available from
http://www.isda.org.

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Figure 57. Give-Up


Figure 56. Normal Trade Client Sells Protection at 500 Bps Running
Client Sells Protection at 500 Bps Running Client’s prime broker may charge a fee for this service

Client Bank of America, NA

Margin 1000 bps


running Protection
500 bps
Protection Client
running

500 bps
running
Protection
Client's Counterparty Client's Counterparty

Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

In a typical give-up agreement, the client’s prime broker will specify a credit line for
the client. The trade is automatically approved unless the prime broker declines the
trade within a pre-specified period of time; for example, within two hours. If the prime
broker declines the trade, the client remains responsible for any associated unwind
costs. For example, if a client sells CDS protection and spreads widen by the time a
prime broker declines a trade, the client will owe Bank of America, N.A. money for
unwinding the transaction. Should a client sell CDS protection and spreads tighten by
the time a prime broker declines a trade, the client will not receive the mark-to-market
gain.
Some investors with ISDA Some clients with ISDA Master Agreements prefer to trade CDS with give-ups, rather
Master Agreements than do new trades, because of more favorable margin requirements at the prime
prefer to trade CDS with broker. This reason for lower margin is that the prime broker should have a better sense
give-ups of a client’s overall risk profile than one particular dealer. So in return for lower
margin, the client may be willing to pay a per-trade give-up fee to the prime broker.
Since all give-ups transact through the prime broker, the client may incur significant
Counterparty risk; i.e., the risk of a Credit Event at the prime broker.
Counterparty Risk and Leverage
As an unfunded market, CDS market participants promise to exchange cash flows
following a potential Credit Event. There are no hard assets set aside to guarantee
payment. As such, should the protection Seller default on his obligation to pay the
required cash flows post-Credit Event, the protection Buyer simply becomes a general
48
creditor of the protection Seller.

Initial Margin
To reduce Counterparty risk, Counterparties are required to post collateral (margin). As
of year-end 2007, ISDA estimates that there was approximately $2.1 trillion in

48
For the United States. In Europe, credit default swaps may have a different seniority post-Bankruptcy.

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collateral in circulation, up from $1.3 trillion in each of 2006 and 2005. These numbers
49
are across all derivatives transactions, not just credit derivatives.
There are two types of margin, initial and variation. Initial margin is based on both risk
of a particular trade and Counterparty creditworthiness. All Counterparties will pay
higher margin to sell protection at 500 bps than 200 bps. Regardless of spread, high-
risk Counterparties will pay more margin than low-risk Counterparties. Generally, only
50
hedge funds are required to post initial margin, and only when they sell protection.
For instance, suppose that a dealer believes it would take approximately two weeks to
discover that a Counterparty were no longer creditworthy, decide to unwind that
Counterparty, obtain the necessary approvals, and effect an unwind. Initial margin then
would reflect the dealer’s expected loss over a two-week period, with respect to that
Counterparty’s portfolio. An as-yet unresolved question in the current market
environment—and the subject of significant attention—is how best to measure the
magnitude and volatility of expected losses.
The example in Figure 58 assumes that a dealer believes spreads could double during
the forced unwind period, with a loss of 8.2 points. The dealer scales that potential loss
by 80%, to reflect a lower likelihood of the Counterparty defaulting. Initial margin is
then 6.6 points (8.2 points potential loss x 80% scaling factor).

49
ISDA Margin Survey 2008, available from http://www.isda.org.
50
Although other investors may not be required to post initial margin, this is in part because the Counterparty is usually satisfied that investors’
internal regulations require the holding of (internal) reserves. Separately, hedge funds may be required to post initial margin when they buy
protection on wide-spread or risky credits (for example, wider than 500 bps), to reduce the risk that a hedge fund may not be able to meet
variation margin requirements.

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Figure 58. Hypothetical Example of Initial Margin Calculation


Investor Sells Protection and Pays Initial Margin to Dealer

Scenario
where
dealer
believes
spreads
could
double
Initial during
Spread potential
forced
unwind
period

Initial Margin = 8.2 points x Scaling Factor to Account for Likelihood of


Counterparty Default. For example, at 80% scaling factor:
Initial Margin = 8.2 points x 80% = 6.6 points
Sources: Bloomberg; Banc of America Securities LLC estimates.

Importantly, initial margin requirements assume that a Counterparty will not default at
the same time as a potential Credit Event. If a Counterparty and a Reference Entity
were to file for bankruptcy at about the same time, losses would be significantly higher.
For example, at 40% recovery, losses would be 60% of notional, far higher than the
6.6% collected in Figure 58.
Counterparties who share a greater portion of their portfolio with a particular dealer
may face better margin requirements because of offsetting risk. For example, suppose
that one hedge fund sells protection exclusively through one dealer but buys protection
exclusively to another dealer. That hedge fund will face relatively high margin
requirements on its sell-protection trades, because the relevant dealer will believe the
hedge fund is exclusively long risk. By contrast, a different hedge fund that has more
balanced sell- and buy-protection trades through dealers may face better margin
requirements, because dealers will be aware that the hedge fund’s portfolio is more
balanced.

Leverage
Since initial margin is significantly less than 100%, protection Sellers are able to
employ leverage. In principle, at 10% margin, a protection Seller is able to leverage

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10x (1 / 10%). Figure 59 illustrates sample leverage that CDS protection Sellers may
use. Many investors hold additional, internal reserves, so actual leverage is likely to be
significantly lower.
Figure 59. Sample Leverage that Protection Sellers May Employ in Credit Derivatives
Leverage Estimated as 1 / Margin Requirement

Low Risk Counterparty


60 High Risk Counterparty
50
Leverage (X) 40
30
20
10
0
100 150 200 250 300 350 400 450 500
5y CDS Spread (bps)
Margin requirements may vary significantly across Counterparties. See Figure 58 for an example of initial margin calculation.
Source: Banc of America Securities LLC estimates.

Variation Margin
The second type of margin is variation margin. This type of collateral accounts for mark-
to-market P&L and is set in the Credit Support Annex, or “CSA,” discussed in the
operational overview on page 65. If an investor suffers mark-to-market losses beyond a
pre-established threshold, he is required to pay variation margin. For example, the
threshold may be zero for a higher-risk Counterparty and several million dollars for a
lower-risk Counterparty. These payments may be reimbursed, if the investor
subsequently realizes mark-to-market gains. All types of Counterparties, regardless of
whether they buy or sell protection, are subject to variation margin requirements.

Required Collateral
Required collateral is billed in cash (for example, $100,000), but may be posted with
securities at a certain ratio. For example, an investor may be allowed to post five-year
maturity Fannie Mae or Freddie Mac securities at a ratio of 98%. This means that, for
every $100,000 in required collateral, the investor must post $102,041 face value of
securities ($100,000 / 98%). Posted collateral earns interest at the Federal Funds rate.

Marks
As part of the margin process, CDS investors receive marks for outstanding trades.
51
Generally, marks are supplied via website at a pre-established frequency (e.g., daily).

51
Some investors also choose to purchase third-party data. Markit Group Ltd is one popular third-party data provider, although this should not
be construed as a recommendation.

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ISDA Master Agreement


Rules surrounding margin and collateral posting often are agreed in a Credit Support
Annex to the ISDA Master Agreement, which is a governing document usually signed
52
during the approval process for derivatives trading.

Termination Events
If a Counterparty breaches any one of “termination event” criteria specified in the
ISDA Master Agreement, the other party may force an unwind of all existing trades.
Among the criteria are:
X Bankruptcy of the Counterparty
X Failure to Pay required payments, such as coupons or margin
X An event beyond a party’s control, such as a circumstance that makes it unlawful to
continue the CDS contract
X Note that Counterparties also may agree to an additional termination event based
on a material ratings downgrade; for example, to high yield or triple-B
Following a forced unwind, Counterparties are required to exchange the net P&L at
current marks (a “close-out” amount). The non-defaulting party may obtain marks from
53
third-party dealer quotes, or if such information is not available, an internal model.
The non-defaulting party must supply details of its calculations to its Counterparty.
The close-out amount is calculated on the same day for all types of trades covered by
the ISDA Master Agreement—for instance, credit derivatives, equity derivatives, and
interest rate derivatives. The net close-out amount across all products is offset against
any collateral (margin) held by the non-defaulting party. If there is any collateral
shortfall, payment may be due as soon as the same business day.
As one might imagine, practically, implementing this process may prove difficult and
disruptive, and is one reason why the CDS market is working on the development of a
clearinghouse, discussed below.

The Clearing Corporation


Currently, the CDS market is working on a clearinghouse to guarantee selected trades.
Rather than face banks or broker-dealers as Counterparties, investors would face the
clearinghouse, known as “The Clearing Corporation.” Recall that, currently, if a
Counterparty defaults, then the remaining party would follow the “Termination Events”
54
above, or in the extreme, become a general creditor in bankruptcy proceedings. By
contrast, if a member of the clearinghouse were to fail, then losses would be allocated
55
among other clearinghouse members. As such, the clearinghouse would reduce

52
ISDA Master Agreements often are based on standardized 1992 or 2002 forms, as published by the International Swaps and Derivatives
Association, Inc. (ISDA).
53
This is just one method for determining a close-out amount. The actual method used depends on the ISDA Master Agreement. For example, in
the 1992 ISDA Master Agreement, the close-out amount may be determined by either (i) obtaining quotes on the non-defaulting party’s side
of the market (bid or offer), for replacement trades with identical terms to the trades being terminated. The close-out amount is based on an
average of these quotes, or if no quotes are obtained, then (ii) use internal models or third-party quotes, including costs such as terminating
hedges and funding. In some cases, (ii) may be chosen as the initial method. The 2002 ISDA Master Agreement specifies a combination of the
two approaches from the 1992 ISDA Master Agreement.
54
For the United States. In Europe, credit default swaps may have a different seniority post-Bankruptcy.
55
The allocation of losses applies only if a member of the clearinghouse were to fail. If a member (for example, a bank or broker-dealer)
processes a trade for a non-member (for example, a medium-sized hedge fund), that member would be responsible for all losses attributed to

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Counterparty exposure. In its early stages, this proposal may take effect for a small
number of trades, among a small number of counterparties, toward the end of 2008.

Exchange-Traded CDS
Currently, essentially all CDS trading volume is over-the-counter, but it is possible to
trade credit default swaps on an exchange, with the exchange as a Counterparty.
Broadly speaking, exchange-traded CDS is a fixed recovery swap that trades in
present-value terms. For example, rather than paying 100 bps running for five years,
the protection Buyer makes a single up-front payment for the present value of the swap.
Following a Credit Event, the protection Buyer receives a fixed recovery rate rather
than the actual recovery rate of the cheapest-to-deliver Bond or Loan. Figure 60
summarizes the major features of exchange-traded CDS versus over-the-counter CDS.

the non-member. In the extreme case, if such losses were to cause the clearinghouse member to fail, such losses could be allocated among
remaning clearinghouse members.

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Figure 60. Over-the-Counter CDS versus Exchange Traded CDS


North America

Over-the-Counter CDS Chicago Board Options Chicago Mercantile


Exchange (CBOE) Exchange (CME)
Counterparty • Bank or Broker-Dealer • Exchange
Execute trade with • Bank or Broker-Dealer • Broker for the Exchange
Market size $62 trillion total CDS market size • Zero open interest
estimate (ISDA 2007)
Quotation • Spread • Points Upfront (No Running)
Coupon Payments • Quarterly • None
Initial Price • Single-names: Par, or for wider- • Par minus present value of the contract
spread credits, discount + 500 bp
running coupon. Indices:
Premium or discount + fixed
running coupon.
Trade size • $2 MM - $10 MM • Contracts of $100,000 • Depending on the product,
contracts of $100,000 or fixed
DV01 of $500
Credit Events • Bankruptcy, Failure to Pay, and • Failure to Pay or another Event • Depending on the product,
for selected Reference Entities, of Default or Restructuring as same as for Over-the-Counter
Modified Restructuring specified by the Exchange CDS, or Bankruptcy and Failure to
Pay
Redemption Event • N/A • Swap terminates early if no • N/A
Relevant Obligation remains
(e.g., following a full tender)
Maturity • 20th Day each of Mar, Jun, • 3rd Friday each of Mar, Jun, • 2nd Business Day preceding
Sep, and Dec Sep, and Dec the third Wednesday of the
Contract Month, initially proposed
to be Mar, Jun, Sep and Dec

Recovery • Floating (Determined by • Single-names: Zero. Baskets: • Fixed at contract inception by


Physical or Cash Settlement) As specified by the exchange the exchange
Trading Hours • Over-the-counter Trading Day • Monday 8:30am - Friday 3pm, • Sunday 5pm - Friday 4pm,
Chicago time Chicago time
Margin Requirements Set by • Credit Support Annex with Bank • Minimum standard set by exchange, but may be increased by
or Broker-Dealer broker

Calculation Agent • Typically the Bank or Broker- • Exchange


Dealer, unless both parties are
Banks or Broker-Dealers, in which
case the protection Seller usually
is the Calculation Agent
Open interest as of April 22, 2008, as shown on Bloomberg.
To access CME contracts on Bloomberg, type CEM <GO> 3 (CBT) <GO>. Then see contracts in the “CDS” category.
To access CBOE contracts on Bloomberg, type CBOE <GO> 1 (CBOE Equity Index, Volatility and Credit Option Products) <GO>. Then see “CEBO” (Credit Event Binary Option) products.
Sources: Bloomberg; CME; CBOE; Banc of America Securities LLC estimates.

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Credit Strategy Research 35
May 27, 2008

Appendix IV – CDS Operations Management


Sample Confirmations and Trade Recaps

Sample Confirmation for a New Trade


To help ensure that credit default swaps are standardized across Counterparties, a
standard confirmation references a Physical Settlement Matrix (“Matrix”), published by
ISDA. The Matrix clarifies Credit Events, Deliverable Obligations Characteristics, and
similar features of CDS contracts. A sample confirmation and excerpt of the Physical
Settlement Matrix are shown below:

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May 27, 2008

Sample Confirmation (Term Sheet)


Date: March 27, 2008
To: [Name and Address or Facsimile Number of (the “Buyer”) (Party B)]
From: Bank of America, N.A. (the “Seller”) (Party A)
Re: Credit Derivative Transaction
The purpose of this “Confirmation” is to confirm the terms and conditions of the Credit Derivative Transaction entered into between us on the Trade Date
specified below (the ”Transaction”). This Confirmation constitutes a “Confirmation” as referred to in the ISDA Master Agreement specified below.
The definitions and provisions contained in the 2003 ISDA Credit Derivatives Definitions as supplemented by the May 2003 Supplement and the 2005 Matrix
Supplement to the 2003 ISDA Credit Derivatives Definitions (as so supplemented, the “2003 Definitions”), as published by the International Swaps and
Derivatives Association, Inc. (“ISDA®”), are incorporated into this Confirmation. In the event of any inconsistency between the 2003 Definitions and this
Confirmation, this Confirmation will govern.
This Confirmation supplements, forms a part of, and is subject to, the ISDA Master Agreement dated as of [date], as amended and supplemented from time
to time (the “Agreement”), between you and us. All provisions contained in the Agreement govern this Confirmation except as expressly modified below.
The terms of the Transaction to which this Confirmation relates are as follows:
1. General Terms
Transaction Type: NORTH AMERICAN CORPORATE
Trade Date: March 27, 2008
Matrix Publication Date: December 6, 2007
Effective Date: March 28, 2008
Scheduled Termination Date: June 20, 2013

Floating Rate Payer: Bank of America, N.A. (the “Seller”) (Party A)


Fixed Rate Payer: TBD (the “Buyer”) (Party B)
Calculation Agent: Seller
Calculation Agent City: New York
Reference Entity: Comcast Corporation
Reference Obligation The obligation defined as follows:
Primary Obligor: Comcast Corp
Maturity: January 15, 2014
Coupon: 5.3%
CUSIP: 20030NAE1
2. Fixed Payments
Fixed Rate Payer Payment Dates: June 20, 2008, and thereafter, the 20th day of each March, June, September, and December
Fixed Rate: 1.55% per annum
3. Floating Payment
Floating Rate Payer Calculation Amount: USD 10,000,000
4. Credit Events
Restructuring: Applicable
Please confirm your agreement to be bound by the terms of the foregoing by executing a copy of this Confirmation and returning it to us.
Yours sincerely,
[PARTY A]
By: ______________________________________
Name:
Title:
Confirmed as of the date first written above:
[PARTY B]
By: ______________________________________
Name:
Title:
Indicative sample, for illustrative purposes only.
Sources: ISDA; Banc of America Securities LLC.

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Physical Settlement Matrix


Transaction Type North American Corporate European Corporate
Business Days If the Floating Rate Payer Calculation Amount is If the Floating Rate Payer Calculation Amount is
denominated in denominated in
USD: London & New York EUR: London & TARGET
EUR: London, New York & TARGET USD: London & New York
GBP: London GBP: London
JPY: London & Tokyo JPY: London & Tokyo
CHF: London & Zurich CHF: London & Zurich
Calculation Agent City New York London
All Guarantees Not Applicable Applicable
Conditions to Settlement Notice of Publicly Available Information Applicable Notice of Publicly Available Information Applicable
Credit Events Bankruptcy Bankruptcy
Failure to Pay Failure to Pay
Restructuring, if specified as applicable in the Restructuring
relevant Confirmation Modified Restructuring Maturity
Restructuring Maturity Limitation Limitation and Conditionally
and Fully Transferable Obligation Transferable Obligation
Applicable Applicable
Obligation Category Borrowed Money Borrowed Money
Obligation Characteristics None None
Settlement Method Physical Settlement Physical Settlement
Physical Settlement Period As per Section 8.6 of the Definitions capped at 30 Business Days
30 Business Days
Deliverable Obligation Category Bond or Loan Bond or Loan
Deliverable Obligation Characteristics Not Subordinated Not Subordinated
Specified Currency Specified Currency
Not Contingent Not Contingent
Assignable Loan Assignable Loan
Consent Required Loan Consent Required Loan
Transferable Transferable
Maximum Maturity: 30 years Maximum Maturity: 30 years
Not Bearer Not Bearer
Escrow Applicable Applicable
60 Business Day Cap on Settlement Not Applicable Applicable
Additional Provisions for Physically Settled Default Not Applicable unless otherwise specified as Not Applicable
Swaps – Monoline Insurer as Reference Entity Applicable in the relevant Confirmation
(January 21, 2005)
Additional Provisions for a Secured Deliverable Not Applicable unless otherwise specified as Not Applicable
Obligation Characterictic (June 16, 2006) Applicable in the relevant Confirmation
Additional Provisions for Reference Entities with Not Applicable unless otherwise specified as Not Applicable
Delivery Restrictions (February 1, 2007) Applicable in the relevant Confirmation
Additional Provisions for STMicroelectronics NV Not Applicable Applicable if the Reference Entity is
(December 6, 2007) STMicroelectronics NV, otherwise Not Applicable
Fixed Rate Payer Payment Dates frequency Quarterly Quarterly
Indicative sample, for illustrative purposes only.
Although we highlight North American and European corporates, the full Physical Settlement Matrix contains more types of CDS transactions.
Source: ISDA.

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Credit Strategy Research 35
May 27, 2008

Sample Trade Recaps and Mechanics


Figure 61 shows a sample trade recap, in which Bank of America, N.A. (for example)
buys $5 million protection at a premium of 40 bps:
Figure 61. Sample Trade Recap for a New Trade

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

Mechanically, the protection Buyer (in this case, Bank of America, N.A.) will pay the
protection Seller $5,000 per quarter (40 bps x $5 million notional / 4 quarters) on the
th
20 day each of March, June, September, and December.
In the first coupon period, the protection Buyer will pay only the premium for the
number of days that the trade was effective (April 22, 2008 to June 19, 2008, which is
one day prior to the first coupon date). In future periods, coupons will be paid at the
th th th
end of a quarter (e.g., coupon paid on June 20 is for March 20 to June 19 ).
Note, by market convention, one month before a quarterly CDS roll, single-name trades
st
switch to a long coupon. For example, if a trade occurs on November 21 , one month

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Credit Strategy Research 35
May 27, 2008

before the December 20 roll, the first coupon will be on March 20. At that time, the
56
protection Buyer will pay a coupon for four months (November—March).
The last coupon period will include the Scheduled Termination Date (maturity), and
runs from March 20, 2015 to (including) June 20, 2015. However, if a Credit Event
occurs, the protection Buyer must pay accrued interest up to and including the Event
Determination Date (usually the same day as the Credit Event, or the next Business
Day). Then coupon payments will stop and the Counterparties must settle the contract.
Unwind
Figure 62 shows a sample trade recap in which an investor bought protection at 399 bps
and now wishes to unwind with Bank of America, N.A. (for example) at 680 bps. On
$4 million notional, Bank of America, N.A. must pay $531,240 to execute the trade:

56
The reason for a long first coupon dates to earlier years of CDS, when Counterparties settled trades by facsimile and agreed upon quarterly
coupon payments by spreadsheet. The market needed time to complete these tasks and therefore moved to a long first coupon one month
before a roll.

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Credit Strategy Research 35
May 27, 2008

Figure 62. Sample Trade Recap for an Unwind

Sources: Bloomberg; Banc of America Securities LLC estimates.

Attached to the trade recap are the calculations for the $531,240 unwind fee, shown in
Figure 63:

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Credit Strategy Research 35
May 27, 2008

Figure 63. Calculations Attached to Sample Trade Recap for an Unwind

Notional

Dates
Unwind
Spread
Original
Spread

Unwind
Effective
Date

Paid to Original Protection Buyer


Sources: Bloomberg; Banc of America Securities LLC estimates.

Assignment
Figure 64 shows a sample trade recap in which a client bought protection at 20 bps and
now wishes to assign that trade to Bank of America, N.A. (for example) at 50 bps. On
$8 million notional, the client will receive $109,796. This is because Bank of America,
N.A. buys protection at 50 bps, but will only pay 20 bps running to the original
(“Remaining”) Party. Bank of America, N.A. pays the present value of the 30 bps
difference (50 bps – 20 bps) discounted at a risky rate of LIBOR + 30 bps / [ 1 – 40%
expected recovery rate ] to the client upfront, less accrued interest, for a total of
$109,796.

Credit Default Swap Primer 81


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Credit Strategy Research 35
May 27, 2008

Figure 64. Sample Trade Recap for an Assignment

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

Attached to the trade recap are the calculations for the $109,796 assignment fee, shown
in Figure 65:

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Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Figure 65. Calculations Attached to Sample Trade Recap for an Assignment

Notional

Dates

Original Assign-
Spread ment
Spread
Paid by
Buyer

Sources: Bloomberg; Banc of America Securities LLC estimates.

Sample Request for an Assignment


2005 Novation Protocol
An assignment involves three parties: the “Remaining Party,” who remains on the CDS
An assignment involves contract even after the assignment takes place; the “Transferor,” who assigns (transfers)
three parties liability for the contract; and the “Transferee,” to whom the contract is assigned
(transferred).
Technically, an assignment may not occur unless the Remaining Party agrees to face
Prior to assigning a the Transferee. This is because the original CDS contract was a bilateral agreement
trade, the Remaining between the Remaining Party and the Transferor. To remove the Transferor from the
Party must agree to face original CDS contract and replace it with the Transferee, the Transferor must obtain
the Transferee permission from the Remaining Party.
However, historically, assignments were executed without the permission of the
Remaining Party. This is one of the concerns highlighted by market regulators.
Consider an original trade between a broker-dealer and a client, which is then assigned
to a different broker-dealer. This often results in a decrease in Counterparty risk,
because the new broker-dealer is viewed as more credit worthy than the client (e.g., a
hedge fund). Expecting that the original broker-dealer (the Remaining Party) will agree
to the assignment, the client (Transferor) and the new broker-dealer (Transferee) have
simply assigned the trade, and later sought permission from the Remaining Party.
Operationally, this resulted in a backlog of assignments, where Remaining Parties may
not know which Counterparty they face for months at a time. Should a Credit Event

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occur before the assignment backlog is completed, the Remaining Party may contact
the wrong Counterparty for payment. Moreover, should either the Transferor or
Transferee file for Bankruptcy, the Remaining Party may not know its exact credit
exposure for some time.
In September 2005, the Federal Reserve and 14 dealers met to discuss risks to the credit
derivatives market. On October 24, 2004, the 2005 Novation Protocol took effect for
the CDS market. This Protocol requires the following:
The Transferee must receive consent from the Remaining Party by 6pm, in the location
The 2005 Novation of the Transferee, on the day an assignment is agreed to. If the Transferee does not
Protocol requires that the receive consent by 6pm, the assignment will instead be booked as a new trade. That is,
Transferee receive instead of the mechanics of Figure 90, the trade would follow Figure 89.
consent by 6pm on the
trade date. Otherwise, The 2005 Novation Protocol is interpreted as an amendment to the ISDA Master
the assignment will be Agreement and is irrevocable. Clients who do not participate in the Protocol must
booked as a new trade obtain permission from the Remaining Party before attempting to assign (also called
“novate”) a trade.
As part of the 2005 Novation Protocol, below is a sample e-mail or Bloomberg
message from the Transferor to the Remaining Counterparty, required to execute an
assignment. In a March 2008 letter to the Federal Reserve, dealers stated plans to
implement a way for novation requests to be submitted by electronic platform, rather
57
than e-mail, beginning in late 2008.

57
http://www.newyorkfed.org/newsevents/news/markets/2008/an080327.pdf.

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Credit Strategy Research 35
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From: [contact name at Transferor]


To: [contact name at Remaining Party]
CC: [contact name at Transferee]

Re: Request for Consent to Proposed Transfer


Transaction References (include if available):
[Our Reference Number: ]
[Your Reference Number: ]
[Third Party Reference: eg Swapswire, DTCC and reference information]

We have agreed with the proposed Transferee to the transfer by novation of the transaction described below (the “Transaction”), subject to your consent to
such transfer.

Transferor: [ ]
Proposed Transferee: [ ]
Novation Trade Date: [ ]
Trade Date: [ ]
Novated Amount: [ ]

Details to Include for Credit Derivative Transactions


Reference Entity / Ticker / RED Code: [ ]
Reference Obligation / CUSIP: [ ]
Scheduled Termination Date: [ ]
[Notional allocation ] [ ]
[Non-Standard Terms ] [ ]

Details to Include for Interest Rate Derivative Transactions


Termination Date: [ ]
Notional Amount: [ ]
[Fixed Rate:] [ ]
[Floating Rate:] [ ]

Please advise promptly as to your consent to the transfer by novation of this Transaction, by replying to all addressees of this email and indicating your
decision regarding consent.
Indicative sample, for illustrative purposes only.
Source: ISDA.

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Credit Strategy Research 35
May 27, 2008

Give-Up
In a give-up, Bank of America, N.A. (for example) faces a client’s prime broker as a
Counterparty, as discussed on page 67. The prime broker then faces the client in a
separate trade. Give-ups may be done for margining purposes (the prime broker sees
the client’s entire portfolio, resulting in potentially lower margin) or because a client
only has one ISDA Master Agreement in place (with the prime broker, as opposed to
with each bank and broker-dealer). Figure 66 shows a sample trade recap.
Figure 66. Sample Trade Recap for a Give-Up

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

Sample Credit Event Documentation


To trigger settlement of a CDS contract, a series of notices must be served. A brief
explanation appears in Figure 67, followed by sample documentation below.

86 Credit Default Swap Primer


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Credit Strategy Research 35
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Figure 67. Types of Notices


Credit Event Notice Can usually be served by Buyer or Seller
Describes in detail the Credit Event that has occurred
Must be served no later than 14 calendar days after Scheduled Termination Date
Day it is effective is called Event Determination Date

Notice of Publicly Available Must contain a copy of the relevant Publicly Available Information
Information
Sources must be internationally recognized, published or electronically displayed news sources
Two sources typically required
Usually delivered at the same time as a Credit Event Notice

Notice of Physical Settlement Details of the Deliverable Obligations that Buyer will deliver to Seller (in physical settlement)
Must be delivered within 30 calendar days of Event Determination Date
Source: 2003 ISDA Credit Derivatives Definitions.

Sample Credit Event Notice and Notice of Publicly Available Information


A Credit Event Notice A Credit Event Notice (“CEN”) states that a Credit Event has occurred. In a standard
states that a Credit Event confirm, both the Buyer and Seller of protection are permitted to deliver a CEN at any
has occurred. A Notice of time from the Credit Event date until trade maturity. A Notice of Publicly Available
Publicly Available Information (“NOPAI”) documents the Credit Event and may consist of a copy of a
Information documents Petition for Bankruptcy filing or newspaper articles:
the Credit Event
[Date]
[Counterparty Address and Contact Information]
[Non-Party Calculation Agent Address and Contact Information]

SAMPLE CREDIT EVENT NOTICE


AND
SAMPLE NOTICE OF PUBLICLY AVAILABLE INFORMATION

Re: Credit Derivative Transaction(s) referencing [Reference Entity] detailed on


Annex A hereto

Reference is made to the Credit Derivative Transaction(s) described on Annex A hereto


(the “Transaction(s)”) between us. Capitalized terms used and not otherwise defined in
this letter shall have the meanings given them in the confirmation of the respective
Transaction.

This letter is our Credit Event Notice to you in respect to each of the Transaction(s) that
a Bankruptcy Credit Event occurred with respect to [Reference Entity] on or about
[date of filing], when [Reference Entity] filed a petition for voluntary Chapter 11
protection in the U.S. Bankruptcy Court in the [applicable bankruptcy court] (the
“Bankruptcy Filing”).

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This letter also comprises our Notice of Publicly Available Information with respect to
this Credit Event. Accordingly, we provide the Publicly Available Information attached
hereto.

Nothing in this letter shall be construed as a waiver of any rights we may have with
respect to the Transaction(s).

Sincerely,
Bank
_______SAMPLE_______
Name:
Title:
ANNEX A

Scheduled Fixed
Trade Effective Floating Rate
Bank Reference Number Termination Rate Index
Date Date Payer
Date Payer

[Attach Notice of Publicly Available Information]

Sample Notice of Physical Settlement


For physically settled A “Notice of Physical Settlement” (NOPS) is typically delivered 30 calendar days after
trades, a Notice of the Event Determination Date and specifies which bonds the Buyer of protection
Physical Settlement intends to deliver, to physically settle the Credit Default Swap.
specifies which bonds
For CDS (often called “cash”) settlement protocols that have taken place, a NOPS is
the protection Buyer
not delivered. Instead, both Counterparties sign an adherence letter to the relevant CDS
intends to deliver
settlement protocol.

[Date]
[Counterparty Address and Contact Information]
[Non-Party Calculation Agent Address and Contact Information]

SAMPLE NOTICE OF PHYSICAL SETTLEMENT

Re: Credit Derivative Transaction(s) referencing [Reference Entity] detailed on


Annex A hereto

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Reference is made to the Credit Derivative Transaction(s) described on Annex A hereto


(the “Transaction(s)”) between us. Reference is also made to the Credit Event Notice(s)
previously delivered.
This letter constitutes a Notice of Physical Settlement with respect to each of the
Transaction(s). Any capitalized term not otherwise defined in this letter will have the
meaning, if any, assigned to such term in the confirmations of the respective
Transactions or, if no meaning is specified therein, in the 2003 ISDA Credit
Derivatives Definitions.
We hereby confirm that we will settle each Transaction and require performance by
you in accordance with the Physical Settlement Method. Subject to the terms of each
Transaction, we will deliver to you on or before the Physical Settlement Date the
following Deliverable Obligation(s), each with an outstanding principal balance equal
to the outstanding principal balance specified below opposite such Deliverable
Obligation:

Outstanding Principal
Balance to be
Issuer Coupon Maturity CUSIP ISIN Delivered 58
USD
USD
USD

Sincerely,

Bank

_______SAMPLE_______
Name:
Title:

ANNEX A
Fixed
Effective Scheduled Floating Rate
Bank Reference Number Trade Date Rate Index
Date Termination Date Payer
Payer

58
The aggregate outstanding principal balance of all Deliverable Obligations identified should equal the aggregate of the Floating Rate Payer
Calculation Amounts of all the Transactions. This notice assumes all Deliverable Obligations will be denominated in USD.

Credit Default Swap Primer 89


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Credit Strategy Research 35
May 27, 2008

Chapter V – CDS Trading Management


This section discusses trading and risk analytics specific to the CDS market. Readers
looking for a basic introduction to credit derivatives may wish to focus on sections
toward the front of this more advanced chapter.

Sample Trader Runs

Single-Name CDS
Figure 68 shows a sample single-name CDS trader run. Notice that the bid-offer spread
is 20 bps for a standard five-year maturity (in this case, 6/20/2013), usually the most
liquid part of the CDS curve. In this case, the bid-offer spread widens to 30 bps for
shorter-dated maturities (6/20/2010).
Keep in mind that this example is for a relatively widespread credit (475/495 bps in
five-year CDS). For investment grade credits, the bid-offer spread is typically 4 bps to
10 bps in five-year CDS.

90 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 68. Bloomberg Screen of Sample Single-Name CDS Trader Run

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

CDX Indices
The CDX indices are available on Bloomberg at CDSI <GO> or CDX10 CDS <Corp>
<GO> (CDX9 for Series 9, CDX8 for Series 8, etc.). To use the customized CDSW
screen, select one of the indices (or sub-indices) and type CDSW <GO>.
The Reference Entity composition of the selected index or sub-index may be viewed on
Bloomberg by typing MEMB<GO>, after selecting the relevant index. Alternatively,
on the CDSW (“Credit Default SWap”) screen, click the red “Members” icon.
Figure 69 illustrates a sample trader CDX.NA.IG Series 10 run. The rows denote the
maturity (June 20, 2013 for 5Y and June 20, 2018 for 10Y). The bid-offer spread is 1
bp in 5Y IG and 2 bps in 10Y.
Prior to the credit crunch beginning summer 2007, bid-offer spread was approx 0.25 bp
in IG, 0.50 bp in HVOL, and 3 bps in HY.
Keep in mind that because the CDX indices are composed of credit default swaps, the
pricing convention is reversed from the cash market for investment grade. That is,
when quoted in spread, the bid is lower than the offer.

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Credit Strategy Research 35
May 27, 2008

Figure 69. Bloomberg Screen of Sample CDX.NA.IG Trader Run

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

Figure 70 shows the relevant CDSW screen for an investor who sells IG10 (Investment
Grade index, Series 10) protection at 102 bps (dealer bids 102 bps). Since the index
trades with a fixed coupon of 155 bps, the protection Seller pays $256,560 upfront
(based on a $10 million notional) and receives 155 bps running. This is different from
single-name CDS, where the fixed coupon usually equals the running spread (i.e., at
inception, single-name CDS usually trades at par).

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May 27, 2008

Figure 70. Bloomberg CDSW Screen for CDX.NA.IG.10

Notional

Sell
Coupon Protection
At 102
Settle bps

Paid by
Seller
Sources: Bloomberg; Banc of America Securities LLC estimates.

For the high yield market, Figure 65 shows a sample run of the overall index (HY10
and HY9) and the leveraged loan CDS index (LCDX10 and LCDX9). Since the indices
trade in dollar price, and price and spread are inversely related, the bid is higher than
the offer in spread terms. That is, an investor may buy the CDX HY Series 10 index at
$96 7/8 in dollar price or 582 bps in spread.

Credit Default Swap Primer 93


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Credit Strategy Research 35
May 27, 2008

Figure 71. Bloomberg Screen of Sample CDX.NA.HY and LCDX.NA Trader Run

For illustrative purposes only.


Sources: Bloomberg; Banc of America Securities LLC estimates.

CDS Rolls
Every three months, To help make execution straightforward, credit default swaps have standardized
single-name CDS “rolls” maturities. For example, a “five-year” trade executed on April 1, 2008 matures on June
to a new standard 20, 2013, which is just over five years. Every three months, single-name CDS “rolls” to
maturity date a new standard maturity date. The CDX indices roll every six months:

94 Credit Default Swap Primer


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Credit Strategy Research 35
May 27, 2008

Figure 72. New Maturities for CDX Indices, versus Single-Name CDS
Roll Occurs on the 20th Day of the Month
New Maturity
Month of Roll CDX Indices Single-Name CDS
March June June
June No Roll September
September December December
December No Roll March
Single-name CDS rolls on March 20th, June
20th, September 20th,and December 20th. CDX IG, HVOL, and XO roll on March 20th and September
20th. CDX HY rolls on March 27th and September 27th. LCDX rolls on April 3rd and October 3rd. For more details, please see Figure 74.
Source: Banc of America Securities LLC estimates.

For single-name CDS, this results in a potential mismatch between actual and quoted
maturities, as detailed in Figure 73:
Figure 73. Don’t Be Confused by Market Convention
March 20, 2008 Roll Date
On the roll date, “five-Year” CDS matures in 5.25 years. “4.75-Year” CDS matures in 5 years.

Actual Maturity Market


Contract as of 20 Mar 08 Convention
20-Jun-2013 5.25 years "5 years"
20-Mar-2013 5 years "4.75 years"
Source: Banc of America Securities LLC estimates.

That is, on the roll date, “five-year” CDS actually matures in 5.25 years. Over the
following three months, single-name CDS rolls down from 5.25 years to 5 years (center
column of Figure 73). But by CDS market convention, this is referred to as rolling
down from the “5 year” point on the curve to the “4.75 year” point on the curve (far
right column of Figure 73).
Typically, investors roll to maintain liquidity; that is, the on-the-run five-year contract
Typically, investors roll to is usually the most liquid point on the credit default curve. Other investors sell 7-year
maintain liquidity credit default protection and let their contracts roll down to the 5-year point on the
curve, at which time they look to unwind contracts. For more on CDS rolls, please see
the Chapter Appendix on page 113.

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Credit Strategy Research 35
May 27, 2008

Figure 74. Roll Schedule Across Credit Derivatives Products


Roll Date and New Maturity
New Maturity
CDX IG, HVOL, XO,
Roll Date Single-Name CDS EM and all iTraxx CDX HY Index LCDX Index ABX Index CMBX Index
Indices
January 19 - - - - Legal final (~40 years) -
March 20 June 20 June 20 - - - -
March 27 - - June 20 - - -
April 3 - - - June 20 - -
April 25 - - - - - Legal final (~40 years)
June 20 September 20 - - - - -
July 19 - - - - Legal final (~40 years) -
September 20 December 20 December 20 - - - -
September 27 - - December 20 - - -
October 3 - - - December 20 - -
October 25 - - - - - Legal final (~40 years)
December 20 March 20 - - - - -
The ABX index was scheduled to roll to Series 08-1 on January 19, 2008, but was delayed because, under index rules, only five deals qualified for inclusion.
The CMBX index was scheduled to roll to Series 5 on April 25, 2008, but was delayed until May 22, 2008 to include more recent deals.
Source: Markit Group Ltd; Banc of America Securities LLC estimates.

Sample P&L Calculation

For a Buyer of Single-Name Protection


Figure 75 shows sample P&L scenarios for a Buyer of single-name protection. The
investor buys $10 million notional of credit default protection at 80 bps, and
subsequently unwinds the trade at 120 bps. We show a six-month holding period, with
cases in which the investor rolls or does not roll.

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Credit Strategy Research 35
May 27, 2008

Figure 75. Sample P&L Calculation for a Buyer of Single-Name Protection


Buy Protection in March at 80 Bps and Unwind Six Months Later (in December) at 120 Bps
Contract Roll Unwind P&L
Size Expiry Horizon Fees Buy Protection (Sell Protection) Principal Carry Net P&L Return
($ Thous.) (Month) (Years) (bps) Spread (bps) Spread (bps) ($ Thous.) ($ Thous.) ($ Thous.) (Annualized)
Roll, with all spread widening occurring after the roll
10,000 June 0.25 N/A 80 80 0 -20 -20
10,000 September 0.25 4 84 120 159 -21 138
Total 159 -41 118 2.4%

Roll, with all spread widening occurring before the roll


10,000 June 0.25 N/A 80 120 176 -20 156
10,000 September 0.25 4 124 120 -17 -31 -48
Total 159 -51 108 2.2%

No Roll
10,000 June 0.50 N/A 80 116 151 -40 111 2.2%
Sources: Bloomberg; Banc of America Securities LLC estimates.

Buyer of Protection Rolls, With All Spread Widening Occurring After the Roll
In the first scenario, CDS stays constant at 80 bps over the first three months. As such,
the investor earns zero principal over the first three months, but pays $20,000 in carry
(80 bps x $10 million notional x 0.25 years).
The roll costs the investor 4 bps. Mechanically, the investor unwinds the original trade
at 80 bps, and enters into a new trade at 84 bps. A new confirm, not an amendment to
the original confirm, is issued. Accordingly, the roll increases the cost of carry to 84
bps per annum.
Figure 76 shows the CDSW screen that an investor would use to project profit on the
new trade, assuming that 5-year CDS will widen to 120 bps. The investor would earn
$159,000 in principal, as shown in the “Principal” line of Figure 76 (toward the
bottom-left). The investor also pays $21,000 in carry (84 bps x $10 million notional x
0.25 years).
To project forward P&L, the effective date is one calendar day (T+1) following the roll.
th
Since the investor rolls on June 20 , the new trade would be effective on June 21, 2008
and mature September 20, 2013. Lastly, the valuation date (toward the bottom-left) is
the date on which the investor expects to unwind the trade, in this case September 20,
2008.

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Figure 76. Calculating P&L On A Sample Trade


Investor Buys Protection at 84 Bps (On the Roll) and Unwinds at 120 Bps
Investor rolls so that contract maintains an on-the-run five-year maturity (in this case, September 20, 2013)

Effective
Date of
New
Trade Current
Market
Maturity Spread
of New
Trade

Strike of
New
Trade

Expected
Unwind
Date

Principal P&L from


Spread Widening
This calculation uses the spot interest rate curve at trade inception. It would be more accurate to use the 3-month forward curve (i.e., the expected interest rate curve at trade unwind), but this feature is
currently not supported in Bloomberg. We show the Bloomberg screen to follow market convention.
Sources: Bloomberg; Banc of America Securities LLC estimates.

Over the six-month life of the trade, the investor earns $118,000 ($159,000 principal –
$20,000 carry in the first three months – $21,000 carry in the second three months).
The total return is 2.4% ($118,000 / $10 million notional / 0.50 years).
Buyer of Protection Rolls, With All Spread Widening Occurring Before the Roll
The middle section of Figure 75 shows the scenario in which protection still widens to
120 bps, but now all spread widening occurs before the roll. In this case, the investor
still earns $159,000 principal, but in two parts. Over the first three months, CDS
widens from 80 bps to 120 bps, resulting in a principal gain of $176,000. Then, a 4-bp
roll means that the investor enters into a new contract at 124 bps. With credit quality
constant, this contract rolls down to 120 bps over the second three months, resulting in
a $17,000 principal loss.
The main difference between the first two scenarios lies in the cost of carry. In the first
scenario, where spreads widen after the roll, carry is 80 bps ($20,000) during the first
three months and 84 bps ($21,000) during the second three months. In the second
scenario, where spreads widen before the roll, carry is the same 80 bps ($20,000)

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during the first three months, but increases to 124 bps ($31,000) during the second
three months.
Lower carry reduces net P&L from $118,000 in the spreads-widen-after-the-roll
scenario, to $108,000 in the spreads-widen-before-the-roll case. Returns are 2.4% and
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2.2%, respectively.
Buyer of Protection Does Not Roll
The bottom section of Figure 75 shows the case in which the investor does not roll.
Rather than keeping a five-year on-the-run contract, the investor unwinds a 4.75-year
contract after three months. In this case, there is a tradeoff for P&L:
The investor does not increase the cost of carry by the 4-bp roll, which benefits P&L.
However, since CDS has a three-month shorter maturity than the on-the-run contract,
spreads only widen to 116 bps, not 120 bps. Moreover, since CDS rolls down from 5-
to 4.75-years, the duration shortens. This reduces P&L from spread widening. Rather
than earning $158,000 in principal (roughly calculated as 36 bps spread widening, from
84 bps after the roll to 120 bps, x 4.319 duration), the investor earns $151,000 (roughly
calculated as 36 bps spread widening, from 80 bps to 116 bps, x 4.143 duration).
Net P&L is therefore $111,000 ($151,000 principal – $40,000 carry). This results in a
return of 2.2% ($111,000 / $10 million / 0.5 years).
Overall Tradeoff for the Buyer of Protection
Overall, there is a tradeoff between carry and duration. If an investor rolls, he pays a
For protection Buyers, higher cost of carry (the roll fee) but keeps a roughly constant duration. If an investor
rolls result in a tradeoff does not roll, he saves the roll fee, but suffers from a progressively shortening duration.
between carry and In addition, the investor risks reduced liquidity by not maintaining an on-the-run
duration contract.

For a Seller of Single-Name Protection


Figure 77 shows similar results for an investor who sells single-name protection at 80
bps, and subsequently unwinds the trade at 40 bps:

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The annualized return is calculated as $118,000 net P&L / $10 million notional / 0.50 years (first scenario) or $108,000 net P&L / $10 million
notional / 0.50 years (second scenario).

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Figure 77. Sample P&L Calculation for a Seller of Single-Name Protection


Sell Protection at 80 Bps and Unwind at 40 Bps
Contract Roll Unwind P&L
Size Expiry Horizon Fees Sell Protection (Buy Protection) Principal Carry Net P&L Return
($ Thous.) (Month) (Years) (bps) Spread (bps) Spread (bps) ($ Thous.) ($ Thous.) ($ Thous.) (Annualized)
Roll, with all spread tightening occurring after the roll
10,000 June 0.25 N/A 80 80 0 20 20
10,000 September 0.25 4 84 40 199 21 220
Total 199 41 240 4.8%

Roll, with all spread tightening occurring before the roll


10,000 June 0.25 N/A 80 40 181 20 201
10,000 September 0.25 4 44 40 18 11 29
Total 199 31 230 4.6%

No Roll
10,000 June 0.50 N/A 80 36 190 40 230 4.6%
Sources: Bloomberg; Banc of America Securities LLC estimates.

Notice that, for spread tightening scenarios, the protection Seller does at least as well
In spread tightening by rolling to a new on-the-run contract. This is both because the investor receives a
scenarios, protection premium for rolling (in this case, 4 bps) and because duration extends.
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Sellers do at least as well


by rolling to a new on-the- For spread widening scenarios, these two factors would counteract: If the investor did
run contract not roll, he would lose money at the duration of the 4.75-year CDS contract. If the
investor did roll, he would lose money at the duration of the 5-year CDS contract—so
that principal fell by more than in the no-roll case—but would keep the 4-bp roll
premium.
Also noteworthy is that investors, particularly hedge funds, often sell protection with
margin. For example, an investor may post 3.5% collateral for selling five-year
protection at 80 bps ($350,000 on $10 million notional) and keep an additional 16.5%
of internal reserves, for total collateral of 20%. If the annualized return is 4.6%, as in
the no-roll scenario of Figure 77, the annualized ROE is 23% (4.6% return / 20%
collateral).

Implied Probability of Default


For investors who are It is possible to back out an implied probability of default, based on the traded credit
willing to assume a default spread and an assumed recovery rate. The logic is as follows. If CDS is fairly
recovery rate, it is priced, the expected gain from selling protection must exactly offset the expected loss:
possible to back out an
Expected Gain = Expected Loss
implied probability of
default At a one-year horizon, the expected gain is simply the spread. Assuming that CDS is
priced solely on default risk, the expected loss is notional minus recovery, times the
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probability of default. That is:
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We assume an upward-sloping curve. An inverted curve could result in the protection Seller paying a premium to roll.

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Spread = [ Probability of Default ] x [ 1 – Recovery ]


So that:
[ Probability of Default ] = Spread / [ 1 – Recovery ]
In other words, the one-year probability of default is the spread, divided by one minus
The one-year probability the expected recovery rate. For example, at a credit default spread of 400 bps and a
of default is the spread, recovery rate of 40%, the one-year probability of default is 7% (400 bps / [ 1 – 40% ] ).
divided by one minus the 62

expected recovery rate


Figure 78 compares the five-year implied probability of default with realized default
rates, for bonds (not CDS) rated Baa by Moody’s. For example, the January 1999 point
compares the five-year implied probability of default (based on Baa spreads in January
1999) with the five-year actual default rate (as realized for January 1999—January
2004).
Figure 78. At 800 bps, the 5y Implied Prob. of Default Is 49% Figure 79. Implied Default Probability Generally Trades Wide to
Implied Probability of Default by CDS Spread Realized Default Rate
Baa-Rated Bonds (Not CDS)
For example, Jan-99 point compares 5y implied default probability with
the default rate eventually realized over the same five years

100 bps 400 bps 800 bps 5y Implied Probability of Default


5y Realized Default Rate
60 5y Long-Term Average Default Rate (1920 -2007)
50 30%
Implied Probability

Baa Default Probability


of Default (%)

40 25%
30 20%
20 15%
10 10%
0 5%
1 2 3 4 5 0%
Tenor (Years) Jan-99 Jan-01 Jan-03 Jan-05 Jan-07
5y Implied Probability of Default is based on Par CDS Equivalent Spread to LIBOR for Baa-rated
Assumes flat credit curve and 40% recovery rate. cash bonds (not CDS) in the Banc of America Securities High Grade Broad Market Index,
Source: Banc of America Securities LLC estimates. Assumes flat credit curve and 40% recovery rate.
5y Realized Default Rate and 5y Long-Term Average Default Rate (1920-2007) obtained
from Moody’s Investors Service, “Corporate Default and Recovery Rats, 1920-2007,”
February 2008.
Sources: Moody’s; Banc of America Securities LLC estimates.

Implied default Naturally, the market prices factors other than default risk into pricing, such as liquidity
probabilities trade wide and mark-to-market risks. The implied probability of default extracted from CDS
to historic default rates spreads includes these other factors. As Figure 78 suggests, investors should realize

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If there is a default, the Seller of protection loses notional minus recovery. This is because the protection Seller owes notional on the CDS
contract but receives a bond from the protection Buyer. The likelihood that this event will occur is simply the probability of default.
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At longer horizons, the probability of default is 1 – exp( -[ Spread ] / [ 1 – Recovery ] x [ Horizon ] ). For example, with a CDS spread of 800
bps and an expected recovery rate of 40%, the five-year implied probability of default is 1 – exp( – 0.08 / ( 1 – 0.4 ) x 5 ), or 49%.

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that the actual probability of default is typically far lower than that implied by CDS
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spreads.

Mind the Discount Factor


CDS trades are discounted at LIBOR plus the implied probability of default. This
reflects the market-implied risk that the Reference Entity may suffer a Credit Event
during the life of the contract.
Figure 80 illustrates that an investor who earns, say, 400 bps on one trade and loses 400
bps on another trade will not be P&L neutral, unless the two trades have the same
unwind spread. The reason is that each trade will have a different probability of default
and therefore a different discount rate.

Figure 80. CDS P&L is Determined by the Discount Rate


Investor Makes 400 Bps in One Case, But Loses 400 Bps in Another Case
Net, investor loses money, because of different discount rates

20
13.9
15
10
P&L (Points)

5
0
-5 -2.3
-10
-15
-20 -16.2
Buy 400, Unwind 800 Buy 800, Unwind 400 Net
“Buy 400, Unwind 800” discounted at L + 800 / ( 1 – 40% Recovery Rate).
“Buy 800, Unwind 400” discounted at L + 400 / ( 1 – 40% Recovery Rate).
Sources: Bloomberg; Banc of America Securities LLC estimates.

CDS Duration and Curve Trades


Similar to cash bonds, CDS contracts have an associated duration and DV01. By
market convention, many single-name CDS investors use the CDSW screen on
Bloomberg to calculate these sensitivities.

63
For near-distressed credits, the implied probability of default becomes more meaningful because default risk starts to dwarf liquidity and
mark-to-market risk factors.

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Figure 81. Calculating CDS Duration and DV01


Implement Trade at 100 Bps
Type: TICKER Equity CDSW <GO>

Current
Market
Spread
Coupon

Dollar Value of a 1 bp
Change in Spread
Investors may also access the CDSW screen by typing TICKER Corp CDSW <GO>.
Sources: Bloomberg; Banc of America Securities LLC estimates.

In Figure 81, an investor executes a CDS trade at 100 bps. This is the “Deal Spread”
section on the left-hand side of the screen. (Sometimes, deal spread is referred to as
“coupon” or “strike.”) Since we are analyzing the trade at inception, the current (mark-
to-market) spread is also 100 bps, as illustrated in the circled portion on the right-hand
side of the screen. Spread DV01 is shown in the “Sprd DV01” portion toward the
bottom-center of the screen. For example, at a 100-bp starting spread, a 1 bp spread
change will result in approximately $4,572 of P&L, for a $10 million notional position.
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Cash bond investors frequently refer to this number as a duration of 4.572.
As illustrated in Figure 82, duration varies inversely with spreads. Intuitively, a 1 bp
move on a credit trading at 10 bps is more significant than a 1 bp move on a credit
trading at 1,000 bps.

64
The calculation is $4,572 DV01 / $10 million notional x 10,000. The multiplication by 10,000 occurs because DV01 refers to the change in
P&L per basis point, and a basis point is 1/10,000 of a dollar. Also note, we show a flat credit curve of 100 bps on the right side of Figure 81,
but the market is slowly moving toward using a full credit curve (different spread for different maturities), particularly in Europe.

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Figure 82. Duration Varies Inversely with Spreads


Duration and DV01 vs. 5y CDS
A 1bp move at 10 bps is more significant than a 1 bp move at 1,000 bps

5.00 5,000

DV01 per $10mm Notional


4.75 4,750
4.50 4,500

Duration
4.25 4,250
4.00 4,000
3.75 3,750
3.50 3,500
3.25 3,250
3.00 3,000
0 100 200 300 400 500 600 700 800 900 1000
5y CDS
Source: Banc of America Securities LLC estimates.

As a rule-of-thumb, durations are approximately 4.0 – 4.5 for five-year CDS, 5.0 – 6.0
for seven-year CDS, and 6.25 – 7.75 for ten-year CDS.

Weights on DV01-Neutral Curve Trades 65


To calculate the weights on single-name curve trades, calculate the duration for each
leg of the trade. Then divide the duration of one leg by the other.
For example, suppose an investor sells five-year protection at 100 bps and buys ten-
year protection at 110 bps. Often, this trade is referred to as “buying 5s/10s,” because
the investor profits when the 5s/10s curve steepens.
Five-year duration is about 4.5 and ten-year duration is 7.7. The investor should sell
approximately 1.7 times as much five-year protection as he buys in ten-year protection
(7.7 / 4.5).
To find carry, multiply the weight on each leg by its respective spread, or 1.7 x 100 bps
– 1 x 110 bps. In this case, carry is 60 bps per annum, meaning $60,000 per $17 million
of five-year and $10 million of ten-year notional. Payments are exchanged quarterly, so
th
the investor receives $15,000 on the 20 day each of March, June, September, and
December.
When trading, this example often would be referred to as “buying $10 million 5s/10s
DV01-neutral,” with the notional referring to the longer-dated (ten-year) maturity. Still,
an investor always should confirm the exact notionals before execution.

Notional-Neutral Curve Trades (Jump-to-Default Hedging)


Particularly for near-distressed or volatile credits, investors may instead use notional-
neutral curve trades. The reason is that investors are less worried about duration risk

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A note regarding analytics: To adjust for the absolute level of spreads, the CDS market often looks at credit curves in percent. A higher
number means a flatter credit curve—for example, a 5s/10s curve at 80% (five-year spreads somewhat below ten-year spreads) is flatter than a
5s/10s curve at 50% (five-year spreads well below ten-year spreads).

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(small spread changes) and more worried about jump-to-default risk (large spread
changes, or an outright Credit Event).
For example, an investor with a bullish view may sell $10 million of five-year
protection and buy $10 million of one-year protection. The investor will be long
duration, because he sells protection on the longer duration asset (five-year protection).
This supports the investor’s bullish view. However, if the investor is wrong and the
Reference Entity suffers a Credit Event (in the first year), the investor will be hedged,
because gains on the short-maturity leg will exactly offset losses on the long-maturity
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leg.

Butterfly Trades
With a curve trade, an investor may hedge one risk, either small spread moves (DV01-
neutral) or jump-to-default moves (notional-neutral). “Butterfly trades” combine two
curve trades to hedge both extremes. For example, an investor may sell five-year
protection and buy both three- and ten-year protection. Both the 3s/5s and 5s/10s legs
are DV01 neutral. The investor would still be exposed to moderate spread moves,
which fall between the extremes of a small, parallel curve move and outright default.

Implied Forward Spread


The implied forward spread shows the market’s expectation of future spreads, based on
the current (spot) credit curve. Consider two trades, illustrated in Figure 83. An
investor who wants to be long five-year risk may consider two trades:
X Sell five-year protection today, or
X Sell three-year protection today and then in three years, sell two-year protection.
The breakeven spread for two-year protection that begins in three years is called the
implied forward spread. By “breakeven,” we mean the spread that makes the two trades
equivalent.

66
Assuming a Bankruptcy or Failure to Pay Credit Event. The investor may not be fully hedged following a Modified Restructuring. For details,
please see Chapter VI – CDS Case Studies and Legal Issues on page 152, especially the section “Practical Trading Considerations Following a
Restructuring” on page 157.

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Figure 83. Implied Forward Spread


Two Equivalent Trades: Sell Five-Year CDS, or
Sell Three-Year CDS, and Then in Three Years, Sell 2y CDS at the Implied Forward Spread

Sell 5y CDS
Sell 3y CDS, and then in three years, sell 2y CDS at implied forward
Implied Forward
250
200

Spread (bps)
150
100
50
0
1 2 3 4 5
Year
Assumes 40% recovery rate.
Source: Banc of America Securities LLC estimates.

An investor who believes the implied forward spread is too high may execute a curve
flattener. To do this, the investor would sell longer-dated protection and buy shorter-
dated protection. Figure 84 illustrates how to calculate the implied forward spread in
Bloomberg:

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Figure 84. Calculating the Implied Forward Spread


For a Two-Year CDS Contract Beginning March 20, 2011
Type: TICKER Equity CDSW <GO>

Starting
and
Ending
Dates of
Forward
Contract

Full
Credit
Curve

Implied
Forward
Spread
Investors may also access the CDSW screen by typing TICKER Corp CDSW <GO>.
Sources: Bloomberg; Banc of America Securities LLC estimates.

CDS Curve Flattening (And Inversion) Since Summer 2007


Though 1H07 saw CDS Since summer 2007, the CDS market has seen significant volatility in CDS curves.
curves steepen on record Figure 85 shows recent performance of 5s/10s CDS curves. After CDS curve
LBO activity, the real steepening in the first half of 2007, on record LBO activity, the real story was
story was unprecedented unprecedented flattening (and inversion) in the second half of the year. Front-end
curve flattening (and illiquidity, coupled with dealers’ desire to reduce default risk, resulted in DV01-neutral
inversion) during 2H07 5s/10s flatteners. In these trades, dealers buy more five-year protection (short risk) than
they sell in ten-year protection (long risk), giving them a hedge against outright
defaults while remaining long duration.

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Figure 85. Unprecedented Flattening (And Inversion) in CDS Curves Since Summer 2007
On-the-Run CDX IG 5s/10s Curve (bps)

40
30

CDX IG 5s/10s Curve (bps)


20
10
0
-10
-20
-30
Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08

Not adjusted for changes in on-the-run index constituents.


Source: Banc of America Securities LLC estimates.

The Transition from Spread to Points Upfront


Once five-year CDS Once five-year CDS spreads approach the 700-bp range, the quoting convention often
spreads approach the changes from running spread to points upfront plus a 5% running coupon. For example,
700-bp range, the quoting instead of a “1000-bp” five-year CDS spread, quotes typically change to “16.4 points
convention often changes upfront plus a 5% running coupon.” Mechanically, the change means:
from running spread to
Under a points upfront convention, the Buyer of protection pays $1,640,000 (16.4
points upfront plus a 5%
points on $10 million notional) at inception.
running coupon
Moreover, the Buyer of protection pays $125,000 per $10 million notional quarterly
(5% per annum), beginning on the next quarterly coupon date.
The logic in moving to a points upfront convention is as follows: Suppose a Reference
Points upfront reduce Entity were to default on the day that a trade becomes effective. Under a spread
Credit Event risk for the convention, the Seller of protection loses notional minus recovery, without ever having
protection Seller received a coupon payment from the protection Buyer. Under a points upfront
convention, the Seller of protection would keep the points upfront, as shown in
Figure 86:

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Figure 86. Mechanics for a Credit Event Occurring on Effective Date of Single-Name CDS Trade
$10 Million Notional, 40% Recovery Rate, and 16.4 Points Upfront + 5% Running Coupon
Five-Year CDS

Quoting Seller Loses (Buyer Profits)


Convention P&L Example
Spread Notional - Recovery 10 - 4 = 6
Points Upfront Notional - Recovery - Points Upfront 10 - 4 - 1.64 = 4.36
Assumes a flat credit curve.
Source: Banc of America Securities LLC estimates.

Since summer 2007, points upfront have affected the automobile, homebuilder, media,
monoline insurer, and paper sectors. For more details, please see the Chapter Appendix
on page 115.

Assignments, Unwinds, and Jump Risk


How does a CDS investor terminate an existing trade? Consider Figure 87, which
shows a sample trade, in which an investor buys protection at 500 bps running.
Suppose that protection widens to 1000 bps, and the investor wishes to terminate the
trade at a profit. In general, there are three ways to do this:
Figure 87. Original Trade Figure 88. An Unwind is Straightforward
Investor Buys Protection at 500 bps Investor Unwinds Trade, with Same Counterparty, at 1000 bps
500 bps is $500,000 per annum on $10 million notional 1000 bps is equivalent to 16.4 points upfront + 500 bps running

Client Client

500 bps 16.4 points


Protection
running upfront

Client's Counterparty Client's Counterparty


Payments are made quarterly. Payments are made quarterly.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

Unwind
CDS unwinds occur when The investor may unwind his position with the original Counterparty, as illustrated in
an investor terminates a Figure 88. To terminate the trade, unwinds are settled in present value (points upfront).
trade with the original In this case, the unwind spread is 1000 bps, and the deal (also called original, or
Counterparty running) spread is 500 bps. 1000 bps is equivalent to 16.4 points upfront plus 500 bps
running.

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So, the client owes 500 bps, and the Counterparty owes 16.4 points upfront plus 500
bps running. The running coupons cancel out, so that the client simply receives 16.4
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points upfront, less accrued interest. The original trade is then terminated.
Figure 89. A New Trade Requires Client to Post Margin… Figure 90. …An Assignment Adds Risk
Investor Sells Protection with A New Counterparty at 1000 bps Investor Sells Protection at 1000 bps, on Assignment from 500 bps
Investor faces both BANA and original Counterparty Client does not post margin. BANA faces additional risk.

Bank of America, NA Bank of America, NA

16.4 points
Margin 1000 bps upfront
running Protection
Client Client
500 bps Protection
running
500 bps
running
Protection
Client's Counterparty Client's Original Counterparty
Payments are made quarterly. Payments are made quarterly.
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

New Trade
To terminate a CDS trade Naturally, the original Counterparty may not always have the most favorable market. If
with a different the client instead wants to take profits through a new counterparty, one way is to
Counterparty, a new simply sell protection at 1000 bps. As Figure 89 shows, the client receives 1000 bps
trade often requires the running from the new Counterparty (BANA) and pays 500 bps running to the original
investor to post margin counterparty. The client keeps the difference, realizing profit over the remaining life of
the trade.
There are two main disadvantages that make new trades unpopular in the marketplace.
First, while an unwind allows the client to terminate the original trade, now the client
has two trades, one with the original Counterparty and one with the new Counterparty.
This adds complexity from an operational and risk perspective. Moreover, because the
client is selling protection to the new Counterparty, he will likely be required to post
margin (collateral).

Assignment
The client may avoid The client may avoid posting margin, and terminate the original trade, by selling
posting margin, and protection to the new Counterparty on assignment (sometimes called “novation”).
terminate the original Figure 90 shows the setup. The new Counterparty pays the client 16.4 points upfront.
trade, by trading with a Moreover, the original trade is amended, so that going forward, the original
new counterparty on Counterparty faces the new Counterparty (BANA). The client’s name is removed from
assignment the trade; i.e., from the client’s perspective, the original trade is terminated. Going
forward, BANA pays the original Counterparty 500 bps running.

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If the original trade were at 300 bps, and the unwind still at 1000 bps, the appropriate conversion would be to 22.9 points upfront + 300 bps
running (assuming 40% recovery). Now the client would owe 300 bps running, and the counterparty would owe 22.9 points upfront plus 300
bps running. The running coupon would cancel out, so that the client would simply receive 22.9 points upfront, less accrued interest.

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Take Profits in Small Chunks: Jump Risk on Assignments and Unwinds


Quotes for CDS contracts Quotes for CDS contracts traded on assignment or unwind are often less favorable than
traded on assignment for new trades. This is because an assignment or unwind adds additional risk. In a new
may be wider than for trade, the new Counterparty may receive margin from the client, and cash flows are
new trades paid quarterly. By contrast, in an assignment, the new Counterparty receives no
collateral, and instead must pay the client cash flows upfront (e.g., 16.4 points).
To understand the risk, consider a Credit Event on the Effective Date of the new CDS
contract. In a new trade, the new Counterparty would have paid just one day’s accrued
interest for that protection (the running coupon / 360). But in an assignment, the new
Counterparty would have paid (and would lose) 16.4 points for the same protection.
Why? In an assignment, the new Counterparty only pays 500 bps running for protection
that is currently worth 1000 bps in the market. The present value of the difference
between the market spread and the premium paid by the new Counterparty, to the
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original counterparty (500 bps), over the life of the trade, is the 16.4 points. This is
commonly called jump to default risk in the CDS market: Since the new Counterparty
would lose more if a Credit Event occurred early on in the life of the trade, quotes for
an assignment may be less favorable than quotes for a new trade. Market convention
requires that an investor state that the trade is on assignment before executing the
69
trade. For more details, please see the Chapter Appendix on page 123.
In September 2005, the Federal Reserve and 14 dealers met to discuss risks
surrounding assignments. This meeting resulted in the 2005 Novation Protocol, which
requires an investor to obtain permission before assigning a trade. For more details,
please see 2005 Novation Protocol on page 83.

Interest Rate Sensitivity


Although CDS is based on credit risk, interest rates still affect the present value of
trades. The reason is that CDS contracts discount cash flows at LIBOR plus the implied
probability of default (page 100).
Figure 91 shows that the impact of interest rates increases as CDS moves away from
par. Consider an investor who sold protection and then spreads tighten. The investor
will have a mark-to-market gain. If interest rates decline, the present value of that gain
will increase, resulting in further gains.
By contrast, if the investor sells protection, but spreads widen, he will have a mark-to-
market loss. If interest rates decline, the present value of that loss will increase,
resulting in further losses.
A steeper LIBOR curve led by the front-end approximates an interest rate decline,
while a steeper LIBOR curve led by the back end approximates an interest rate rise. By
“back end,” we mean dates close to the maturity of the CDS contract.

68
This amount goes to the client in return for the right to pay only 500 bps running to the original Counterparty for protection, which is worth
1000 bps running in the current market. The present value of the 500 bps running depends on the timing of default, and is calculated based on
market expectations. For example, suppose a Credit Event never occurs. Then the market applied too high a discount rate in calculating the
15.7 points upfront, and the new Counterparty was better off having traded the credit at 15.7 points upfront + 500 bps running (total payment:
15.7 + 5 x 5 years = 15.7 + 25 = 40.7 points) than it would have been at 1000 bps running (10 x 5 years = 50 points). But if a Credit Event
occurs immediately, the market applied too low a discount rate in calculating the points upfront, and the new Counterparty would have been
better off trading at 1000 bps running spread (1000 bps x 1 day’s accrued interest = 3 bps) than at 15.7 points upfront + 500 bps running (15.7
+ 5 x 1 day’s accrued interest = 15.71 points).
69
This risk exists in any CDS trading in points upfront. “Jump to Default Risk” accounts for the difference in quoting CDS protection in points
upfront vs. running spread, because a dealer buying protection in points upfront faces this risk (and therefore would pay less for the
protection) than when buying protection on running spread.

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Figure 91. Sensitivity of CDS Contracts to Interest Rates


“IR01” Means CDS P&L Due to 1 Bp Move in Interest Rates
Assumes parallel shift in LIBOR curve
Investor sold 5y CDS protection at 500 bps

600 Protection Seller Made Money

IR01 ($ per $10mm notional)


400 Lower Rates Increase Gain
200
0
-200 Protection Seller Lost Money
Lower Rates Increase Loss
-400 Strike (Coupon)
-600
-800
0 200 400 600 800 1000 1200 1400 1600 1800 2000
5y CDS
Sources: Bloomberg; Banc of America Securities LLC estimates.

Compared to spread duration, the effect of interest rates is relatively small, as


illustrated in Figure 92. Intuitively, this is because spreads affect both the discount rate
and the amount of money being discounted (unwind spread minus coupon), while
interest rates only affect the discount rate. Nonetheless, given the magnitude of recent
declines in interest rates, CDS investors should understand the implications.

Figure 92. CDS Contracts Are Much Less Sensitive to Interest Rates Than to Spread
“IR01” Means CDS P&L Due to 1 Bp Move in Interest Rates
Assumes parallel shift in LIBOR curve
Investor sold 5y CDS protection at 500 bps

IR01 Spread DV01


6000
Strike (Coupon)
$ per $10mm notional

5000
4000
3000
2000
1000
0
-1000
0 200 400 600 800 1000 1200 1400 1600 1800 2000
5y CDS
Sources: Bloomberg; Banc of America Securities LLC estimates.

Figure 93 shows how to calculate interest rate sensitivity in Bloomberg:

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Figure 93. Calculating Interest Rate Sensitivity (IR01) in Bloomberg


In Bloomberg, Type <TICKER> Corp CDSW <GO>
IR01 Displayed in Bottom Row of Center Column

Current
Spread

(Better to
Notional
use full
5y CDS credit
curve)

Coupon

Result
Depends
on
Protection Seller Gains Protection Seller Loses Recovery
$2,682.49 per 1 bp Spread $361.72 per 1 bp Parallel Rate
Tightening Tightening in the LIBOR curve
Sources: Bloomberg; Banc of America Securities LLC estimates.

Appendix V – CDS Trading Management


More on Single-Name CDS Rolls
Beginning in summer As discussed in the main text, every three months, single-name CDS “rolls” to a new
2007, liquidity became standard maturity date. But, beginning summer 2007, CDS liquidity became strongly
strongly focused on the focused on the five-year (historic benchmark) maturity. Models of the CDS curve
five-year maturity, making became less accurate, making the roll harder to predict. Below, we describe our general
the roll harder to predict methodology for estimating the roll in single-name CDS, comparing its performance in
early 2007 with early 2008.
As a simple model for the single-name CDS roll in the five-year sector, we look at the
value of three months on the 4s/5s CDS credit curve. We take the 4s/5s CDS credit
curve across a variety of single-name CDS contracts and divide by four. As discussed
in the main text (page 94), the reason we look at the 4s/5s curve is that an investor who
rolls is extending a contract’s quoted maturity from 4.75 years (e.g., December) to 5

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years (e.g., March). If the 4s/5s curve is not available, we look at the 3s/5s curve and
divide by eight quarters.
We then regress this “estimated roll” against five-year credit default spreads. To
In general, to model the account for the tendency of credit curves to flatten (in percentage terms) at wider
single-name CDS roll, spreads, we use a logarithmic regression. We recognize that in most credit
look at the value of three environments—not that of summer 2007 and early 2008—four-year CDS may trade at
months on the 4s/5s (or 90% of five-year CDS, for Reference Entities with five-year spreads wider than 200
3s/5s) CDS credit curve
bps. But for Reference Entities with five-year spreads tighter than 50 bps, four-year
CDS may trade at just 75% of five-year CDS.
Figure 94 shows the results for February 2007, as compared with February 2008 in
Figure 95. In both cases, we only look at Reference Entities with five-year CDS trading
350 bps or tighter. Notice that the model worked significantly better in 2007.

Figure 94. Simple Model of the Single-Name CDS Roll: Feb 07


Estimated roll widens about 0.37 bps per 10% widening in spread Figure 95. Model Doesn’t Work in Feb 08
For example, at 200 bps, estimated roll is 9.5 bps. At 220 bps, estimated Weak explanatory power (low R2)
roll is 9.9 bps. Variation in roll estimates is extreme, in part due to liquidity concerns

y = 3.73Ln(x) - 10.24 y = 1.31Ln(x) - 3.74


14 14
Est. Three-Month Roll (bps)

Est. Three-Month Roll (bps)


R2 = 0.82 R2 = 0.22
11 11
8 8
5 5
2 2
-1 -1
-4 -4
-7 -7
-10 -10
0 100 200 300 0 100 200 300
5y CDS (bps) 5y CDS (bps)
27 Feb 07. 27 Feb 08.
Based on 312 Reference Entities with five-year CDS 350 bps or tighter. Based on 258 Reference Entities with five-year CDS 350 bps or tighter.
Source: Banc of America Securities LLC estimates. Due to spread widening, fewer Reference Entities are in Figure 95 than in Figure 94.
Source: Banc of America Securities LLC estimates.

For February 2007, we estimate the following equation:


Estimated Three-Month Roll = 3.73 x ln(5-Year CDS Spread) – 10.24 bps
This equation means that, for every 10% (percent, not bps) change in spread, the
For every 10% (percent, estimated roll widens about 0.37 bps (0.373 bps to be more exact). For example, at 200
not bps) change in bps, the estimated roll is 9.5 bps (3.73 * ln(200) – 10.24). At 220 bps, which is 10%
spread, the estimated wider than 200 bps, the estimated roll is 9.9 bps (3.73 * ln(220) – 10.24).
roll widens about 0.3 bps
On a roll date, “five-year CDS” extends maturity--for example, from December 20,
2012 to March 20, 2013. As such, even if credit quality remains constant, five-year
CDS should widen, assuming an upward-sloping curve. (Beginning in summer 2007, a
number of Reference Entities started to see significantly inverted curves.)
If five-year CDS widens by less than the predicted roll, a Reference Entity is said to
“capture less than the roll.” For example, on December 20, 2006, five-year Citizens
Communications CDS widened 6 bps versus a predicted widening (roll) of 8 bps. CDS

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traders may refer to this situation by saying that the market captured 75% of the roll (6
bps actual / 8 bps predicted).
Not surprisingly, the model is not perfect and will work less well for Reference Entities
with flatter credit curves or liquidity concerns, such as those seen since summer 2007.
Do not use the model for very unusual sectors, such as the autos and auto parts.

More on Points Upfront

Converting Between Spread and Points Upfront


Figure 96 shows how to convert between spread and points upfront plus a 5% running
coupon in Bloomberg. Type <TICKER> Corp CDSW <GO>, and select the reference
obligation. For publicly traded companies, a shortcut is to type <TICKER> Equity
CDSW <GO>:
Figure 96. Converting from Spread to Points Upfront + 500 Bps Running Coupon
In Bloomberg, Type <TICKER> Corp CDSW <GO>
In Five-Year CDS, 1000 Bps Is About the Same as 16.4 Points Upfront Plus 5% Running Coupon

5y CDS at
1000 bps

(Better to
use full
5y CDS credit
curve)

500 bps
Running

Result
Depends
Heavily on
$1,638,370 / $10mm Notional = Recovery
16.4 Points Upfront + 5% Running Spread Rate
This is about equal to 1000 bps all running spread
Source: Bloomberg; Banc of America Securities LLC estimates.

The circled fields show major points of which to take note. For the maturity date, we
have chosen five-year CDS, but simply enter the actual maturity date of the credit
default swap. Set the deal spread equal to 500 bps to reflect the 5% running coupon. On
the far-right portion of the screen, enter the credit curve. We have chosen to keep the

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credit curve flat at 1000 bps (the five-year CDS spread), although it would be more
accurate to enter a full credit curve. In the bottom-right hand corner, enter the assumed
recovery rate; we have chosen 40%.
Now look near the bottom-left hand corner, in the field marked “Principal.” Notice that
the resulting value of the credit default swap is $1,638,370. On $10 million notional,
this is equivalent to 16.4 points upfront. In other words, a five-year CDS spread of
1000 bps is about equal to 16.4 points upfront, plus a 5% running coupon.
Recovery Rate and Credit Curve Matter

The conversion between Raising the assumed recovery rate reduces points upfront. Intuitively, a protection
spread and points Buyer will pay less for credit risk with a higher recovery rate. This is because the
upfront depends on the protection Buyer is entitled to par minus recovery, following a Credit Event.
assumed recovery rate A steeper credit curve increases points upfront. This is because front-end cash flows
and credit curve will have a lower discount rate, lowering the present value.
Similarly, an inverted credit curve decreases points upfront. This is because front-end
cash flows will have a higher discount rate, raising the present value.
Figure 97. Major Issues to Consider When Converting Spread to Points Upfront
Effect on Points Upfront + 5% Running Coupon
Risk Factor for a Given Spread

Assumed Recovery Rate Rises

Credit Curve Steepens


Source: Banc of America Securities LLC estimates.

How to Convert from Points Upfront to Spread


Similarly, Figure 98 shows how to convert from points upfront + 500 bps running, to
all running spread. Enter the points upfront (“up-front fee”) and 500 bps running
coupon (“deal spread”). Then change the “Mode” on the blue “Calculator” bar to “2.”
This mode allows you to convert from points upfront to all running spread.

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Figure 98. Converting from Points Upfront + 500 Bps Running Coupon to All Running Spread
In Bloomberg, Type <TICKER> Corp CDSW <GO>
In Five-Year CDS, 20 Points Upfront Plus 5% Running Coupon Is About the Same as 1142 Bps All Running Spread (Flat Curve)

Equivalent
Running
5y CDS Spread

20 Points
Upfront +
500 Bps
Running

40%
Recovery
Change Mode to calculate spread Rate
(input points upfront, output spread)
Sources: Bloomberg; Banc of America Securities LLC estimates.

Unwinding Trades with Points Upfront


Unwinding a Trade in Points Upfront That Was Executed in Running Spread
For a trade that was executed in running spread, but unwound in points upfront, simply
70
convert the unwind level into its equivalent running spread. For example, consider an
investor who bought protection at 600 bps and now wishes to unwind at 10 points
upfront + 500 bps running. As shown in Figure 99, 10 points upfront + 500 bps running
is 781 bps to a five-year maturity, assuming a 40% recovery rate. As shown in Figure
100, the protection buyer receives 6.45 points ($645,000 per $10 million notional) less
accrued interest, if any.

70
The present value of trades in points upfront versus running spread is identical. The only difference is the timing of cash flows. However,
because all cash flows in an unwind are exchanged immediately (more accurately, at T+3 calendar days), the distinction between points
upfront and running spread is not meaningful. As such, just convert points upfront + 500 bps running to all running spread, and then calculate
the unwind as normal.

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Figure 99. Unwinding a Trade in Points Upfront, Which Was Executed in Running Spread: Part I
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Points Upfront + 500 Bps Running (Deal Spread), to Obtain Equivalent Running Spread

Points
Upfront
Level is for
a Trade
Effective
T+1
(4/11/08),
at a Given Equivalent
Maturity Running
Spread

10 Points
Upfront +
500 Bps
Running

40%
Recovery
Change Mode to calculate spread Rate
(input points upfront, output spread)
Sources: Bloomberg; Banc of America Securities LLC estimates.

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Figure 100. Unwinding a Trade in Points Upfront, Which Was Executed in Running Spread: Part II
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Original (Deal) Spread and Equivalent Running Spread on Unwind

Notional,
Effective
Date, and
Maturity
Date
Equivalent
Running
Spread on
Unwind
(From
Original Part I)
Spread

40%
Recovery
Protection Buyer Receives $644,662.12 Change Mode to calculate price Rate
less $33,333.33 accrued interest = (input spread, output present value)
$611,328.79
Sources: Bloomberg; Banc of America Securities LLC estimates.

Unwinding a Trade in Points Upfront That Was Executed in Points Upfront


For a trade that was executed in points upfront, and then is unwound in points upfront,
simply use a “strike,” or deal spread, of 500 bps. For example, consider an investor
who bought protection at 15 points upfront + 500 bps running. The investor paid 15
points upfront, and that cash flow is done. If the investor now wishes to unwind at 20
points upfront + 500 bps running, he will receive 20 points, with the coupons canceling
out. See Figure 101.
Following the unwind, net profit will be 5 points (20 points received upon unwind – 15
points paid at trade inception), less coupon payments on the 500 bps running.

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Figure 101. Unwinding a Trade in Points Upfront, Which Was Executed in Points Upfront
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Deal Spread is 500 Bps Running, Upfront Fee is the Unwind Level

Notional,
Effective
Date, and
Maturity
Date

Both
Original
Trade
and
Unwind
Use 500
Bps
Running

40%
Recovery
Protection Buyer Receives $2,000,000 less Change Mode to calculate spread Rate
$27,777.78 accrued interest = (input points upfront)
$1,972,222.22
Sources: Bloomberg; Banc of America Securities LLC estimates.

Unwinding a Trade in Running Spread That Was Executed in Points Upfront


Similarly, for a trade was executed in points upfront and then is unwound in running
spread, use a “strike,” or deal spread, of 500 bps. For example, consider an investor
who sold protection at 10 points upfront + 500 bps running. The investor received 10
points upfront, and that cash flow is done. If the investor now wishes to unwind at 400
bps running, he will receive the present value of the difference in coupons (500 bps –
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400 bps), discounted at LIBOR plus the unwind probability of default.
Net profit will be 10 points received at trade inception plus 4.1 points profit on the
unwind, plus coupon payments on the 500 bps running.

71
To a one-year horizon, the discount rate is L + 400 bps unwind spread / ( 1 – 40% assumed recovery rate ). For details, please see the section
“Implied Probability of Default” on page 100.

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Figure 102. Unwinding a Trade in Running Spread, Which Was Executed in Points Upfront
In Bloomberg, Type <TICKER> Corp CDSW <GO>
Enter Original Coupon (Deal Spread) of 500 Bps and Unwind Spread

Points
Upfront
Were
Exchanged
at
Notional, Inception,
Effective So
Date, and Irrelevant
Maturity Upon
Date Unwind

Original
Trade Unwind
Uses 500 Spread
Bps
Running
Coupon

40%
Recovery
Protection Seller Receives $411,760.36 Change Mode to calculate price Rate
plus $27,777.78 accrued interest = (input spread, output present value)
$439,538.14
Sources: Bloomberg; Banc of America Securities LLC estimates.

Breakeven Between Running Spread and Points Upfront


It is possible to calculate a breakeven, between which an investor is indifferent between
trading in running spread or points upfront plus a running coupon. Take an investor
who is considering two trades: a running spread of 1000 bps, or 16.4 points upfront
plus a running coupon of 500 bps.
At trade inception, the At trade inception, the protection Seller receives a higher premium for trading in points
protection Seller receives upfront plus a running coupon. In our example, the points upfront investor receives
a higher premium for 16.4 points upfront, versus nothing for the running spread investor.
trading in points
However, if there is no Credit Event, the points upfront investor will receive a lower
upfront…
total premium over the life of the trade: 41.4 points (16.4 points upfront + 5 points per
…But, if there is no year x 5 years) versus 50 points for the running spread investor (1000 bps = 10 points
Credit Event, then the per year x 5 years). In-between, there is a breakeven.
points upfront investor Figure 103 illustrates the breakeven graphically. If a Credit Event occurs prior to the
receive a lower total breakeven, the investor would have been better off selling protection in points upfront
premium over the life of
the trade

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plus a running coupon. If a Credit Event occurs after the breakeven, the investor would
have been better off selling protection in running spread.

Figure 103. Breakeven Between Running Spread and Points Upfront


1000 Bps Running vs. 16.4 Points Upfront + 500 Bps Running

Assignment (Pts Upfront + Running Coupon)


60 New Trade (Running Spread)

Total Cashflows (Points) 50 Cashflows


40 Breakeven after
3.3 years
30
20
10
0
0 1 2 3 4 5
Year
Assumes flat credit curve.
Actual results will depend on interest rate curve at trade inception.
Source: Banc of America Securities LLC estimates.

Should a Credit Event occur relatively late in the trade (or not at all), ex-post the
investor learns that he should have applied a lower discount rate to the cash flows. That
is, the investor should have received fewer points upfront for selling protection.
Our setup is identical to an investor who originally bought protection at 500 bps, and
now wants to unwind at 1000 bps. If the investor implements a new trade, he sells
protection at 1000 bps running spread. If the investor trades on assignment, the
assignee (bank or broker-dealer to whom the trade is being assigned) pays the investor
16.4 points upfront. The assignee then pays the original (“Remaining”) Party 500 bps
running coupon.
The difference in cash flows is called “jump risk,” and is described more fully on page
123 in this Appendix.

Lower DV01 in Points Upfront


A trade in points upfront It is also noteworthy that a trade in points upfront plus a running coupon (or an
plus a running coupon assignment) has less DV01 risk than running spread (or a new trade). The reason is that
has less DV01 risk than points upfront are certain; they have no duration risk—i.e., regardless of whether
running spread spreads widen or tighten, the points upfront remain constant. Only the running
coupon—in our example, 500 bps—has duration risk. However, a trade entirely in
running spread—in our example, 1000 bps—is subject to duration risk on the whole
trade. See Figure 104.

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Figure 104. Points Upfront + Running Coupon (Or An Assignment) Has Less DV01 Risk Than
Running Spread (Or a New Trade)
Only the running coupon has DV01 (mark-to-market) risk. Points upfront are certain.

DV01 Points Upfront + 500 bps Running DV01 All Running

DV01 per $10mm Notional


5,000
4,000
3,000
2,000
1,000
0
0 250 500 750 1000 1250 1500 1750 2000
5y CDS (bps)
Source: Banc of America Securities LLC estimates.

More on Jump to Default Risk – Take CDS Profit in Small Chunks

The Unwind Surprise


As spreads gap wider, For credits that gap wider in spread, investors who bought protection may find their
buyers of CDS protection contracts relatively difficult to unwind. The reason is “jump risk”: as investors look to
take a haircut to unwind bank and broker-dealers to pay out significant profits, it becomes progressively more
trades difficult, and expensive, for the bank or broker-dealer to hedge positions. This results in
reduced ability to unwind trades with substantial profits. Trades that are unwound often
result in lower payout than the investor might expect.

CDS Profit Creates Jump Risk


Consider an investor who bought MBIA AA protection at 85 bps (the “strike”) on
September 21, 2007, and then in December 2007, wants to unwind at 450 bps, with a
profit of 14 points. In other words, the price of the CDS contract has fallen from par to
$86 ($100 – $14).
A bank or broker-dealer that accepts this trade must pay the investor 14 points, and
then hedge the transaction with a new trade at par (450 bps). This setup leaves the bank
or broker-dealer with “jump risk”: If there is a Credit Event at the underlying Reference
Entity immediately after trade inception, the bank or broker-dealer will lose 14 points:
X Bank or broker-dealer buys protection from investor, and pays 14 points: P&L
post-Credit Event = 100 – Recovery – 14
X Bank or broker-dealer hedges by selling protection in a new trade: P&L post-Credit
Event = – (100 – Recovery)
X Net P&L post-Credit Event = – 14
Alternatively, consider the change in issuer exposure to the bank or broker-dealer from
buying $10 million notional protection. Normally, with expected recovery of 40%,
issuer exposure would decline $10 million x (1 – 40%), or $6 million. However, in our
sample unwind/assignment, the dealer would also pay $1.4 million (14 points) to the

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investor. Accordingly, issuer exposure would only decline the normal $6 million, less
the $1.4 million payout to the investor. In other words, buying protection on
unwind/assignment becomes less valuable to the bank or broker-dealer, because it
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serves as less of a hedge against fundamental default risk. See Figure 105.

Figure 105. Change in Issuer Exposure from Buying Protection


Five-Year CDS, $10mm Notional

Buy $10mm Protection at 450 bps Buy $10mm Protection at 450 bps
Change in Issuer Exposure from - New Trade - Assignment/Unwind from 85 bps
Buying Protection ($ MM) 0
-1
-2
-3
-4
-5
-6
$10mm x ( 1 - Recovery )
-7 minus Initial $1.4mm Payment
$10mm x ( 1 - Recovery )
Source: Banc of America Securities LLC estimates.

Figure 106 illustrates jump risk across a range of five-year CDS spreads, for an
investor who originally bought protection at 85 bps:

Figure 106. Jump Risk

Unwind (or Assignment) from 85 bps New Contract


30
Jump Risk (Points)

25
20
15
10
5
0
0 100 200 300 400 500 600 700 800 900 1000
5y CDS (bps)
Source: Banc of America Securities LLC estimates.

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By “default risk,” we mean the Credit Events specified in North American corporate CDS contracts: Bankruptcy, Failure to Pay, and for
selected Reference Entities, Modified Restructuring.

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Adjusting CDS to Compensate for Jump Risk


It is possible to adjust the unwind (or assignment) spread on CDS to account for jump
risk. Consider Figure 107, which compares cash flows in a new trade (450 bps) with an
older trade (85 bps coupon):
X At trade inception, jump risk is 14 points, meaning that the bank or broker-dealer
would lose this amount, if a Credit Event were to occur.
X However, as time passes, the bank or broker-dealer benefits from paying a lower
coupon (85 bps) on the old trade, which reduces jump to default risk.
X Somewhat offsetting the lower coupon, the bank or broker-dealer loses
reinvestment income on the initial 14 points paid out to the investor.
X The trades break even just before maturity.

Figure 107. Cash Flows on a New Trade, versus an Unwind (or Assignment)
New Trade at 450 bps vs. Unwind or Assignment Struck at 85 bps
Jump risk is 14 points at trade inception, but declines to zero just before maturity

New Trade at 450 bps Original Trade (85 bps Coupon)


Cumulative Payout (Points)

25
20
15 Breakeven just
Jump Risk
10 before maturity
at Trade
5 Inception
0
0 1 2 3 4 5
Calendar Year
Five-year CDS matures after 5.25 calendar years, assuming trade inception on a quarterly roll date.
Original trade (85 bps coupon) adjusted to reflect loss of reinvestment income on jump risk, assuming reinvestment at 3-month LIBOR.
Source: Banc of America Securities LLC estimates.

To hedge jump risk, the bank or broker-dealer may buy front-dated protection. Assume
$10 million of five-year CDS notional. Then:
X At trade inception (year 0), jump risk is $1.39 million (13.9 points x $10 million
notional). The bank or broker-dealer buys $2.31 million of one-year protection at
500 bps, with a present value of $124,577.
The reason for buying $2.31 million notional is that, with an expected recovery rate
of 40%, expected P&L post-potential Credit Event would be $2.31 million x (1 –
40%), or $1.39 million, the same as initial jump risk. Figure 108 shows jump risk
by year (the difference between the two lines in Figure 107), while Figure 109
shows the notional needed to hedge that jump risk, based on the expected recovery
rate.
X Jump risk declines over the life of the trade, but remains positive until year 4.75,
when the unwind breaks even with a new trade. To hedge, the bank or broker-

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dealer buys smaller amounts of one year protection at the beginning of years one–
three. By “the beginning of year one,” we mean one year after trade inception.
X After the breakeven in year 4.75, the dealer effectively has negative jump risk; that
is, the cumulative payout on a new trade would exceed the cumulative payout on
the unwind. To make the two trades equivalent, the bank or broker-dealer would, in
theory, sell a small amount of three-month protection at the beginning of year 4.75.
Of course, in reality, such short maturities do not trade. The present value of all
73
protection purchased, as a hedge to jump-to-default risk, is $255,492.
X To compensate for the cost of buying protection, the bank or broker-dealer
subtracts $255,492 from the $1.39 million that normally would be paid upon a
CDS unwind (from 85 bps to 450 bps), for a total payment of $1.13 million.
This payout is equivalent to a CDS unwind at 372 bps. As such, while a new trade
would be quoted at 450 bps, an unwind or assignment (strike 85 bps) would be quoted
at 372 bps. Although 372 bps is the fair value for an unwind in this model, we caution
that, in practice, the market does not use this model. Actual quotes may vary
substantially.

Figure 108. Jump Risk to Hedge an Unwind/Assignment versus


a New Trade Figure 109. CDS Notional Needed to Hedge Jump Risk
New Trade at 450 bps vs. Unwind or Assignment Struck at 85 bps New Trade at 450 bps vs. Unwind or Assignment Struck at 85 bps
Five-Year CDS Five-Year CDS

4.0 4.0 40% Recovery 60% Recovery


3.5 3.5
Jump Risk ($ Millions)
Jump Risk ($ Millions)

Notional to Hedge

3.0 3.0
2.5 2.5
2.0 2.0
1.5 1.5
1.0 1.0
0.5 0.5
0.0 0.0
0 1 2 3 4 0 1 2 3 4
Beginning of Year 1y Protection Needed in Beginning of Year
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

Jump Risk is Far More Important for CDS Widening than for CDS Tightening
Importantly, jump risk is far more important for CDS widening than for CDS
tightening. The reason is simple: as CDS tightens, the implied likelihood of a Credit
Event decreases. Consider the reverse of the previous trade, where an investor now
sells protection at 450 bps and wishes to unwind at 85 bps.

73
Net, the bank or broker-dealer buys $2.31 million of one year protection (present value $124,577), $1.79 million of one year protection
beginning in one year (present value $73,092), $1.26 million of one year protection beginning in two years (present value $37,609), $0.71
million of one year protection beginning in three years (present value $15,590), and $0.13 million of one year protection beginning in four
years (present value $4,372). The total present value of all protection purchased is $255,241. Assumed credit curve: 6m: 500 bps, 1y: 500 bps,
2y: 490 bps, 3y: 475 bps, 4y: 460 bps, 5y: 450 bps.

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May 27, 2008

With improved credit quality, it costs the bank or broker-dealer substantially less to
hedge jump risk. For example, while one-year CDS was 500 bps in our earlier example,
74
at improved credit quality, we assume that one-year CDS tightens to just 65 bps. A
lower cost to hedge jump risk means a lower adjustment to “fair value” on an unwind.
As illustrated in Figure 110, the “fair value” unwind haircut for CDS widening is 78
bps (CDS widens from 85 bps to 450 bps, but unwind at 372 bps). But as shown in
Figure 111, the unwind haircut for CDS tightening is just 3 bps (CDS tightens from 450
75
bps to 85 bps, but unwind at 88 bps).

Figure 110. Haircut is Greater When Credit Deteriorates… Figure 111. …Than When Credit Improves
5y CDS, Adjusted for Unwind from 85 Bps 5y CDS, Adjusted for Unwind from 450 Bps
Investor Bought Protection Investor Sold Protection

5y CDS (bps) 5y CDS (bps)


5y CDS Adj. for Unwind from 85 bps 5y CDS Adj. for Unwind from 450 bps

Adj. Unwind from 450 bps


Adj. Unwind from 85 bps

450 450
400 400
350 350
Strike (bps)

Strike (bps)
300 3 bps
300
250 250 Haircut
200 78 bps 200
150 Haircut 150
100 100
50 50
0 0
0 75 150 225 300 375 450 0 75 150 225 300 375 450
5y CDS (bps) 5y CDS (bps)
Assumed credit curve: 6m: 500 bps, 1y: 500 bps, 2y: 490 bps, 3y: 475 bps, 4y: 460 bps, 5y: Note that the five-year CDS (red-dashed line) is in the figure; it is hard to see simply because it
450 bps. is so close to adjusted CDS (thick gray line).
Source: Banc of America Securities LLC estimates. Assumed credit curve: 6m: 65 bps, 1y: 65 bps, 2y: 70 bps, 3y: 75 bps, 4y: 80 bps, 5y:
85 bps.
Source: Banc of America Securities LLC estimates.

Reducing Jump Risk


Most of the complexity surrounding jump risk occurs when spreads widen significantly
th
in-between a quarterly CDS roll (the 20 each of March, June, September, and
December). With each roll, the bulk of investors unwinds existing trades, and resets
them with new trades at par. This generally keeps CDS liquid and avoids the jump risk
issues outlined above. However, a rapid widening in spreads intra-roll causes CDS to
fall well below par, increasing jump risk and reducing liquidity. Currently, several
options are available to CDS investors, although we acknowledge that none is ideal:
X For credits with only moderate spread changes, roll each quarter. Rolls cause CDS
to reset to par, reducing jump risk and maintaining on-the-run liquidity.
X For credits with substantial spread changes intra-quarter, consider unwinding after
moderate profits (3–5 points), and then immediately re-implement the trade.
Although this results in some extra paying of bid-offer spread, it significantly
reduces jump risk, keeping CDS more liquid. For example, with MBIA AA, an

74
We assume one-year CDS at 65 bps, two-year CDS at 70 bps, three-year CDS at 75 bps, four-year CDS at 80 bps, and five-year CDS at 85
bps.
75
Note that the five-year CDS (red-dashed line) is in Figure 111; it is hard to see simply because it is so close to adjusted CDS (thick gray line),
in our improving credit scenario.

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investor who bought protection at 85 bps, but unwound and then immediately re-
bought CDS every 150 bps of widening, would have paid extra bid-offer but
76
maintained substantially higher liquidity.
X Consider an offsetting new trade rather than an actual unwind. For example, rather
than unwinding CDS at 450 bps (from an original strike of 85 bps), sell protection
in a new trade at 450 bps. This will eliminate jump risk entirely, but give the
undesirable effect that payments are only accrued over time (450 bps per annum,
paid quarterly) rather than immediately (14 points).

76
The paying of bid-offer in this example may be thought of as paying for jump risk at each smaller jump, rather than leaving the entire bid-
offer payment for jump risk until the final trade unwind. However, paying at each smaller jump should improve liquidity, because more banks
or broker-dealers should be willing to transact at smaller jumps.

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Chapter VI – CDS Case Studies and Legal Issues


Case Studies
The CDS market is an evolving one. As the industry matures, rules and procedures are
clarified through individual cases. Below, we highlight some case studies, focusing on
events since 2005. Events are sorted by year, and then alphabetically. For more details,
please see the page number indicated in the far-right column. The remainder of this
Chapter focuses on many of the outcomes from these case studies.

Significance Credit Description Result Page

2008

Major Monoline As the market considers the possibility of a potential Credit ISDA organizes a 158
Insurers Event at a monoline insurer, wide disparity in the price of committee to address
potential Deliverable Obligations raises concern that typical CDS possible changes to CDS
(so called-”cash”) settlement protocols may not work. Moreover, (“cash”) settlement
proposed “good bank”/”bad bank” splits raise concerns about a protocols for monolines,
potential split of CDS contracts into one entity with structured and to plan for physical
finance assets and another entity with primarily municipals. settlement if necessary.

Tembec To avoid Bankruptcy, Tembec bondholders agree to cancel their Despite a payoff for 17
(TMBCN) existing notes in exchange for equity. Tembec had missed a bondholders that
coupon payment, but notes are canceled before the indenture’s resembles a default, CDS
grace period expires. Tembec borrows a new four-year term loan. contracts are not
triggered. Even if
protection Buyers were to
find a way to trigger, only
the new term loan would
be deliverable, resulting in
a presumed recovery rate
close to par.

2007
Domtar Domtar Inc. bondholders agree to exchange more than 75% of Domtar Inc. CDS succeeds 132
(DTC) outstanding debt into new Domtar Corp. notes. to Domtar Corp.

Equity Office In connection with an LBO by Blackstone Group LP, a tender Small notional remains of 21
Properties offer is announced for existing EOP bonds. Some protection EOP bonds, primarily by
(EOP) holders do not tender, to ensure a deliverable into CDS protection holders.
contracts.
Tyco (TYC) Tyco spins off into three separate divisions, with greater than Tyco International Ltd CDS 132
25% but less than 75% of original Tyco debt assumed by each and Tyco International
division. Group SA CDS each split
into three entities, with
1/3 of the original
notional per entity.

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Significance Credit Description Result Page

2006
Alltel (AT) AT spins off wireline business. To keep spin-off tax-free, a AT CDS splits 50% Alltel, 132
temporary spin-off company (SpinCo) exchanges more than 25% 50% Windstream.
of Alltel debt for new notes. SpinCo then merges with
Windstream.

Bombardier Bombardier announces that Bombardier Capital (OpCo) Bombardier Capital CDS 21
(BOMB) financials will be consolidated with Bombardier Inc (HoldCo). expected to become near-
Bombardier states that no new debt will be issued out of worthless after last bond
Bombardier Capital. matures, in May 2009,
due to lack of a
Deliverable Obligation.

CarrAmerica Blackstone acquires CRE. Some protection buyers buy CRE CDS becomes near- 21
(CRE) bonds and then refuse to accept a tender offer, to ensure a worthless.
Deliverable Obligation into CDS.

Major Cendant
(CD)
Following a spin-off of four divisions, Cendant Corp (later
renamed Avis Budget Group, Inc.) remains a HoldCo, with no
No Succession. Beginning
February 2007, OpCo debt
132

debt. In 2006, because Cendant Corp does not guarantee OpCo becomes deliverable into
Cendant Car Rental Group (later renamed Avis Budget Car HoldCo (Cendant Corp,
Rental, LLC) , new OpCo debt is not deliverable into existing renamed Avis Budget
Cendant Corp CDS contracts. However, in February 2007, a Group, Inc.) CDS.
guarantee is added, making new OpCo debt deliverable.

RJR RAI acquires Conwood. To overcome restrictive covenants in RJR CDS Succeeds to RJR. 132
(OpCo), RAI (HoldCo) exchanges existing RJR bonds for new RAI
bonds. RAI purposely structures transaction so that RJR CDS can
Succeed to RAI. Specifically, RAI does not guarantee existing
RJR debt.

Major Verizon (VZ) Verizon spins off directories business. The transaction structure
is similar to Alltel, but with the added twist that some existing
VZ CDS splits 50%
Verizon, 50% Idearc.
132

Verizon Bonds are exchanged for Loans in the new directories


business (Idearc). Investor debate ensues as to whether a Bond-
for-Loan exchange counts in calculations for CDS Succession.
Overall market later agrees that such exchanges do count.

Wendy’s Wendy’s sells Tim Hortons, which generates more than half of No Succession. WEN CDS 132
(WEN) Wendy’s EBITDA. However, only assets, not debt, move to Tim widens to reflect increased
Hortons. leverage.

2005

Major Calpine Calpine files for Bankruptcy. Although convertible bonds Parties adhering to the 19,
(CPN) normally are deliverable into CDS trades (see Railtrack case CDS (so-called “cash”) 143
(Part I) study in 2000), two Calpine convertibles are expressly settlement protocol agree
subordinated to the prior payment, in full, of all Calpine secured that only the convertible

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Significance Credit Description Result Page

debt. One of those convertibles is also expressly subordinated to which is not expressly
five Calpine senior unsecured notes. None of those notes is the subordinated to the five
Reference Obligation. This raises a question of whether the senior unsecured notes
convertibles are pari passu or better in seniority to the Reference will be deliverable. Parties
Obligation, making them deliverable into CDS contracts, or who do not agree must
subordinated to the Reference Obligation, making them not either physically settle or
deliverable into CDS contracts. reach a bilateral
agreement with an
individual dealer.

Major Calpine
(CPN)
Calpine files for Bankruptcy at 10:57 pm New York time on
December 20, 2005, after the 11:59pm GMT expiration time of
No Succession.
December 20, 2005
19

(Part II) CDS contracts with a December 20, 2005 maturity. maturity CDS protection
holders cannot trigger a
Credit Event.

Major Delphi
(DPH)
Delphi files for Bankruptcy. Bonds short squeeze on concern that
protection buyers may not be able to find a Deliverable
CDS market adopts a
voluntary CDS (so-called
22,
143
Obligation because of the large notional of CDS. “cash”) settlement
protocol. Standard CDS
contracts continue to
specify physical
settlement, but market
begins to expect an option
to cash settle in the
future.

Federated Federated Department Stores, Inc. (FD) acquires The May MAY and FD CDS succeed 132
(FD)—May Department Stores Company (MAY), including all of MAY’s debt. to Federated Retail
(MAY) On the same day, FD’s debt is transferred to Federated Retail Holdings, Inc.
Holdings, Inc.

Hertz (HTZ) In connection with a HTZ LBO, HTZ announces a $2.3 BB tender No Succession. 132
plan. In addition, Ford Motor Credit (FMCC) anounces plans to
offer to exchange $2.4 BB of HTZ debt, for FMCC debt. The
exchange offer raises concerns that HTZ CDS may split 50% HTZ
/ 50% FMCC. FMCC later cancels the exchange offer.

2002

Major Xerox (XRX) Xerox extends the maturity of a syndicated bank loan facility, Obligations payable in 152
triggering a Modified Restructuring Credit Event. Sellers of USD, GBP, EUR, CAD,
protection suffer when Buyers deliver JPY-denominated bonds CHF, and JPY are
that trade significantly below USD bonds. deliverable into CDS
contracts.

2000

Major Conseco Conseco extends maturities on loans. Although many loan-


holders do not view this event as particularly negative for the
CDS contracts adopt
Modified Restructuring
152

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Significance Credit Description Result Page

(CNO) credit, some protection buyers trigger a Credit Event and deliver (North America) or
long-maturity bonds that trade significantly below par. Protection Modified-Modified
sellers suffer significant losses. Restructuring (Europe),
which significantly
shortens the maximum
maturity of obligations
deliverable following a
restructuring.

Major Railtrack
(RAITRA)
Railtrack, Britain’s national rail-system owner, files for
Bankruptcy. The cheapest-to-deliver is a convertible bond, which
ISDA issues a memo and
legal opinion suggesting
47

leads to debate about whether convertible bonds are deliverable that the convertible bond
into CDS contracts. is deliverable. Later, the
2003 ISDA Credit
Derivatives Definitions
generally allow
convertibles to be
delivered into CDS
contracts.
Domtar (2007): Succession for a trade date on or prior to November 19, 2007.
Tyco (2007): Tyco International Group SA split for a trade date on or prior to June 29, 2007, with 1/3 of the original notional to each of Tyco International Group SA, Covidien International Finance SA,
and Tyco Electronics Group SA. Tyco International Ltd split for a trade on or prior to June 29, 2007, with 1/3 of the original notional to each of New Tyco International, Covidien Ltd, and Tyco Electronics
Ltd.
Alltel (2006): Split for a trade date on or prior to July 17, 2006.
RJR (2006): Succession for a trade date on or prior to May 30, 2006.
Verizon (2006): Split for a trade date on or prior to November 17, 2006.
Delphi (2005): The first CDS (so-called “cash”) settlement auction was for Collins and Aikman (CKC), which filed for Bankruptcy in May 2005. However, intense public interest in cash settlement started
after the short squeeze for Delphi, which filed for Bankruptcy in October 2005.
Federated—May (2005): Succession for a trade date on or prior to August 30, 2005.
Conseco (2000): We note that only selected North American Reference Entities, generally investment grade, use Modified Restructuring. Other Reference Entities trade with No Restructuring, so that
restructuring is not a Credit Event.
Railtrack (2000): Convertibles are deliverable, provided that the right to convert or exchange the obligation, or to require the issuer to purchase or redeem the obligation, has not been exercised on or
before the delivery date. Additionally, the option to convert must be solely at the option of holders, or a trustee acting on behalf of holders.
Sources: ISDA; Banc of America Securities LLC estimates.

Succession—How Corporate Finance Affects Credit Derivatives


Succession What happens if a Reference Entity is merged, acquired, or some other change is made
with respect to its corporate structure? This issue is one referred to as Succession in
CDS terms and is addressed specifically in the 2003 ISDA Credit Derivatives
Definitions. However, as we discuss below, Succession rules are among the most
unclear portions of the Definitions, and have at times created significant uncertainty in
the marketplace since late 2005.
In general, the Succession rules may be summarized as follows:
X If one entity succeeds to 75% or more of the Relevant Obligations of the Reference
Entity (meaning Bonds and Loans, hereafter referred to as Relevant Obligations),
that entity will be the sole Successor for the entire Credit Derivative Transaction.
X If one or more entities each directly or indirectly succeeds to more than 25% of the
Relevant Obligations and more than 25% of the Relevant Obligations remain with
the Reference Entity, each such entity and the Reference Entity will be a Successor
for a new Credit Derivative Transaction. The notional for each Credit Derivative
contract will be the original notional, divided equally by the number of Successors.

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X If one or more entities succeeds to a portion of the Relevant Obligations but no


entity succeeds to more than 25% of the Relevant Obligations and the Reference
Entity continues to exist, there will be no Successor and the Reference Entity and
Credit Derivative Transaction will not change.
Additionally, there are some special cases:
X If one entity succeeds to more than 25% but less than 75% of the Relevant
Obligations and the original Reference Entity remains with 25% or less of the
Relevant Obligations, the entity that succeeds to more than 25% of the Relevant
Obligations will be the sole Successor for the entire Credit Derivative Transaction.
X If more than one entity succeeds to more than 25% of the Relevant Obligations and
not more than 25% of the Relevant Obligations remain with the Reference Entity,
the entities that succeed to more than 25% of the Relevant Obligations will each be
a Successor for a new Credit Derivative Transaction. The notional for each Credit
Derivative contract will be the original notional, divided the number of Successors.
X Finally, if one or more entities succeeds to a portion of the Relevant Obligations
but no entity succeeds to more than 25% of the Relevant Obligations and the
Reference Entity ceases to exist, the entity that succeeds to the greatest percentage
of Relevant Obligations will be the sole Successor for the entire Credit Derivative
Transaction. If two or more entities succeed to an equal percentage of Relevant
Obligations, the entity that succeeds to the greatest percentage of obligations of the
Reference Entity—namely, all obligations, not just Bonds and Loans—will be the
sole Successor for the entire Credit Derivative Transaction.

Main Issues Surrounding Succession


Succession highlights Succession highlights that CDS and cash are different assets. While a cash investor
that CDS and cash are owns a specific bond, a CDS investor owns protection on a class of debt (e.g., senior
different assets unsecured) within a company. As a derivative instrument, CDS contracts therefore
have additional uncertainty.
There are five main issues surrounding Succession: 1) the percent of Relevant
Obligations that succeed to a new company, 2) the timeline associated with an early
repayment or tender offer, 3) guarantees, 4) covenants and indentures, and 5)
accounting considerations. We illustrate each category with a case study.
In addition, page 162 in this chapter discusses the implications of a proposed “good
bank” / “bad bank” split on CDS Succession for monoline insurers.

Percent of Relevant Obligations that Succeed to a New Entity


In September 2005, in connection with a Hertz LBO, Hertz announced a $2.3 billion
tender plan for debt maturing prior to 2010. In addition, Ford Motor Credit announced
plans to offer to exchange $2.4 billion of Hertz debt, maturing in 2010 and beyond, for
Ford Motor Credit debt. Although in the end, Hertz announced the exchange offer, not
Ford Motor Credit, it is worthwhile to note the effect on the CDS market, had the
exchange offer remained with Ford.
If Ford Motor Credit had succeeded to more than 25% of the Relevant Obligations of
CDS may split into Hertz, Hertz CDS would have split into two contracts. For every $10 million notional
multiple contracts in original Hertz protection, the investor now would have held $5 million in Hertz

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77
protection and $5 million in Ford Motor Credit protection. Relevant Obligations
78
included Hertz Bonds and Loans outstanding immediately prior to the exchange date.
Importantly, Relevant Obligations excluded debt outstanding between Hertz and its
Affiliates, as determined by the Calculation Agent.
By contrast, if Ford Motor Credit succeeded to 25% or less of the Relevant Obligations
of Hertz, there would be no succession. All of the original Hertz CDS notional would
have continued to reference Hertz debt.
Figure 112 shows an analysis of possible scenarios for Ford Motor Credit succeeding
Hertz. Overall, it looked likely that Ford Motor Credit would have succeeded to more
than 25% of Hertz, which prompted Hertz spreads to widen following the exchange
offer announcement. However, depending on the calculation method—and this is
subject to interpretation—Ford would have been either slightly above or below the 25%
threshold.
As an important note, the 2003 ISDA Definitions suggest that total debt should be
calculated as of the date immediately prior to the exchange. This means that, should the
tender and exchange have occurred simultaneously, total debt may have still included
the tendered notes. The denominator would be larger, making it harder for Ford Motor
Credit to succeed Hertz.

77
In the extreme case, if Ford Motor Credit were to succeed to 75% or more of Hertz debt, then CDS contracts would simply reference Ford
Motor Credit. That is, $10 million notional of original Hertz protection would become $10 million notional of Ford Motor Credit protection.
78
The exchange date may be referred to as the Succession Event date.

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Figure 112. Would Ford Motor Credit Have Succeeded to More than 25% of Hertz?
Based on 10-Q, June 2005
Dollars

Excluding Affiliate Debt


All Debt Excl. Ford Note Excl. Ford Note
and Subsidiary Debt
Debt:
ABS Debt 2,480,198
Note to Ford (Subordinated debt) 1,185,000 EXCLUDED EXCLUDED
Senior Notes 5,198,142
Debt at Foreign Subsidiaries:
Banks
Commercial Paper 1,896,738 EXCLUDED
Other borrowings
Total debt 10,760,078 9,575,078 7,678,340

Exchange Amount 2,400,000 2,400,000 2,400,000


% of Total Debt 22.3% 25.1% 31.3%
Would CDS have split into 1/2 Hertz, 1/2 FMCC ? No Yes, But Borderline Yes
Sources: Securities and Exchange Commission; Hertz; Bloomberg; Banc of America Securities LLC estimates.

Based on all Hertz debt outstanding, Ford Motor Credit only would have succeeded to
22.3% of Hertz debt, meaning that all notional protection would stay with Hertz. This
is the second column of Figure 112.
However, the two right columns subtract Affiliate debt, which is how the actual 25%
threshold is determined. ISDA Definitions are broad regarding the definition of
Affiliate debt, so we include two scenarios, one which excludes a note between Ford
79
and Hertz, and one which also subtracts foreign subsidiary debt. Under both of these
scenarios, Ford Motor Credit would have succeeded to more than 25% of Hertz debt,
meaning that half of notional protection would have remained with Hertz and half
would have become Ford Motor Credit protection. So we believe the most likely
outcome would have been that half of notional protection would remain with Hertz and
half would become Ford Motor Credit protection.
A Caveat: What Happens If There Is No Reference Obligation
Moreover, for Hertz protection, we note a caveat: the combination tender-exchange, as
A tender or exchange announced at the time, would have taken out all senior unsecured debt. This left the
offer may result in no question of what Hertz CDS would reference:
Reference Obligation for
a CDS contract 1. Provided that Hertz issued new senior unsecured debt under the LBO’d entity, the
Reference Obligation would change to reflect the new issuance. We would expect
Hertz spreads to trade wider to reflect higher leverage at the new company.

79
Our initial belief was that foreign subsidiary debt should be excluded, but we show both scenarios to emphasize that the results are subject to
interpretation.

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2. In the less-likely scenario that Hertz did not issue senior unsecured debt under the
new parent company, there would be no Reference Obligation for the Hertz
protection. Should a Credit Event have occurred, the Buyer of protection would be
forced to deliver an obligation structurally senior to senior unsecured debt (e.g.,
secured debt). That obligation would be likely to have a higher recovery rate than
senior unsecured debt, which would make credit default protection less valuable.
For example, if senior unsecured debt had a recovery rate of 40%, the protection
Buyer would profit $3 million post-Credit Event ($5 million notional – $2 million
recovery). But if there were no senior unsecured debt and the protection Buyer
were forced to deliver a more senior obligation, say with a recovery rate of 50%,
the protection Buyer would profit only $2.5 million post-Credit Event ($5 million
notional – $2.5 million recovery).
80
Less valuable protection would suggest potentially tighter Hertz spreads. If Hertz
later had issued senior unsecured debt under the LBO’d entity, credit default
spreads should have widened back out to reflect senior unsecured recovery rates.
CDS Follows Debt, Not Equity

Succession language is Notice that CDS Succession language is based on debt, not equity. For example, in
based on debt, not equity 2006, Wendy’s sold Tim Hortons, which generated more than half of Wendy’s
EBITDA. However, Tim Hortons did not assume any of Wendy’s existing debt. As
such, all CDS notional remained with Wendy’s. Spreads widened to reflect higher
leverage; that is, the same amount of debt but fewer assets.

Timeline Surrounding an Early Repayment or Tender Offer


In October 2005, Cendant Corp. unveiled plans to split the company into four separate
publicly traded companies (by summer 2006) in an effort to increase shareholder value:
X Cendant announced plans to spin off into four separate entities: Real Estate, Travel
Distribution, Hospitality, and Car Rental.
X Existing debt would be apportioned between Real Estate and Travel. These two
entities accounted for close to 70% of EBITDA and pretax earnings.
X Management suggested that Real Estate, Travel, and Hospitality would all emerge
with investment grade ratings. Car Rental would emerge with a high BB rating.
Initially, general market belief was that the Cendant name would disappear. Car Rental
(Avis) would acquire the broader Cendant Corp., and remain the surviving entity. This
assumption later proved incorrect; we discuss the implications in the “Guarantees”
section below. But for illustrative purposes, we now analyze the implications of those
initial market beliefs.
According to bond indentures, Cendant could not sell or transfer a substantial portion
The timeline associated of properties or assets. This led to a belief that Cendant would prepay its debt
with an early repayment obligations shortly before the spin-offs. Management acknowledged that the newly
of debt matters spun off entities would likely need to tap the markets, suggesting that Cendant did not
intend to disadvantage its existing bondholders.
The key issue for CDS is timing:

80
There are two counteracting factors: wider spreads from a new parent company with higher leverage, and tighter spreads from the Buyer of
protection only being able to deliver debt structurally senior to senior unsecured.

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Scenario 1: Cendant repays its debt before the company splits


In this case, all notional CDS would remain as Cendant. Should the Cendant name have
disappeared and Car Rental (Avis) became the surviving entity, all notional CDS
eventually would become Car Rental (Avis). CDS would price roughly as the
probability of Avis reissuing debt over the remaining life of the contract (e.g., 5 years),
multiplied by the expected spread at re-issuance.
If Car Rental were to issue debt shortly after the company split, CDS should widen
significantly because of an expected high-BB rating versus BBB+ for Cendant before
the initial spin-off news. In turn, CDS should price at about the expected new issue
81
spread for the Car Rental division.
Scenario 2: Real Estate and Travel assume all existing Cendant debt before an
early repayment
In this case, the only relevant entities for CDS would have been Real Estate and Travel.
This is because Cendant stated that all existing debt would be apportioned between
these two divisions.
If either Real Estate or Travel assumed at least 75% of all debt, all CDS would have
gone to that division. Otherwise, CDS notional would have split evenly between the
two divisions. (This is the same as for the Hertz case study above.) For example, this
scenario could have occurred if Real Estate or Travel borrowed from a bridge loan
facility and used the proceeds to exchange existing Cendant Corp debt for new Real
Estate or Travel debt:
Figure 113. Hypothetical Scenarios for Cendant CDS
If Then a $10mm CD trade becomes
Real Estate takes 75% of CD debt a $10mm Real Estate division trade
Real Estate takes 60% of CD debt a $5mm Real Estate trade
and a $5mm Travel Trade
Assumes that all debt not transferred to Real Estate would have been transferred to Travel.
Source: Banc of America Securities LLC estimates.

With Real Estate and Travel combined representing about 70% of EBITDA and an
expected investment grade rating for both entities, the CDS spread would not have
widened significantly.
What We Saw in the Market
As shown in Figure 114, the market initially placed the greatest weight on Scenario 1,
assuming that Cendant would repay its debt before the company split. In turn,
protection would succeed to Car Rental (Avis). This caused CDS to widen
approximately 20 bps in the immediate aftermath of the news (an effective downgrade
from triple-B to double-B). By contrast, cash bonds tightened approximately 30 bps in
anticipation of an early repayment of debt.

81
On the opposite extreme, if Car Rental never issued new debt, CDS should tighten to zero because protection references no debt. This is not a
particularly realistic scenario following an LBO.

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Figure 114. Cendant Cash versus CDS, 1 June 2005 – 1 December 2005
CD 6.25% 2010 Interpolated CDS

110

100

90

Spread (bps)
80

70

60

50

40

30
1-Jun 1-Jul 1-Aug 1-Sep 1-Oct 1-Nov 1-Dec

Source: Banc of America Securities LLC Estimates.

Guarantees and “Orphaned CDS”


The effect of Guarantees As noted in the previous section, the initial market belief that the Cendant name would
disappear proved wrong. In March 2006, Cendant announced that Cendant Corp. would
continue to exist, as a holding company for Cendant Car Rental Group (Avis).
Moreover, Cendant Corp. would not guarantee Cendant Car Rental Group, as
illustrated in Figure 115.

Figure 115. Without a Downstream Guarantee, Cendant Car Rental Group Debt Would Not Be
Deliverable Into Cendant Corp CDS
Reference Entity Remains Cendant Corp
In February 2007, a Downstream Guarantee was added, making Cendant Car Rental Group Deliverable into
Cendant CDS

Cendant CDS Cendant Corp

Initially,
No Guarantee X Intermediate
Holding Cos

New Debt Cendant Car Rental Group Sr Sec


Sr Unsec

...
Cendant Corporation later changed its name to Avis Budget Group, Inc. Cendant Car Rental Group, LLC later changed its name to Avis Budget
Car Rental, LLC.
Sources: Cendant; Banc of America Securities LLC estimates.

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The significance of a downstream guarantee is as follows. Cendant Corp. basically


became a shell corporation, with no assets and no debt. New debt (likely) would be
issued only out of the Cendant Car Rental Group operating company. This debt would
be deliverable against holding company (Cendant Corp.) CDS only if the holding
company (Cendant Corp.) guarantees the operating company’s debt.
If the holding company does not provide a guarantee, as with Cendant Corp. initially,
operating company debt cannot be delivered against a CDS contract in the original
(Cendant Corp. holding) company. In turn, CDS contracts written on the original
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Cendant Corp. company became near-worthless and spreads tightened.
As a further twist, in February 2007, a group of investors paid Cendant Corp. (by then
renamed Avis Budget Group, Inc.) $14 million to guarantee $1 billion in senior
unsecured bonds at Cendant Car Rental Group (by then renamed Avis Budget Car
Rental, LLC). With the downstream guarantee, bonds become deliverable into Cendant
Corp. CDS, giving CDS fundamental value and causing spreads to widen.
Guarantees, More Generally
For Reference Entities For Reference Entities located in North America, only downstream guarantees (from
located in North America, parent to subsidiary) are valid in standard CDS confirms. See Figure 116. The
only downstream guarantee must be unconditional and irrevocable, where the holding company (parent)
guarantees, from parent owns a majority of the operating company (subsidiary).
to a majority-owned
subsidiary, are valid Moreover, although not applicable to Cendant, we note that upstream guarantees (from
subsidiary to parent) are not taken into account for Reference Entities located in North
America. For CDS on an operating company, under no circumstance is holding
company debt deliverable.

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We note that, in Cendant Corp.’s case, CDS later widened on LBO concerns at the new (post-spinoff) entity.

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Figure 116. Effect of Guarantees on CDS Contracts, Globally


Based on Location of Reference Entity, Regardless of Where Trade Is Executed
Globally, guarantees must be unconditional and irrevocable to be valid for CDS contracts

5 Indicates debt is deliverable


North America Europe
If Parent Guarantees Subsidiary
Is parent debt deliverable into subsidiary CDS? No No
Is subsidiary debt deliverable into parent CDS?
If parent owns majority of subsidiary 5 5
If parent owns minority of subsidiary No 5
If Subsidiary Guarantees Parent
Is parent debt deliverable into subsidiary CDS? No 5
Is subsidiary debt deliverable into parent CDS? No No
If Subsidiary A Sideways Guarantees Subsidiary B
Is subsidiary A debt deliverable into subsidiary B CDS? No No
Is subsidiary B debt deliverable into subsidiary A CDS? No 5
Globally, debt delivered must be pari passu or better than the Reference Obligation in seniority, regardless of security.
Also of note: If the parent (or subsidiary) guarantees a third-party, third-party debt is deliverable into parent (or subsidiary) CDS, for Europe only.
If a third-party guarantees the parent (or subsidiary), parent (or subsidiary) debt is deliverable into third-party CDS, for Europe only.
Sources: ISDA; Banc of America Securities LLC estimates.

The reason for the discrepancy is precedent for U.S. courts to declare upstream (and
sideways) guarantees invalid, after Bankruptcy proceedings begin. For a guarantee to
be valid, the entity providing the guarantee must receive sufficient consideration.
For example, suppose that, in exchange for an upstream guarantee, the parent provides
a downstream guarantee to the subsidiary. If the parent has significant assets that
improve the overall credit profile of the subsidiary, the upstream guarantee should be
valid because the subsidiary received a clear benefit. By contrast, if the parent has no
assets, the upstream guarantee may be declared invalid post-Bankruptcy because the
subsidiary received no clear benefit. Owing to this uncertainty, upstream guarantees are
not taken into account for CDS contracts on North American Reference Entities.
Downstream guarantees are taken into account because anything benefiting a majority-
owned subsidiary also benefits the parent company.
When ISDA Definitions were last written in 2003, the general view of the CDS
community was that guarantees were more likely to be upheld in European courts. In
particular, the view was that European courts would tend to look at benefits to the
organization as a whole, rather than each distinct corporate entity. As such, a broader
class of guarantees applies to CDS contracts on Reference Entities located in Europe,
83
as illustrated in Figure 116.
A CDS contract on an operating company that has no Deliverable Obligation is
sometimes called “orphaned CDS.” For example, an orphaned CDS situation may
occur when a company’s debt is tendered for in connection with an LBO and that
company subsequently becomes an operating company within the post-LBO entity.

83
To implement these issues, confirmations for Reference Entities located in North America state: “All Guarantees: Not Applicable,” regardless
of where the trade occurs. Confirmations for Reference Entities located in Europe state: “All Guarantees: Applicable.” Globally, a guarantee
must be unconditional and irrevocable, to be taken into account for CDS contracts.

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Unless the operating company issues new debt, there will be no Deliverable Obligation
into CDS contracts and CDS will become near-worthless.

Covenants and Indentures


Covenants and CDS investors should understand that covenants and indentures affect bonds only, not
indentures affect bonds protection. For example, in October 2005, reports of private equity firms trying to buy
only, not protection Computer Sciences Corp (CSC) sent the stock price up from the mid-$40s to the high-
$50s. Normally, such LBO activity would send bond spreads wider, but CSC debt
contained a negative pledge provision. The company was prohibited from issuing liens
or other securitized assets in excess of 15% (for 2009 bonds) or 20% (for other bonds)
of consolidated net tangible assets. This led to a belief that the company would either
securitize existing bondholders or launch a tender offer.
By contrast, CDS does not benefit from bond indentures and was expected to succeed
to the new, post-LBO entity. In turn, as illustrated in Figure 117, CDS widened by far
more than cash, making a buy protection, buy bonds strategy profitable. (Spreads on
both bonds and protection later tightened as LBO concerns dissipated.)
Figure 117. Computer Sciences Corp Cash versus CDS, 1 June 2005 – 1 December 2005

CSC 5% 2013 Interpolated CDS


225

200

175
Spread (bps)

150

125

100

75

50

25

0
1-Jun 1-Jul 1-Aug 1-Sep 1-Oct 1-Nov 1-Dec

Source: Banc of America Securities LLC estimates.

Similarly, in December 2005, Temple Inland added step-up provisions to new issue
bonds, effectively giving investors a cushion should the company later be LBO’d. If the
company is downgraded to high yield, bondholders receive a 25-bp step-up per one
notch downgrade by either Moody’s or S&P, up to a maximum of 200 bps. Such a
downgrade would be likely to cause bonds to outperform CDS, as bonds would benefit
from step-ups while CDS would not. (In particular, on LBO news, CDS should widen
to reflect the capital structure of the new LBO’d entity.)

Accounting Considerations (Tax-Free Spinoffs)


In 2006, the telecommunications sector saw multiple Succession Events driven by
Accounting accounting considerations: trying to keep spin-offs tax free. Consider Alltel, which
considerations may
cause CDS contracts to
split

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spun-off its $3.9 billion wireline business to Windstream. Had Windstream simply paid
Alltel $3.9 billion in cash, the transaction would have triggered a capital gain for Alltel.
Instead, Alltel created a temporary spinoff company (SpinCo). SpinCo issued a roughly
$2.4 billion special dividend to Alltel, which represented Alltel’s tax basis. In addition,
SpinCo exchanged approximately $1.5 billion in Alltel debt. As a debt-for-debt
exchange, the $1.5 billion was not taxable to Alltel. SpinCo then merged with Valor
Communications Group. The merged entity then was renamed Windstream.

The $1.5 billion exchange represented 26.2% of the Relevant Obligations of Alltel, just
above the 25% threshold. As such, $10 million Alltel CDS notional split into $5 million
Alltel and $5 million Windstream.

Operational Issues Surrounding Succession Events


Single-name trades that are effective on or before the Effective Date of a Succession
How Succession Events Event will split. As CDS trades normally are effective T+1, the trade typically must
affect single-name and occur no later than one Business Day before the Effective Date.
index trades
Index trades are effective as of the inception date of the index and settle with accrued
interest. As such, indices that were effective on or prior to the date of a Succession
Event will split, regardless of the trade date.

Example
For example, a Succession Event occurred on July 17, 2006 in Alltel Corporation,
which caused trades to split 50% Alltel Corporation / 50% Windstream Corporation. At
the time, the CDX IG6 was the on-the-run investment grade index, of which Alltel
Corporation was a member.
Single-Name Trades
A single-name trade in Alltel Corporation must have occurred on or prior to July 16,
2006 (effective July 17, 2006) to split. An investor would now have two trades, both
with the original fixed coupon, for half of the original notional. Although the
Calculation Agent will update its internal systems to reflect the new position, the trade
will not immediately be rebooked in DTCC. The investor would reference the original
trade with its original trade number.
Should the investor later wish to modify the trade—for example, partially or
completely unwind, or assign—then at that time, the Calculation Agent will terminate
the original trade in DTCC and book two new trades, each with a new trade number.
The new trades would reflect the new position in each of Alltel and Windstream.
Index Trades
However, index trades in CDX IG6 always split, regardless of the trade date. Alltel
Corporation, which had an original weight of 0.8% (1 / 125 Reference Entities), will
now have an effective weight of 50% x 0.8% = 0.4%. Windstream Corporation will
effectively be added to the index, also with a weight of 0.4%. The original trade will
retain its original trade number, and will not be rebooked by the Calculation Agent.
This is because the Index Name is unchanged—for example, CDX IG6—even though
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the weightings in the index change.

84
The formal Index Name for five-year CDX IG6 is DOW JONES CDX.NA.IG.6 06/11.

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The Alltel Corporation weight in CDX IG7 and later series will not split, because the
indices started trading (were effective) after the Succession Event occurred.

CDS Settlement Protocols


This section discusses the most recent version of the CDS Settlement protocol, as of
The most recent version January 2008. This protocol is expected to be used to settle most single-name, index,
of the CDS Settlement and tranche credit derivatives trades. Even though the standard would be to cash settle,
protocol investors would retain the ability to request physical settlement. Such requests would
be filled to the extent that another market participant was willing to take the opposite
position.
The cash settlement price is determined through an auction process, the mechanics of
which resemble a Treasury auction. All cash-settled trades receive the same recovery
rate. Dealers commit to providing a baseline level of liquidity in the auction. Any
market participant, including dealers, may opt to provide additional liquidity. Third-
parties, Markit and Creditex, administer the process.
To be clear, no one is required to accept the settlement protocol because standard
documentation is currently written for physical settlement. However, in recent
protocols, almost all counterparties have consented.
CDS Settlement protocols have been used only for Bankruptcy Credit Events. The
methodology should be similar for a Failure to Pay. However, should a Modified
Restructuring occur, the protocol would need some changes, as discussed on page 158
in this Chapter.
In addition, there are special issues pertaining to potential CDS Settlement Protocols
for monoline insurers, as discussed on page 160.

Basic CDS Settlement Auction Mechanics


As a first step, As a first step, approximately 15 dealers submit a market on $10 million bonds, with a
approximately 15 dealers 85
maximum 2 point bid-offer spread. These markets represent a sample of the broader
submit a market on $10 market for a particular Reference Entity. Dealers may be required to trade bonds at
million bonds, with a their submitted levels, which provide incentive for the submission of reasonable quotes.
maximum 2 point bid- Moreover, dealers may be required to pay a penalty for markets that are inconsistent
offer spread with those of other dealers (see the section “Incentive for Dealers to Accurately Portray
Markets,” for details). The names of participating dealers, and their respective markets,
are publicly released on the website http://www.creditfixings.com.
For any required trades, dealers may deliver bonds from a publicly disclosed, pre-
specified list of Deliverable Obligations. This should result in dealers quoting the
cheapest-to-deliver obligation, just like in CDS physical settlement.
For example, Figure 118 shows the dealer markets submitted in the 2005 Delphi CDS
settlement protocol:

85
Fifteen dealers is an expectation. The process requires that a minimum number of dealers (e.g., 8) submit markets. The exact minimum
depends on how widely traded the relevant Reference Entity is. Similarly, the $10 million x $10 million market size may change, depending
on the Reference Entity.

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Figure 118. Dealer $10mm x $10mm Markets Submitted into CDS Settlement Auction
Dealer May be Required to Buy $10mm Bonds at its Bid, or Sell $10mm Bonds at its Offer
For example, “Dealer 1” submitted a 67/69 market

Offer (As Submitted by Dealer) Bid (As Submitted By Dealer)


70
69
68

Price ($)
67
66
65
64
63
62
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Dealer Number
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.

Inside Market Midpoint

An indication from The “inside market midpoint” forms a baseline for determining the final cash
dealers regarding fair settlement price. This level is an indication from dealers regarding the fair value of the
value forms a baseline cheapest-to-deliver obligation for the relevant Reference Entity.
for determining the final Figure 119 uses the dealer markets submitted to settle Delphi, to illustrate the
cash settlement price calculation of the inside market midpoint. There are three parts:

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Figure 119. Calculation of Inside Market Midpoint


Inside Market Midpoint Serves as a Baseline for Determining the Final Cash Settlement Price

Sorted Bids (Descending Order)


Sorted Offers (Ascending Order)
70
69
68

Price ($)
67
66
65
64
63
62
10 20 30 40 50 60 70 80 90 100 110 120 130 140 150
Size ($ MM)
Best Half of Non-Tradeable
Tradeable Markets: Markets: Worst Half:
Excluded from calculation Inside Market Midpoint = $66 Excluded from
of inside market midpoint. Average of bids and offers in calculation of inside
Some dealers who the best half. market midpoint.
submitted these markets If there is no demand to No penalty.
pay a penalty to ISDA. physically settle contracts,
the auction settles here.
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.

A “tradeable market” is a market submitted by one dealer that is inconsistent with that
submitted by another dealer. Specifically, a dealer whose bid is above another dealer’s
offer is considered inconsistent: the bidder may have been trying to drive the price
above fair value, while the offerer may have been trying to drive the price below fair
value. These markets are excluded from the calculation of the inside market midpoint
and may be subject to a penalty, as described in the section “Incentive for Dealers to
Accurately Portray Markets.”
86
The remaining non-tradeable markets are divided into two halves. The “best half” is
the lowest half of sorted offers and the highest half of sorted bids. The average of all
these bids and offers forms the inside market midpoint. In Figure 119, the inside market
87
midpoint is $66.
The “worst half” of non-tradeable markets (the far right portion of Figure 119) is the
set of highest offers and lowest bids submitted. These markets are excluded from the
calculation of the inside market midpoint, but there is no penalty.

86
If there is an odd number of non-tradeable markets, the best half is the average, rounded up. In Figure 119, there are 11 non-tradeable markets.
The best 6 form the “best half,” and the worst 5 form the “worst half.”
87
$66 is the average of bids $65.50, $65.50, $65, $65, $65, and $64.50, and offers $66, $66.50, $67, $67, $67, and $67.50, rounded to the
nearest eighth.

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If there is no demand If there is no demand from market participants to physically settle any CDS trades, then
from market participants the final cash settlement price is the inside market midpoint. However, in most cases
to physically settle any there will be at least some investors who wish to physically settle. For example, a
CDS trades, the final traditional investor may have bought protection as a hedge against an existing bond
cash settlement price is position, and now wish to deliver those bonds to physically settle CDS. In such cases,
the inside market the final cash settlement price will be adjusted to reflect the net demand of market
midpoint participants to physically settle.

How to Physically Settle a Trade


When a protection Buyer wishes to physically settle a transaction, a dealer enters an
order to sell bonds. The client will deliver bonds into the trade, which the dealer then
needs to sell.
Similarly, when a protection Seller wishes to physically settle a transaction, a dealer
enters an order to buy bonds. The client wishes to receive bonds from the trade, which
the dealer will need to buy.
Figure 120 and Figure 121 illustrate how a protection Buyer physically settles a
transaction under the protocol. The settlement process may be broken down into two
portions, cash and physical:
Figure 120. How a Trade is Physically Settled Under the Figure 121. Net Cash Flows are the Same as Physical
Protocol Settlement
Protection Buyer Wishes to Physically Settle a $10mm Trade Protection Buyer Delivers Bonds, and Receives $10mm Cash
Protection Buyer Delivers Bonds, Which are then Sold In the Auction. Protection Buyer’s Recovery Rate is the Price at Which He Bought Bonds

Cash Settled Portion:


$10mm x
( 1 - Recovery Rate ) $10mm Cash
Protection Protection
Dealer Investor Seller Buyer
$10mm Bonds
Physically Settled Portion:
$10mm Bonds
$10mm Protection
$10mm x Recovery Rate

Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

In the cash portion, the protection Seller pays the protection Buyer the notional of the
trade, less recovery.
In the physical portion, the protection Buyer delivers bonds. Since the dealer entered an
order to sell bonds, the investor also receives those proceeds, which is simply recovery.
Net, the protection Buyer delivers bonds and receives the notional of the trade. These
net cash flows are the same as those exchanged in physical settlement.
Any investor may enter a request to physically settle, up to his net notional position in
CDS. For example, if an investor is long $20 million of a credit in single-name CDS,
and short $5 million of the same credit in the CDX indices, that investor may request

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physical settlement on $15 million or less. These requests are fulfilled, to the extent
88
that some other market participant is willing to take the opposite position.
Net Open Interest and Direction of Price Changes
The net desire of the market to buy or sell bonds as a result of the Credit Event is called
“net open interest.”

The net desire of the If more protection Buyers than protection Sellers want to physically settle, there will be
market to buy or sell net demand to sell bonds in the cash settlement protocol: the cash settlement price is
bonds as a result of the likely to be lower than then-current cash bond prices. This is in contrast to recent Credit
Credit Event is called Events, where the requirement to physically settle single-name CDS sent protection
“net open interest” Buyers scrambling to buy bonds, resulting in a short squeeze.
Similarly, if more protection Sellers than protection Buyers want to physically settle,
there will be net demand to buy bonds in the cash settlement protocol: the cash
settlement price is likely to be higher than then-current cash bond prices.
The net open interest is released roughly 30 minutes after dealers submit their $10mm x
$10mm markets. Since the credit market (including dealers) does not know beforehand
whether the net open interest will be to buy or sell bonds, it is less likely that bond
prices will move in advance. Naturally, it is possible that cash bond prices will move
after the net open interest has been released.

Determining the Final Price


The final cash settlement The final cash settlement price is that price that clears the net open interest. For
price is that price which example, if the market has a net open interest to sell $100mm in bonds, the final price
clears the net open is the bid that clears $100mm in size.
interest
To clear the market, the dealers’ $10mm x $10mm markets provide a base level of
89
liquidity. Additionally, any market participant may enter a “limit order” to buy or sell
bonds at a specified price. A limit order is an order that will be filled only if needed to
clear the net open interest.
For example, if an investor believes that ultimate cash bond recovery will be 70%, he
may enter a limit order to buy $2mm bonds at a price of $65. If the auction settles
below $65, the investor will receive the $2mm in bonds, on which he ultimately
expects to earn at least 5 points profit (70% ultimate recovery minus maximum $65
90
purchase price). Dealers may enter limit orders directly, and clients may enter limit
orders through any dealer with whom they have a trading relationship.
The open interest is released approximately 2 hours to 3 hours before the collection of
limit orders so the market knows the overall demand to buy or sell bonds in advance.
As such, if there is an extreme open interest, investors should be more likely to place a
limit order because there is a greater chance of a price swing on the cash settlement
91
day.

88
Dealers are required to accept a request for physical settlement that reflects the CDS position of a client with that dealer. Dealers may, but are
not required, to accept a larger order, provided the client states that the order reflects his net position across dealers.
89
All dealers’ $10mm x $10mm markets are used, not just the “Best Half of Tradeable Markets” described in Figure 119.
90
If the investor’s order is filled, then he will pay the final cash settlement price. For example, if the final cash settlement price is, $63, the
investor would expect to earn 7 point profit (70% ultimate recovery minus $63 purchase price). If the auction settles at $65, the investor may
be partially filled on his $2mm order.
91
Should there be a material event or news that may have a significant effect on the price of bonds between the time of the dealers’ $10mm x
$10mm markets and the collection of limit orders, the auction may be cancelled for that day. The entire auction process, including new
$10mm x $10mm markets, would be repeated one business day later.

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Figure 122 illustrates the calculation of the final price, using data from the settlement
of Delphi, in which there was $99mm of net open interest to sell bonds. Notice, more
protection Buyers than Sellers wanted to physically settle. Those protection Buyers
deliver bonds, which then need to be sold in the auction:

Figure 122. Calculation of Final Price in the Cash Settlement Protocol


Combination of Dealer 10mm x 10mm Markets and Limit Bids are Used to Determine the Final Price

Combination of Dealer 10mm x 10mm Unused Bids:


68 Markets and Limit Bids: These orders are not filled.
These orders are filled at the cash
67
settlement price ($63.375).
66
65
Bid ($)

64
63
62
61
60
0 25 50 75 100 125 150 175
Size ($ MM)
Cash Settlement Price:
Bid that clears the $99mm
of bonds that CDS market
participants wanted to sell
as a result of the Credit Event.

$2mm of this final $5mm


limit order is filled at the
cash settlement price ($63.375).
All dealers’ $10mm x $10mm markets are used, not just the “Best Half of Tradeable Markets” described in Figure 119.
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol. There were additional (lower) bids that could
have been used to fill demand beyond $175 million in size (the maximum on the horizontal axis shown here); this figure omits that data
for readability.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.

In this example, the first four orders filled come from dealers’ $10mm x $10mm
markets. The next two orders filled come from limit orders, and so on. The final cash
settlement price is the bid that clears the $99mm in net open interest.
In this case, the final price is $63.375. The participant who bid $63.375 is partially
filled, to the extent necessary to clear the net open interest. All orders that are filled are
done so at the final price (i.e., the participant who bid $65 only pays $63.375).

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Why Participants Should Consider Limit Orders

Limit orders are Limit orders are important to the overall success of the cash settlement auction.
important to the overall Consider the case where 15 dealers submit $10mm x $10mm markets. This provides
success of the CDS baseline liquidity of $150mm.
settlement auction If there is a significant open interest to sell bonds—more protection Buyers than Sellers
want to physically settle—the auction relies on limit orders to fill any balance greater
than the $150mm baseline. Provided there are enough limit orders, this is not a
problem, as illustrated in the example above (Figure 122). However, if there are not
enough limit orders, the final cash settlement price will be zero.
Similarly, if there is a significant open interest to buy bonds—more protection Sellers
than Buyers want to physically settle—the auction also relies on limit orders, in
addition to the dealers’ $10mm x $10mm markets. If there are not enough limit orders,
the final cash settlement price will be 100.

If there is a significant Accordingly, if there is a significant net open interest, market participants should
net open interest, market seriously consider placing limit orders to avoid a final zero or 100 settlement price.
participants should Additionally, notice that an insufficient volume of limit orders means that participants
seriously consider who requested physical settlement will be unable to do so. That is, not enough market
placing limit orders to participants were willing to take the opposite side of the Counterparty requesting
avoid a final zero or 100 physical settlement. In this case, requests for physical settlement will be filled on a pro
settlement price rata basis, against dealer $10mm x $10mm and limit orders that were received.
Preventing Unexpected Results

A provision to help The auction also contains a provision to prevent extreme scenarios from a small net
prevent extreme open interest. For example, if there is a net open interest to sell bonds, there is a general
scenarios expectation that the final auction price will be below the inside market midpoint,
established in the dealers’ $10mm x $10mm markets. But now suppose there were a
very small net open interest to sell just $5 million in bonds. Then, as illustrated in
Figure 123, it is possible that just one limit order, with a relatively high bid, will be
filled. That limit bid would normally become the final price, resulting in an
unexpectedly high recovery rate. To guard against this scenario, if there is a net open
interest to sell bonds, the maximum final price is capped at the inside market midpoint
plus 1% of par.

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Figure 123. Preventing Unexpected Results


If There is a Net Open Interest to Sell Bonds, the Final Price is Capped at Inside Market Midpoint + 1%
If There is a Net Open Interest to Buy Bonds, the Final Price is Floored at Inside Market Midpoint – 1%

With a small open interest,


70 auction normally would …But, auction capped at $67
settle at $70... (Inside Market Midpoint + 1%)
68

Bid ($)
66
64
62
60
0 25 50 75 100 125 150 175
Size ($ MM)
Hypothetical data. Difference from Figure 122 is the level of limit bids and the size of the open interest.
Source: Banc of America Securities LLC estimates.

Similarly, if there is a net open interest to buy bonds, there is an expectation that the
final auction price will exceed the inside market midpoint. Should there be a very small
open interest that would otherwise result in a significant price decline, the maximum
final price will be floored at the inside market midpoint minus 1% of par.
Deliverable Obligations

Dealers are working on a We have said that the auction is on “bonds.” Technically, counterparties that trade
permanent protocol that “bonds” in the auction enter into a single-name CDS contract on the relevant Reference
could be used to settle Entity and may settle that contract with any obligation that is on a publicly available,
all Credit Events pre-specified list of Deliverable Obligations. There is a general expectation that the
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cheapest-to-deliver obligation would be exchanged.
As such, the recent (since 2005) process of arranging an ad hoc CDS settlement
protocol, post-Credit Event, allows adherents to know which obligations will be
deliverable, before entering into the auction.
Longer term, should a similar protocol be incorporated into standard CDS
documentation, a procedure for determining the Deliverable Obligations (and potential
disputes) would need to be added to the protocol. This is because market participants
would bind themselves to the protocol at trade inception, even though the list of
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Deliverable Obligations would not be determined until after a Credit Event. (It is
impossible to determine the list of Deliverable Obligations at trade inception because a
bond may be issued after that date that becomes deliverable into the CDS contract.)
An inter-dealer committee is working on a solution to potential disputes surrounding
Deliverable Obligations.

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The Buyer of bonds (Participating Bidder) enters into a contract to sell credit default protection, and must deliver a Notice of Physical
Settlement, as with any CDS contract. Additionally, we note that loans are also deliverable into credit default protection. But in practice, they
are rarely delivered, because loans usually trade at a much higher price than bonds post-Credit Event. This means that a loan is rarely, if ever,
the cheapest-to-deliver obligation.
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More accurately, market participants would bind themselves to the protocol through the ISDA Master Agreement, or an amendment thereof.

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Incentive for Dealers to Accurately Portray Markets


As mentioned earlier, some dealers who submit markets that are inconsistent with the
markets of other dealers are required to pay a penalty. These are dealers whose $10mm
x $10mm markets are tradeable with another dealer—one dealer’s bid is above another
dealer’s offer (recall Figure 119)—and who are on the opposite side of the net open
interest.
For example, if there is a net open interest to sell bonds, the dealers whose bids formed
part of the tradeable markets are subject to a penalty. The logic is that the bidding
dealers may have attempted to raise the price above fair value. The penalty is the
difference between the relevant bid and the inside market midpoint, as illustrated in
Figure 124.
Figure 124. Determining the Dealer Penalty
When Net Open Interest is to Sell Bonds, Penalty is the Bid Minus the Inside Market Midpoint. Bidding
Dealer Pays the Penalty.
If Net Open Interest Were to Buy Bonds, Penalty Would Be the Inside Market Midpoint Minus the Offer. Offering
Dealer Would Pay the Penalty.

Sorted Bids (Descending Order) Inside Market Midpoint


67.25
67.00
Price ($)

66.75
66.50
66.25
66.00
65.75
0 1 2 3 4 5
Markets Subject to a Penalty
Bidding Dealer Pays Bidding Dealer Pays
1 Point Penalty to 1/2 Point Penalty to
ISDA, on $10mm ISDA, on $10mm
($100,000 Penalty) ($50,000 Penalty)
Bidding Dealer Pays No Penalty Because
1 Point Penalty to Bid is Equal to (or Less
ISDA, on $10mm Than) the Inside
($100,000 Penalty) Market Midpoint
A penalty is only paid if it is positive. For example, if there were a net open interest to sell bonds. and the bid minus the inside market midpoint
were negative, then the bidding dealer would pay no penalty. Similarly, if there were a net open interest to buy bonds, and the inside
market midpoint minus the offer were negative, then the offering dealer would pay no penalty.
For illustration, this figure uses data from the 2005 Delphi CDS cash settlement protocol. However, the method for calculating a penalty
has since changed. This figure shows the calculation of the penalty under the current protocol.
Sources: ISDA; CreditEx; Banc of America Securities LLC estimates.

Similarly, if there is a net open interest to buy bonds, the offering dealer pays the
penalty to ISDA. The logic is that the offering dealer may have attempted to drive the

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price below fair value. The penalty would be the difference between the inside market
midpoint and the relevant offer. Proceeds from the penalty are used to defray auction
94
costs.

Details Around Modified Restructuring


In this section, we present a detailed discussion of Modified Restructuring, a single-
name CDS Credit Event, primarily used by the North American investment grade
market. The North American high yield market also sometimes uses Modified
Restructuring, particularly for Reference Entities that were downgraded from
investment grade. Europe (investment grade and high yield, single-name and iTraxx
indices) uses Modified-Modified Restructuring.
For both Modified and Modified-Modified Restructuring, the triggers for a Credit
Event are the same. For this reason, we simply write “Restructuring” below when
describing triggers, similar to the terminology used in the 2003 ISDA Credit
Derivatives Definitions. When discussing which obligations a protection buyer may
deliver post-Credit Event, Modified and Modified-Modified Restructuring differ, and
in these cases, we will be more specific.

Restructuring Criteria
Bankruptcy and Restructuring
The table below summarizes the five Restructuring criteria. Any one of these criteria
causes a Restructuring Credit Event to occur. Once this happens, parties may begin the
CDS settlement process.

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Penalties are only due if they are positive. For example, if the net open interest were to sell bonds, and the bid minus the inside market
midpoint were negative, the bidding dealer would pay no penalty. Similarly, if the net open interest were to buy bonds, and the inside market
midpoint minus the offer were negative, the offering dealer would pay no penalty.

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Figure 125. Restructuring Criteria


2003 ISDA Restructuring Definitions- one or more of the following events
A reduction in the rate or amount of interest payable or the amount of scheduled interest accruals

A reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates

A postponement or other deferral of a date or dates for either (a) the payment or accrual of interest or (b) the payment of principal or premium

A change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation

Any change in the currency or composition of any payment of interest or principal to any currency which is not a Permitted Currency

Exceptions to these rules include:


Administrative, accounting, tax or other technical adjustment occurring in the ordinary course of business

Events that do not directly or indirectly result from a deterioration in the creditworthiness or financial condition of the Reference Entity

Source: 2003 ISDA Credit Derivatives Definitions.

Restructuring Alternatives

The differences between There are four Restructuring alternatives from which the counterparties choose when
various Restructuring setting up the CDS: No Restructuring, Restructuring, Modified Restructuring, and
Criteria Modified-Modified Restructuring.
In the US and Europe, plain vanilla Restructuring—sometimes called “Old
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Restructuring”—has been rarely used since the Conseco Restructuring in 2000.
Instead:
X For single-name CDS contracts on US investment grade and many fallen angel
Reference Entities, the market standard is Modified Restructuring.
X For other CDS contracts on US Reference Entities, such as single-name high yield
CDS, some single-name rising-star CDS and the CDX indices, the standard is No
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Restructuring.
X For CDS contracts on European Reference Entities, investment grade and high
yield, single-name and index, the standard is Modified-Modified Restructuring.
X Recently, for European leveraged loan CDS contracts, the standard has become
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Old Restructuring.
The primary differences between Modified Restructuring and Modified-Modified
Restructuring lie in the maturities and transferability of Deliverable Obligations, as

95
Please see the Case Histories section on page 129 for details. Additionally, note that Old Restructuring continues to be used for Reference
Entities in emerging markets.
96
By fallen angel CDS, we mean a Reference Entity that was investment grade when it originally started trading in CDS and subsequently was
downgraded to high yield. Similarly, by rising-star CDS, we mean a Reference Entity that was high yield when it originally started trading in
CDS and subsequently was upgraded to investment grade.
97
This is because European leveraged loan CDS limits Deliverable Obligations to the Reference Obligation(s) and other senior loans with the
same security and the same or equivalent guarantees. With the universe of Deliverable Obligations already limited, it seemed unnecessary to
include the additional maturity limitation of Modified-Modified Restructuring. For more details, please see page 169.

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illustrated in Figure 126. Notice that there is a difference in Deliverable Obligations,


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based on whether the protection Buyer or Seller declares a Credit Event:
X If the protection Buyer declares a Restructuring, then Modified and Modified-
Modified Restructuring attempt to limit the cheapest-to-deliver obligation to the
portion of the credit curve that was restructured. Modified Restructuring also
essentially limits Deliverable Obligations to bonds only (not loans). If the
Reference Obligation fails to meet these criteria, it will not be deliverable.
X However, if the protection Seller declares a Restructuring, these limitations do not
apply. The protection Buyer may deliver the same obligations as for a Bankruptcy
or Failure to pay, usually up to a maximum maturity of 30 years. The logic is that,
because the protection Seller forces the Buyer to settle, the protection Buyer should
have the option to deliver obligations across the credit curve. As such, the
protection Seller is likely to prefer not to trigger a Restructuring Credit Event.
Figure 126. Modified and Modified-Modified Restructuring Guidelines, if the Protection Buyer Declares a Credit Event
If the Protection Seller Declares a Credit Event, Deliverable Obligations are the Same as for a Bankruptcy or Failure to Pay (See Figure 13 on page 20)
Maturity Limitation Date For Modified Restructuring (North America): The maximum maturity of the Deliverable Obligation submitted by
the protection Buyer is the later of the Scheduled Termination Date of the CDS contract, and the shorter of (i) 30
months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan. What’s
important here is that these are relatively short-term and thereby limit the cheapest-to-deliver option.

For Modified-Modified Restructuring (Europe): The maximum maturity of the Deliverable Obligation submitted by
the protection Buyer is 60 months (for restructured bonds or loans) or 30 months (for all other Deliverable
Obligations) following the Restructuring Date, or the Scheduled Termination Date of the CDS contract, whichever
is later.

Fully Transferable Obligation (North For Modified Restructuring (North America): Obligation must be fully transferable to an eligible assignee.
America) or Conditionally Transferable Essentially, this limits Deliverable Obligations to bonds (not loans).
Obligation (Europe)
For Modified-Modified Restructuring (Europe): The Deliverable Obligation must be transferable to any entity that
regularly engages in loan and securities markets, either without consent, or with consent of the Reference Entity,
not to be unreasonably withheld.

Multiple Holder Obligation Restructuring Credit Events are triggered only by Multiple Holder Obligations (MHOs). This prevents parties from
profiting by triggering bilateral loans. MHOs have at least 4 unaffiliated lenders, two-thirds of which consent to
the Restructuring. For the two-thirds consent, each holder has one vote, even if affiliated with another holder.

For Reference Entities based in North America, the two-thirds consent is deemed automatically satisfied if the
restructured obligation is a bond. 99
Source: 2003 ISDA Credit Derivatives Definitions.

Figure 127 and Figure 128 show two examples of which obligations may be delivered
following a Restructuring, assuming that the protection Buyer declares a Credit Event:

98
If multiple Credit Events are declared—for example, Modified Restructuring and Failure to Pay—the limitations of Modified Restructuring
and Modified-Modified Restructuring do not apply.
99
Per the May 2003 Supplement to the 2003 ISDA Credit Derivatives Definitions.

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Figure 127. Example of Which Obligations May Be Delivered Following a Restructuring


Remaining Maturity of CDS Contract is Four Years
Under MR, the protection Buyer may deliver an obligation with a maturity of up to 4 years after the
Restructuring date

Years 30m Maturity Maturity 60m Maturity


Post-Restructuring Limitation of CDS Limitation

0 1 2 3 4 5

North Max. Maturity


America (MR) (All Deliverables)

Europe (MMR) Max. Maturity Max. Maturity


(Non-Restructured (Restructured
Deliverables) Deliverables)
For North America, (1) Deliverable Obligations are essentially limited to bonds (not loans) and (2) 30m Maturity Limitation is the shorter of (i)
30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan.
For further details on maturity limitations and transferability, please see Figure 126.
Sources: ISDA; Banc of America Securities LLC Estimates.

Figure 128. Second Example of Which Obligations May Be Delivered Following a Restructuring
Remaining Maturity of CDS Contract is One Year
Under MR, the protection Buyer may deliver an obligation with a maturity of up to 30 months after the
Restructuring date

Maturity 30m Maturity 60m Maturity


Years of CDS Limitation Limitation

0 1 2 3 4 5

North Max. Maturity


America (MR) (All Deliverables)

Europe (MMR) Max. Maturity Max. Maturity


(Non-Restructured (Restructured
Deliverables) Deliverables)
For North America, (1) Deliverable Obligations are essentially limited to bonds (not loans) and (2) 30m Maturity Limitation is the shorter of (i)
30 months following the Restructuring Date and (ii) the latest maturity date of any restructured bond or loan.
For further details on maturity limitations and transferability, please see Figure 126.
Sources: ISDA; Banc of America Securities LLC Estimates.

Protection Buyer May Choose When to Trigger a Restructuring

Modified Restructuring An investor may think of Modified Restructuring as an American option. Assume that a
resembles an American company’s bonds would trade at $70 post-Restructuring, or $40 post-default. If the
option protection Buyer declares a Restructuring, he stops paying the CDS premium and
receives 30 points (100% par – 70% post-Restructuring price).

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Alternatively, the protection Buyer may continue to pay the CDS premium and hope to
trigger a Bankruptcy or Failure to Pay later in the life of the contract. At that time, the
investor would expect to receive 60 points (100% par – 40% post-default price).
To be clear, the protection Buyer has a choice on when to trigger CDS--that is, when to
declare a Credit Event. He may do so anytime from the date of the Modified
100
Restructuring up to and including 14 calendar days after CDS contract maturity.
These payoff scenarios are illustrated in Figure 129. If the protection Buyer believes
that, once a company has restructured its debt, its probability of default rises
101
significantly, he is likely to wait to trigger CDS.
Figure 129. Restructuring as an American Option
Sample Discounted P&L from Perspective of Protection Buyer, for a CDS with a Premium of 500 Bps
Protection Buyer may trigger a Restructuring or continue to pay the CDS premium and hope to later trigger a
Bankruptcy or Failure to Pay

Discounted Payoff from Triggering a Bankruptcy


Discounted Payoff from Triggering a Restructuring
60
P&L (Points)

40 Potential benefit of
waiting to trigger CDS
20

0
0 1 2 3 4 5
Years Post-Restructuring That the Protection Buyer Waits
to Trigger a Credit Event
Assumes recovery rate of 70% post-Restructuring, or 40% post-Bankruptcy. Discounted by LIBOR.
Source: Banc of America Securities LLC Estimates.

From about 2005 until summer 2007, the value of Restructuring provisions in CDS
contracts had declined from about 5%-10% (Modified Restructuring spreads wider than
No Restructuring spreads) to about 2% for investment grade names. More recently, the
perceived value of Restructuring provisions has increased, in part because of
deterioration in the overall macroeconomic environment.
Exception: CDS—Cash Basis Packages
One exception is CDS—cash basis packages, where the protection Buyer already owns
a bond, and thereby has locked in a recovery rate. Provided that CDS matures later than
the bond, the bond will be deliverable under Modified Restructuring criteria. In this
case, one should generally expect the protection Buyer to trigger a Modified

100
Technically, the timing option also exists following Bankruptcy and Failure to Pay Credit Events. However, because either the protection
Buyer or Seller may trigger CDS and the Deliverable Obligations are the same regardless of who triggers, it should be to one party’s
advantage to immediately declare a Credit Event. As such, the timing option is essentially irrelevant following a Bankruptcy or Failure to Pay.
However, because following a Modified Restructuring, the protection Seller will lose the advantage of the maturity limitation if he triggers,
presumably the protection Seller will not trigger a Modified Restructuring. This creates a meaningful timing option for the protection Buyer.
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Naturally, the closer a CDS contract is to maturity, the more likely the protection Buyer is to trigger Modified Restructuring immediately.

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Restructuring immediately. In practice, this could particularly result in triggers for


102
credits where bonds traded at a deep discount but CDS traded at par.
Practical Trading Considerations Following a Restructuring
Example 1: Curve Trades
Consider an investor who sold front-end protection and bought back-end protection.
Absent a Restructuring, the investor is notional neutral. However, if a Modified
Restructuring occurs, the investor’s position becomes unclear:
X If the investor is triggered on front-end protection, he in turn can trigger the back-
end contract, resulting in no loss.
X By contrast, if the investor is not triggered on front-end protection, he will become
concerned about the potential for a trigger, which could occur at any time until
contract maturity. Accordingly, he will be forced to either hold on to the back-end
position, or to buy front-end protection as a hedge. Such activity could invert the
credit curve and decrease liquidity post-Restructuring.
Example 2: Hedging Risk
Consider the reverse situation, in which an investor sold back-end protection and
hedged by buying front-end protection. Absent a Restructuring, the investor is notional
neutral. However, if a Modified Restructuring occurs:
X If the investor is triggered on back-end protection, he in turn can trigger the front-
end contract, resulting in no loss.
X By contrast, if the investor is not triggered on back-end protection, then once the
front-end contract matures, he will be naked long risk, which could be triggered at
any time until contract maturity.
X Alternatively, if the investor is not triggered on back-end protection, he still can
trigger the front-end contract. But he will lose money if the recovery rate drops
between the date he settles front-end CDS and the date he eventually settles back-
end CDS.
Example 3: Mark-to-Market Risk
Suppose that an investor bought protection but does not want to trigger immediately
post-Modified Restructuring. Presumably, spreads widen and the investor would like to
record mark-to-market gains of the spread change multiplied by the duration.
However, because of the option to trigger the CDS contract at any time until maturity,
duration should shrink. The appropriate duration depends on the difference in expected
recovery rates between a Bankruptcy or Failure to Pay, versus a Modified
Restructuring. Different dealers may assign different recovery rates, resulting in
103
unclear mark-to-market profits and reduced liquidity.

102
For example, suppose that a bond traded at $70, but CDS traded at par (all running spread, as opposed to points upfront). The low dollar price
of the cash bond would make a buy CDS—buy bond trade look attractive. Post-Credit Event, the investor would receive par on CDS with a
locked-in recovery rate of 70%, resulting in a 30 point profit. Assuming CDS matures later than the bond, the investor could deliver the bond
following a Modified Restructuring.
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CDS contracts discount at LIBOR plus the implied probability of default, which changes post-Modified Restructuring. Using the
methodology in the “Implied Probability of Default” section on page 100, CDS contracts (including the CDSW screen on Bloomberg)
typically derive the implied probability of default, to a one-year horizon, as follows:
Expected Gain = Expected Loss
Spread = [ Probability of Default ] x [ 1 – Recovery] + [ 1 – Probability of Default ] x Zero
[ Probability of Default ] = Spread / [ 1 – Recovery ]

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CDS Settlement Protocols


Recent CDS (so-called “cash”) settlement protocols, discussed in the section “CDS
Settlement Protocols“ on page 143, have been used only for Bankruptcy Credit Events.
Should a Modified Restructuring occur in the future, the CDS Settlement Protocol
methodology would probably need to be revised to account for (1) different Deliverable
Obligations based on the maturity of different CDS contracts, and (2) the option to
trigger immediately post-Modified Restructuring or at any time up to and including 14
calendar days after maturity. Currently, ISDA is looking into Modified Restructuring
cash settlement solutions through a working group.

Special Issues Pertaining to CDS on Monoline Insurers


We discuss special In this section, we discuss special issues pertaining to CDS on monoline insurers. First,
issues pertaining to CDS we discuss how rarely used criteria in CDS Bankruptcy definitions could (or could not)
on monoline insurers. result in a Credit Event for monolines. Second, we discuss potential issues in settling
monoline CDS contracts, should a Credit Event be determined. Finally, we address the
implications of a proposed “good bank” / “bad bank” split on monoline CDS contracts.

Defining a Monoline Credit Event


CDS Bankruptcy criteria In the section “Credit Events,” beginning on page 17, we discussed the various criteria
contain more triggers that may trigger CDS contracts. For monolines in particular, a further discussion of
than an actual Bankruptcy criteria is relevant.
bankruptcy filing, any
one of which is sufficient Generally, investors think of Bankruptcy as an actual bankruptcy filing. But Figure 130
to trigger a Credit Event. shows that several other criteria meet the definition of Bankruptcy in CDS contracts,
any one of which is sufficient to trigger a Credit Event.
Next, we apply these criteria to hypothetical scenarios for monoline insurers. We
emphasize that our analysis is incomplete, because it enters a gray area in CDS
language. It may be possible to obtain different—or even opposite—interpretations,
particularly based on additional information available at the time of a potential event.

But post-Modified Restructuring, the protection Seller’s minimum expected Loss rises from zero to [ 1 – Recovery post-Modified
Restructuring ]. Accordingly, the above formula changes to (letting “default” mean a Bankruptcy or Failure to Pay Credit Event):
Expected Gain = Expected Loss
Spread = [ Probability of Default ] x [ 1 – Recovery post-default ] + [ 1 – Probability of Default ] x [ 1 – Recovery post-Modified
Restructuring ]
Probability of Default = [ Spread + Recovery post-Modified Restructuring – 1 ] / [ Recovery post-Modified Restructuring – Recovery
post-default ]
Post-Modified Restructuring, CDS mark-to-market profits and trade unwinds should use LIBOR plus this new implied probability of default.

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Figure 130. Criteria for a Bankruptcy Credit Event


Any one of these criteria is sufficient to trigger CDS Contracts
A Reference Entity:
(a) is dissolved (other than pursuant to a consolidation, amalgamation, or merger)
(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 debt as they become due
(c) makes a general assignment, arrangement or composition with or for the benefit of its creditors
(d) institutes or has instituted against it a proceeding seeking a judgment of insolvency or bankruptcy or any other relief
under any bankruptcy or insolvency law or other similar law affecting creditors’ rights, or a petition is presented for
its winding-up or liquidation, and, in the case of any such proceeding or petition instituted or presented against it,
such proceeding or petition (i) results in a judgment of insolvency or bankruptcy or the entry of a order for relief or
the making of an order for its winding-up or liquidation or (ii) is not dismissed, discharged, stayed or restrained in
each case within thirty calendar days of the institution or presentation threreof
(e) has a resolution passed for its winding-up, official management or liquidation (other than pursuant to a consolidation,
amalgamation or merger)
(f) seeks or becomes subject to the appointment of an administrator, provisional liquidator, conservator, receiver, trustee,
custodian or other similar official for it or for all or substantially all its assets
(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).
Source: 2003 ISDA Credit Derivatives Definitions.

Hypothetical Scenarios for Monoline Insurers (Based on Limited Information—Actual


Results May Differ)
A state regulator prevents a monoline from writing new business
Not a Credit Event, because the monoline has not become subject to the appointment of
an administrator for all or substantially all its assets (Figure 130, clause f).
A state regulator seizes control of a monoline, for all or substantially all its assets
Bankruptcy Credit Event at the monoline (Figure 130, clause f).

Monoline obtains a judgment of insolvency or bankruptcy


Bankruptcy Credit Event at the monoline (Figure 130, clause d).

Monoline admits in writing in a regulatory filing that it is generally unable to pay


debts as they becomes due
Bankruptcy Credit Event at the monoline (Figure 130, clause b).

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A state regulator prohibits a monoline from dividending any payments up to its


holding company, which prevents the holding company from making a coupon
payment
Not a Credit Event at the monoline. Failure to Pay Credit Event at the holding
company, after the expiry of any grace period in the relevant holding company bond
104
indenture.

Settling a Monoline Credit Event


Settlement of monoline Settlement of monoline CDS contracts, should a Credit Event occur, may prove
CDS contracts problematic due to vast dispersion in the recovery rates of potential Deliverable
Obligations. Ultimate contract payoffs depend crucially on the type of instrument
delivered. Notably, owing to their structural characteristics, wrapped (guaranteed) CDO
super seniors typically are not eligible for delivery.
First, we discuss potential issues in settling monoline CDS contracts. We then discuss
recent steps taken by ISDA to potentially reach a solution.

The protection Buyer may Monoline CDS contracts are governed by the usual 2003 ISDA Credit Derivatives
deliver debt that is Definitions plus a 2005 Monoline Supplement. This supplement allows the protection
wrapped by the monoline, Buyer to deliver debt that is wrapped by the monoline insurer, such as a municipal
in addition to bonds and bond or super senior CDO tranche. These Deliverable Obligations are in addition to the
loans. direct debt of a Reference Entity—i.e., bond or loan—that is deliverable under standard
CDS contract language.

Should an investor want Should an investor want to deliver a CDO tranche—for example, a super senior—that
to deliver a CDO tranche, tranche must be guaranteed directly by the monoline, so that the insured instrument
it must be guaranteed (i.e., the tranche) is Borrowed Money. Quoting from the ISDA 2005 Monoline
directly by the monoline. Supplement (emphasis added):
“Qualifying Policy” means a financial guaranty insurance policy or similar
financial guarantee pursuant to which a Reference Entity irrevocably guarantees
or insures all Instrument Payments … of an instrument that constitutes
Borrowed Money … for which another party … is the obligor ...”

Typically, monolines Typically, monolines issued a financial guarantee (wrap) on CDS on super senior
issued a financial tranches, not the underlying super senior tranche. This was done for two main reasons.
guarantee on CDS on First, dealers were not in the business of marking and trading financial guarantees,
CDO tranches, not the whereas they are accustomed to trading CDS. More importantly, CDS is typically
underlying tranche. marked-to-market daily, whereas our understanding is that financial guarantees need
not be re-marked unless they become impaired—namely, unless the tranche suffers a
loss of principal. Since dealers owned the underlying CDO tranche and wanted to be
able to offset potential (now actual) mark-to-market losses, CDS was more attractive
than a direct financial guarantee.
Figure 131 shows a sample structure that would allow for effective insurance from a
monoline but would not be deliverable into CDS contracts. In this structure, a bank
owns a CDO tranche. The bank buys protection from a special purpose vehicle (SPV).
In exchange, the bank receives CDS protection from the SPV. At the same time, a
premium is paid to the monoline, in exchange for a financial guarantee on the CDS.
The bank is thus protected against lost of principal and interest payments.

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A Failure to Pay is a Reference Entity’s failure to make due payments. Usually applies to Borrowed Money, a broader category than simply
Bonds and Loans. Failure to Pay takes into account any grace period specified in the relevant indenture—typically 30 days in the U.S.—and
usually sets a minimum threshold of USD 1 million.

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MBIA provides this description of the process:


LaCrosse Financial Products, LLC (LaCrosse) was created in December 1999 to act
as a counterparty for structured derivative products, primarily pooled credit default
swaps. While MBIA does not have a direct ownership interest in LaCrosse, it is
consolidated in the financial statements of the Company on the basis that substantially
all risks and rewards are borne by MBIA. MBIA’s guarantees of synthetic CDOs are
typically executed through LaCrosse, which enters into a credit default swap with the
counterparty. MBIA Insurance Corp., through a financial guarantee policy, then
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guarantees the obligations of LaCrosse under the credit default swap.
However, because the wrap is not the CDO tranche itself, the CDO tranche would not
be deliverable into CDS contracts referencing the monoline insurer.

Figure 131. Example of CDO Tranche Which Would Not Be Deliverable into Monoline CDS
Monoline Financial Guarantee is on CDS Written by the SPV on the Tranche, Not on the Tranche Itself

Bank, which CDS Premium


owns CDO SPV
tranche
CDS Protection
Financial Financial
Guarantee Guarantee
Premium on CDS

Monoline
insurer

Source: Banc of America Securities LLC estimates.

Challenges with Cash Settlement for Monolines

We think it would be As we discussed in the section “Risk of a Short Squeeze” on page 22, investors have
difficult, though not come to generally expect an option to cash settle of CDS contracts. However, currently,
necessarily impossible, cash settlement is only an expectation, not a requirement. If a monoline were to suffer a
to cash settle a Credit Event, we think it would be very difficult to cash settle.
monoline. The reason is that, as we discussed on page 143 in this Chapter, CDS settlement
protocols (commonly called “cash settlement”) are actually an auction, the mechanics
of which resemble a Treasury auction. Roughly speaking, approximately 15 dealers
submit a market on, say, $10 million bonds, with a 2 point bid-offer spread. Dealers
may be required to trade bonds at their submitted levels, which provides incentive for
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the submission of reasonable quotes.

105
http://www.mbia.com/investor/investor_inquiries_faqs.html. Frequently Asked Question “What is LaCrosse Financial Products?” in Category
“Derivatives & Mark-to-Market.”
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This is only an approximate, and incomplete, description of CDS (so-called “cash”) settlement protocols. For further details, please see “CDS
Settlement Protocols” on page 143.

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Before the beginning of the Before the beginning of the auction, a list of Deliverable Obligations is established, and
auction, a list of any of those obligations may be delivered/received if a dealer is required to trade. For
Deliverable Obligations is example, in the Delphi auction, the 6.55% June 2006, 6.50% May 2009, 6.50% August
established. That is far 2013, and 7.125% May 2009 all were Deliverable Obligations. Similar to CDS, dealers
more straightforward for participating in the auction quote markets assuming they will exchange the cheapest-to-
non-monolines, where only deliver.
bonds and loans are Deliverable Obligation Challenges
deliverable
To assemble a list of Deliverable Obligations for a monoline:
1. The dealer community would have to agree that the each proposed Deliverable
Obligation is indeed deliverable into CDS contracts. This is possible but time-
consuming.
2. Each dealer then would have to value each Deliverable Obligation to
determine the cheapest-to-deliver obligation. This would be a time-consuming
and difficult process, which could impede on the 30 calendar days within
which parties normally settle credit default swaps.
Recovery Rate Risk

Moreover, if even a small Moreover, suppose that the bulk of Deliverable Obligations have a price of $60 to $80,
portion of Deliverable but a few Deliverable Obligations have a price of $10-$20. To clarify, these figures are
Obligations have a very just an example, not a recovery value estimate. Then, the CDS settlement auction
low recovery rate, the would be likely to result in a cash settlement price in the $10-$20 range, because each
auction could result in a dealer would recognize that he may receive the lowest price Deliverable Obligation. As
very low cash settlement such, a CDS settlement protocol, using the to-date methodology, would have a
price substantial risk of realizing a very low recovery rate, in our view.
Potential Solutions

To address these issues, To address these issues, ISDA assembled a working group in February 2008. ISDA
ISDA has assembled a subsequently published a list of obligations that dealers viewed as potentially likely to
working group be delivered into monoline CDS contracts, should a Credit Event occur. The purpose of
the list is simply to “gather and disseminate information as to the range of obligations
that market participants believe may be delivered upon the occurrence of a credit
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event,” and is not intended to be definitive. ISDA also is working with dealers to
develop potential changes to the CDS auction (so-called “cash” settlement)
methodology to accommodate the wide range of potential recovery rates across
deliverables.

Monoline Succession: The “Good Bank” / “Bad Bank” Split


The potential for On February 14, 2008, New York Insurance Department Superintendent Eric Dinallo
monoline insurers to be suggested the potential for monoline insurers to be split into two divisions, one
split into two divisions, referencing municipal bonds and the other referencing structured finance. Should such
one referencing a proposal be enacted, we see the potential for CDS contracts to rally massively, either
municipal bonds and the entirely succeeding (changing Reference Entity) to the municipals division, or splitting
other referencing 50% / 50% notional between the municipals and structured finance businesses.
structured finance
As discussed on page 132 in this Chapter, CDS Succession refers to the potential
change of entity that a CDS contract references (for example, MBIA Insurance Corp).
Succession is based solely on the transfer of debt, not on assets.

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For details, please see http://www.isda.org.

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For a monoline, if For a monoline, if between 25% and 75% of financial-guaranteed obligations are
between 25% and 75% transferred to a new division, existing CDS contracts would split 50% / 50% notional
of financial-guaranteed between the original and the new entity. For example, a $10 million notional contract
obligations are referencing MBIA Insurance Corp. would split into two contracts of $5 million
transferred to a new notional each, one referencing the municipals division and one referencing the
division, then existing structured finance division. At the extreme, if 75% or more of financial-guaranteed
CDS contracts would obligations are transferred to a new division, the original monoline Reference Entity
split 50% / 50% would be deleted entirely and replaced with the new division. These Succession rules
include financial-guaranteed obligations, unlike Succession rules for non-monoline
Reference Entities..
However, as one might imagine, the 25% and 75% thresholds are not clear-cut for
monolines. Figure 132 shows pertinent statistics, prepared by our insurance analyst
Michael Barry. The table divides CDS deliverables into two groups: those based on
financial guarantees to municipal bonds and those based on financial guarantees to
structured finance.
For these early estimates, we exclude CDOs entirely, because many of these products
would neither be deliverable into CDS contracts nor counted for Succession
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purposes. In reality, some portion of CDOs should be included and some portion
excluded, but we do not yet have a sense of this proportion. We also exclude
international financial guarantees because many of these products were written as
reinsurance, which also would not be counted for Succession purposes, in our early
view.

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There are circumstances in which obligations may not be deliverable into CDS contracts but would be considered for Succession purposes.
For example, CDOs with a direct financial guarantee but a maturity greater than 30 years would not be deliverable, but would be counted for
Succession purposes. Similarly, although not applicable for monolines, a subordinated bond would not be deliverable into a senior unsecured
CDS contract, but would be considered for Succession purposes.

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Figure 132. Scenarios for CDS Succession in Monolines


Should Be Viewed in the Context of Preliminary Estimates
Assumes that no CDOs have a direct financial guarantee from monoline insurers. This assumption is inaccurate, but because we do not know which
CDOs have direct financial guarantees, we omit them entirely, for the time being.

$ Millions
ABK FGIC MBIA SCA
Total Net Par Outstanding 556,173 314,814 672,934 154,164

Total Municipals 300,027 224,331 395,731 59,569


Total Structured Credit 176,628 72,016 159,905 70,725
Total International 79,518 18,467 117,298 23,870

CDOs (US + International) 71,500 28,100 130,896 44,300


US CDOs 50,973 28,100 (*) 83,347 40,344
International CDOs 20,527 Not Available 47,549 3,956

Est. Net Par of CDS Relevant Obligations for


Succession (Total Net Par ex-CDOs and ex-Int'l) 425,682 268,247 472,289 89,950

Total Municipals - % 70% 84% 84% 66%


Total Structured Credit, ex-CDOs - % 30% 16% 16% 34%

Would CDS Succeed to Municipals Division? 50% / 50% Split Full Succession Full Succession 50% / 50% Split
Based on Preliminary Information and Data But Borderline (*)
Estimates as of September 30, 2007. We believe that results have not changed materially since then.
(*) For FGIC, the international portion of CDOs is not available, so for our preliminary purposes, we assume it to be zero. A determination of the actual exposure may result in different implications
for CDS.
“Est. Net Par of CDS Relevant Obligations for Succession (Total Net Par ex-CDOs and ex-Int’l): There are circumstances in which obligations may be considered for Succession purposes, but not
deliverable into CDS contracts. For example, CDOs with a direct financial guarantee but a maturity greater than 30 years would be considered for Succession purposes, but would not be deliverable
following a potential Credit Event.
Sources: Company reports; Banc of America Securities LLC estimates.

Actual results would Figure 132 suggests the following implications for monoline CDS. To be clear, these
depend on obligations results are simply preliminary estimates based on financial guarantee disclosures by the
outstanding as of one monolines. Actual results would depend on the universe of Relevant Obligations
day prior to the potential (Bonds and Loans with a direct financial guarantee) as of one day prior to the potential
Succession event Succession event—in this case, likely one day prior to the Dinallo “good bank” / “bad
bank” plan going through—so the final result may differ substantially.
Moreover, we assume that all existing financial guarantees relevant to a particular
division (municipals or structured finance) would be transferred. It is entirely possible
that the transaction would be constructed in a different way, making our estimates
invalid.
Ambac and SCA
Our preliminary estimates suggest that existing notional on CDS would split 50% /
50% between the municipals and structured finance divisions. Particularly for Ambac,
these results are borderline—we estimate that 70% of obligations considered for CDS

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Succession purposes would travel with the municipals, but if the actual number turned
out to be at least 75%, CDS would succeed entirely to the municipals division.
FGIC and MBIA
Our preliminary estimates suggest that existing CDS notional would succeed entirely to
the municipals division with corresponding spread tightening. However, we again
caution that Figure 132 excludes CDOs entirely. In reality, some portion of CDOs is
deliverable into monoline CDS and counted for Succession purposes. A determination
of this number could result in a 50% / 50% split, rather than a full succession.
Additionally, for FGIC, we have assumed that all CDOs are US exposure because of
lack of information. Determination of the international portion of CDOs may change
the denominator in the CDS Succession calculation.

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Chapter VII – Other Credit Derivatives Products


This section discusses products in the credit derivatives market other than single-name
and index CDS referencing corporate unsecured bonds. Such products include synthetic
CDOs, CDS on leveraged loans, and CDS on asset-backed securities.

The Synthetic CDO Market


Strong synthetic demand Whereas the new issue market for cash bonds provides a constant source of supply,
was a catalyst toward leveraged structures known as synthetic CDOs provided a constant source of demand
tighter spreads from for credit risk that was often sourced through single-name CDS from 2005 until early
2005—early 2007 2007. In the synthetic CDO market, dealers typically sold credit risk to the end investor
through one particular tranche. Higher credit-risk tranches, such as equity and
mezzanine structures, had greater leverage. Dealers hedged their short credit-risk
exposure by selling protection in the single-name (secondary) CDS market, resulting in
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tighter CDS spreads.
Figure 133. Investment Grade Synthetic CDO Issuance
January 2003—December 2007
IG Synthetic CDO Issuance ($ Billion)

25
20
15
10
5
-
Jan-03
May-03
Sep-03
Jan-04
May-04
Sep-04
Jan-05
May-05
Sep-05
Jan-06
May-06
Sep-06
Jan-07
May-07
Sep-07
Distributed tranches excluding identifiable super seniors.
Identifiable super seniors defined as transactions with an attachment point higher than 20%, an exhaustion point of at least 50%, or a
super senior notation in Credit Flux data.
Sources: CreditFlux; Banc of America Securities LLC estimates.

However, during 2007, losses in subprime mortgages and traditional cash CDOs caused
synthetic CDO volumes to plummet. See Figure 133. Correlation desks’ until-then
persistent demand to sell protection dried up, shrinking the cushion that had prevented
credit default swap spreads from moving wider.
Potentially, should such structures ever unwind en masse, CDS spreads could move
notably wider, particularly at popular seven- and ten-year maturities. For a further
introduction to the structured credit market, please see the Chapter Appendix on page
179.

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To sell single-name protection on a large number of Reference Entities in different notionals, correlation desks (groups responsible for
managing structured credit risk and banks and broker-dealers) often use lists known as “Bid Wanted in Competition (BWIC).” Each recipient
of the BWIC is responsible for entering a bid on trades in which it is interested. Typically, either the best bid wins a particular trade or the
flow desk bidding the best overall wins the entire list. By contrast, an OWIC is an Offer Wanted in Competition and signals the desire to buy
single-name protection.

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Leveraged Loan CDS (“LCDS”)


For more information on Leveraged Loan CDS, please see our Guide to Leveraged
Loan CDS, September 28, 2006.
Leveraged loan CDS (“LCDS”) allows investors to reference secured loans in
standardized credit derivative contracts. Focused on the double- and single-B high yield
universe, LCDS trades actively on 25 to 40 Reference Entities and is quoted for about
80 entities.
Sellers of protection include hedge funds, who seek quick access to leveraged loan
exposure, often with lower funding costs than a total-return swap on par loans. Bank
loan portfolios may sell protection to add exposure to issuers with underutilized credit
lines.
Similarly, buying LCDS protection provides a more accurate hedge for loan portfolios
than senior unsecured CDS. Leveraged investors may buy LCDS protection to short
credit risk without the need for a repo market.
Figure 134 compares key features of LCDS with senior unsecured CDS:
Figure 134. Overview of Loan CDS vs. Senior Unsecured CDS
For North American Contracts. See Main Text for Major Differences in Europe.
“North America” and “Europe” refer to the location of the Reference Entity, regardless of where a trade Is executed

Loan CDS Senior Unsecured CDS


Size • 2 MM - 5 MM • 2MM - 10MM
Credit Events • Bankruptcy • Bankruptcy
• Failure to Pay • Failure to Pay
• Modified Restructuring (Selected Credits in Single-
Name CDS)
Cancelability • If syndicated secured facility no longer exists • None
Deliverable Obligations • Loans • Bonds
• Revolvers • Loans
Tenors • 3 Years and 5 Years • 1 Year - 10 Years
Settlement • Cash (Recovery rate determined through an • Physical (Cash Settlement Protocols Developing)
through an auction process).
• Ability to physically settle, provided that another
market participant is willing to take the opposite
position.
Successor Language • Relevant Obligations are Syndicated Secured • Relevant Obligations are Bonds and Loans
Additional • Designated Priority (e.g., First Lien) -
Designated Priority is a trading (not a legal)
standard.
Sources: ISDA; LSTA; Banc of America Securities LLC.

Credit Events
If an issuer defaults on LCDS Credit Events are Bankruptcy and Failure to Pay. Importantly, these Credit
just Bonds (not Loans), Events may occur anywhere within Borrowed Money, which includes Loans and
there is a Credit Event in
LCDS

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Bonds. In other words, if an issuer defaults on just its Bonds (not Loans), there still will
be a Credit Event in LCDS.

Early Termination (Cancelability)


LCDS may be terminated For North American Reference Entities, an LCDS contract may be terminated if a
if a Syndicated Secured Syndicated Secured facility is canceled and not replaced within 30 Business Days.
facility is canceled and After that day, either party may deliver an Optional Early Termination Notice to
not replaced terminate (effectively, rip up) the trade. The protection Buyer is required to pay
accrued interest up to and including the termination date.

Practical Issues in Trading LCDS


As a young market, LCDS is evolving toward standardized trading protocols, much like
senior unsecured CDS in the late 1990s and early 2000s. For example, senior unsecured
CDS uses a 40% recovery rate for almost all Reference Entities (autos and near-
distressed credits are exceptions), which facilitates consistent trading and liquidity. For
LCDS in the interim, we point out some practical trading considerations, particularly
for single names.
First, as the market tries to learn the fair value of early termination options, some
protection Sellers find it difficult to unwind profitable single-name LCDS trades. This
is because the Counterparty may argue that, for a credit that has rallied, the likelihood
of prepaying a Syndicated Secured facility rises. Therefore, a haircut should be applied
to the unwind payment, reducing the protection Seller’s profit.
Similarly, some protection Buyers find it difficult to unwind profitable trades, because
a Counterparty may argue that the recovery rate may be relatively high—for example,
85% versus a more commonly used 75%. Since a higher recovery rate would cause the
protection Buyer to make less following a potential Credit Event, the unwind payment
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declines, reducing the protection Buyer’s profit.
When marking LCDS, parties should take these issues into account. Additionally, the
LCDX index (Chapter III – CDX and iTraxx Indices page 48) may offer greater
liquidity both because of its diversification and because LCDX trades in dollar price.
Investors need not agree on haircuts and recovery rates. As long as investors can come
to the same conclusion regarding cash flows (dollar price), it does not matter how they
reach that conclusion.

Settlement
Unlike senior unsecured Unlike senior unsecured CDS trades, LCDS cash settles, using an auction process that
CDS, leveraged loan CDS resembles recent protocols for senior unsecured CDS settlement. That process is
cash settles using an described in Chapter VI – CDS Case Studies and Legal Issues on page 143. Investors
auction process who wish to physically settle may do so through the settlement process, provided that
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another market participant is willing to take the opposite position.

Succession Language
LCDS Succession
language is based on Like senior unsecured CDS, Succession language refers to potential changes in CDS
Syndicated Secured contracts if the Reference Entity is merged, acquired, or undergoes some other change
Loans to its corporate structure. However, in senior unsecured CDS, Succession criteria are

110
Post-Credit Event, the protection Buyer’s expected profit is par – recovery. Accordingly, higher recovery rates reduce expected profit.
111
A Syndicated Secured List helps determine Deliverable Obligations into LCDS contracts. The list is based on dealer polls and is administered
by Markit Group Ltd.

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based on all Bonds and Loans outstanding. LCDS Succession language is based solely
on Syndicated Secured Loans outstanding.
For example, suppose all Syndicated Secured Loans succeed to a new entity, but this
represents 25% or less of all Bonds and Loans outstanding at the Reference Entity.
Only LCDS contracts will succeed. Senior unsecured CDS trades will remain with the
original Reference Entity.
For more details on Succession language, please see Chapter VI – CDS Case Studies
and Legal Issues on page 132.

European LCDS (ELCDS)


European LCDS uses The above discussion focuses on Reference Entities based in North America. Below,
different standards we note some general differences for Reference Entities based in Europe:
X In Europe, Early Termination depends specifically on the Reference Obligation and
assets securing it. In North America, Early Termination depends on all Loans of
the Designated Priority (e.g., first lien).
X In Europe, ELCDS Deliverable Obligations are limited to the Reference
Obligation(s) or other senior loans with the same security and the same or
equivalent guarantees. Under some circumstances, unsecured debt may be
deliverable. In North America, a Deliverable Obligation may have different
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security.
X In Europe, ELCDS uses “old,” or plain vanilla, Restructuring, rather than the
Modified-Modified Restructuring (MMR) used for European senior unsecured
CDS. With the universe of Deliverable Obligations already limited, it seemed
unnecessary to include the additional maturity limitation of Modified-Modified
Restructuring.
X In Europe, physical settlement is the standard. In North America, cash settlement is
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the standard, with a settlement price determined through a market-wide auction.
X In Europe, Successor provisions depend on the Reference Obligation and its
corresponding credit agreement. In North America, Successor provisions depend
on all Loans of the Reference Entity.

Secured CDS
Secured CDS seeks to limit Secured CDS seeks to limit Deliverable Obligations to debt (usually bonds) that
Deliverable Obligations to contain particular security. For example, in 2006, the market introduced secured CDS
those bonds that contain contracts on HCA, with the intention that the only Deliverable Obligation would be
particular security
second lien HCA bonds.
The reason for secured CDS language is that, in senior unsecured CDS, the Reference
Obligation determines only the seniority, not the security, of the Deliverable
Obligation. For example, if the Reference Obligation is a senior secured bond, the
protection Buyer may deliver a senior unsecured bond, following a Credit Event.

112
The North American Deliverable Obligation still must be a loan of the Designated Priority (e.g., first lien) based on a trading standard.
113
In Europe, currently, cash settlement is possible under some circumstances but is based on an auction conducted by the Calculation Agent (in
some cases, the protection Buyer) rather than a market-wide cash settlement price. A group is working on the development of ELCDS market-
wide cash settlement mechanics. In North America, if for some reason there is no LCDS (commonly called cash settlement) auction, or the
auction fails to result in a final price, trades may revert to physical settlement.

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Secured CDS therefore makes two changes from senior unsecured contracts. First, the
Reference Obligation is changed to a secured bond from a senior unsecured bond.
Second, “secured” is added to the list of Deliverable Obligation Characteristics. This
characteristic is based on ISDA language published in June 2006 and requires that the
Deliverable Obligation be secured with at least all of the assets that secure the
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Reference Obligation.
Similar to senior unsecured CDS, should all Deliverable Obligations cease to exist—for
example, through a tender offer--then secured CDS would become near-worthless. The
protection Buyer would be required to continue to pay the CDS coupon but would not
be entitled to receive anything from the protection Seller, should there later be a Credit
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Event.

If the security were to be By contrast, an opposite result occurs if the security goes away. For example, suppose
released, a secured CDS the secured Reference Obligation were to be refinanced and the collateral package
trade would revert to simultaneously released. In this case, the trade would revert to senior unsecured
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senior unsecured CDS CDS. A regular senior unsecured CDS bond would become deliverable, should there
be a Credit Event.

Recovery Locks
Recovery locks, sometimes called recovery swaps, allow an investor to take a view on
recovery rates rather than outright default risk. For example, if an investor buys a
recovery lock at 50% and realized recovery is 60% post-Credit Event, the investor
profits 10 points.
Mark-to-market profits are based on the change in recovery rate relative to the implied
probability of default. For example, suppose an investor buys a recovery lock at 50%
and a Credit Event does not occur. But the market’s expectation for recovery increases
to 60% and the spread remains constant. Figure 135 illustrates that the investor’s mark-
117
to-market profit is $440,399 per $10 million notional.

114
“Additional Provisions for a Secured Deliverable Obligation Characteristic,” ISDA, June 16, 2006. Relevant CDS confirms specify, “Secured
Deliverable Obligation Characteristic: Applicable.”
115
We say near-worthless because, should such an obligation be issued before contract maturity, that obligation would immediately become
deliverable. We note that, in some nonstandard CDS trades, a clause “Substitute Failure Termination Date: Applicable” is inserted into a
confirm, which essentially causes the trade to be ripped up, should there be no Deliverable Obligation.
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Formally, the Deliverable Obligation Characteristic “Secured” would no longer apply.
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A wide bid-offer spread makes it difficult to realize mark-to-market gains on recovery swaps.

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Figure 135. Calculating Mark-to-Market on Recovery Locks with Unchanged CDS Spread
Investor Buys a Recovery Lock at 50% and Market’s Recovery Expectation Increases to 60% Recovery
Set Curve Recovery to False. Input original (“strike”) recovery rate on left side. Input current recovery rate in bottom-right corner. Both Deal Spread and Par
CDS Spread equal the current market spread.

Current
Spread

(Better to
Notional
use full
5y CDS credit
curve)

Original
Recovery
Rate and
Current
Spread

Current
Market
Recovery Swap Buyer Current Recovery
Profit $440,399 Rate

Sources: Bloomberg; Banc of America Securities LLC estimates.

Figure 136 illustrates an investor’s mark-to-market gain on his long recovery lock
position if the market spread widens from 500 bps to 750 bps and the market recovery
rate increases from 50% to 60%. Notice that the mark-to-market is higher than in
Figure 135. This is because a wider spread implies that a Credit Event is more likely.
As the probability of default increases, the chance that the investor realizes the 10 point
differential between the fixed recovery rate (50%) and the market recovery rate (60%)
increases.

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Figure 136. Calculating Mark-to-Market on Recovery Locks with Widening CDS Spread
Set Curve Recovery to False. Input original (“strike”) recovery rate on left side. Input current recovery rate in bottom-right corner. Both Deal Spread and Par
CDS Spread equal the current market spread.

Current
Spread

(Better to
Notional
use full
5y CDS credit
curve)
Original
Recovery
Rate and
Current
Spread

Current
Market
Recovery Swap Buyer Current Recovery
Profit $576,928 Rate

Sources: Bloomberg; Banc of America Securities LLC estimates.

Generally, recovery locks are far less liquid than single-name CDS.

CDS on ABS
CDS on ABS was decimated Credit default swaps on asset-backed securities (CDS on ABS) became popular in 2006
in price during 2007 before being decimated in price during 2007. Below, in the section, “The Decline of
ABX,” we will discuss 2007-early 2008 performance. But first we provide an overview
of CDS on ABS more generally, including Credit Events and mechanics as compared
CDS on ABS is primarily
with CDS on corporate Reference Entities.
designed for “soft” Credit
Events, such as write-downs Instead of focusing on outright default risk, CDS on ABS is primarily designed for
and shortfalls “soft” Credit Events, such as write-downs and shortfalls. The resulting structure,
illustrated in Figure 137, is called “Pay as You Go (PAUG)” CDS.
The protection Seller
must make the Buyer The protection Buyer pays a premium with the same frequency as an underlying
whole for any soft Credit Reference Obligation (denoted by a specific CUSIP in the term sheet), typically
Event monthly. In turn, the protection Seller must make the Buyer whole for any write-downs
or shortfalls. Should the underlying Reference Obligation later repay a shortfall, the
Following a soft Credit protection Buyer reimburses the Seller, with interest compounded at LIBOR.
Event, the protection Buyer
Following a soft Credit Event, the protection Buyer continues to pay the protection
continues to pay the
premium, but on a reduced notional. For example, if the CDS notional was $10 million
protection premium, but on
a reduced notional

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and an interest shortfall amounted to 5%, the protection Buyer would receive $500,000
($10 million x 5%). The protection Buyer then would pay a coupon going forward on
$9.5 million notional ($10 million – $500,000).
Alternatively, following any soft Credit Event, the protection Buyer has the option to
Alternatively, the protection force Physical Settlement, as illustrated in Figure 138. Similar to CDS on corporate
Buyer has the option to credit, the protection Buyer delivers an ABS bond (the specific Reference Obligation
force Physical Settlement noted on the term sheet) and the protection Seller pays the notional amount of
protection.
Although the ability to physically settle technically exists, we note that it may be
difficult to execute, as the underlying Reference Obligation in ABS is often not
sufficiently liquid in large quantity. Growth in the CDS on ABS market during 2006
brought the market to a more Pay As You Go-focused system.
Figure 137. Pay As You Go (PAUG) CDS Figure 138. Optional Physical Settlement
Seller Provides Protection for “Soft” Credit Events Difficult to Execute, Because Hard to Get the Bond
Premium

Buyer Write Downs Seller


Deliver ABS Bond
Interest Shortfalls Buyer Seller
Par Amount

Shortfall Reimbursement
See Figure 139 for details on Credit Events. Source: Banc of America Securities LLC estimates.
Payments are made with the same frequency as the underlying Reference
Obligation, typically monthly.
Source: Banc of America Securities LLC estimates.

Pay As You Go (PAUG) CDS


Figure 139 compares key features of CDS on corporate credit with CDS on ABS:

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Figure 139. Comparison of CDS on Corporate Credit, versus CDS on ABS (Pay as You Go)
PAUG CDS Generally Provides Protection for “Soft” Credit Events

Unsecured CDS (Corporates) CDS of ABS (PAUG)


Reference Obligation • Any Bond or Loan issued by the Reference Entity • Unique issuance specified by a CUSIP
Reference Notional • Fixed over the life of the trade • Amortizing
Credit Events • Bankruptcy • Failure to Pay Principal
• Failure to Pay • Writedown
• Modified Restructuring (Selected Credits in Single- • Distressed Ratings Downgrade
Name CDS) • Maturity Extension
Settlements • Cash or Physical • Optional Physical
Soft Credit Events • Not Applicable • Interest Shortfall
• Principal Shortfall
• Writedown
Maturity • Stated • Legal Final Of Reference Obligation
Source: Banc of America Securities LLC estimates.

Fixed vs. Variable Caps


Pay As You Go CDS has a Following a Soft Credit Event, Pay as You Go CDS has a cap to limit the liability of
cap to limit the liability the Seller of protection. There are two types of caps, fixed and variable. A fixed cap
of the protection Seller limits liability to the annual protection premium. A variable cap limits liability to
LIBOR plus the annual protection premium. Currently, the market appears to be
evolving toward a fixed cap. Figure 140 compares the two caps:
Figure 140. Comparison of Fixed and Variable Caps
Based on a Premium of 150 Bps Per Annum
In a Fixed Cap, Protection Seller’s Liability is Capped at the Premium
In a Variable Cap, Protection Seller’s Liability is Capped at LIBOR + Premium

Fixed Cap Variable Cap


CDS Buyer CDS Seller CDS Buyer CDS Seller
No Credit Event Pays 150 bps Pays 0 bps Pays 150 bps Pays 0 bps
Interest shortfall of 100 bps Pays 150 bps Pays 100 bps Pays 150 bps Pays 100 bps
Interest shortfall of 200 bps Pays 150 bps Pays 150 bps Pays 150 bps Pays 200 bps
Variable cap interest shortfall of 200 bps scenario assumes that LIBOR is at least 0.50%. Otherwise, the CDS Seller’s liability would be capped at LIBOR + 150 bps.
Source: Banc of America Securities LLC estimates.

In the case of No Credit Event, the protection Buyer pays 150 bps and the Seller pays
nothing. Following an Interest Shortfall of 100 bps, the Seller pays the Buyer 100 bps
for both types of cap. This is because the Interest Shortfall is less than the annual
protection premium.
While a fixed cap limits However, should there be an Interest Shortfall of 200 bps, the protection Seller pays the
liability to the annual Buyer only 150 bps, because liability is capped at the annual premium. Under a
protection premium, a variable cap, the protection Seller pays the Buyer the full 200 bps. (We assume that
variable cap limits liability LIBOR is at least 0.50%. Otherwise, the protection Seller would pay the Buyer LIBOR
to LIBOR plus the annual + 150 bps. LIBOR is typically set at a one-month maturity.)
protection premium

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ABX and CMBX Indices


ABX is an index of Home To provide relatively liquid access to the CDS of ABS market, in 2006, the market
Equity Loans introduced a series of indices on Home Equity Loans, called ABX. There are six
indices, based upon the rating of the Reference Obligations: Penultimate AAA (second-
to-last AAA cash flow), AAA (last AAA cash flow), AA, A, BBB, and BBB-. The
BBB and BBB- tranches dominated volume until late 2007, when severe expected
losses pushed volume up the capital structure.
Like the CDX HY index, ABX is quoted in dollar price, with a fixed coupon. As such,
the “Buyer” of the index is like the protection Seller. The “Seller” of the index is like
the protection Buyer.
The ABX index uses a fixed cap equal to the coupon rate (recall Figure 140) and is
intended to roll twice annually, around January 19 and July 19. Credit Events are soft
and include Interest Shortfall, Principal Shortfall, and Writedown. The index is cash
118
settled.

Key Features of ABX Indices


A dealer consortium selects 20 deals among the 25 largest issuers as ranked by sub-
prime home equity issuance. Unlike the CDX and iTraxx indices, there is no overlap
between various series of the ABX index. Deals must meet the following criteria:
X No more than four deals with loans from the same originator
X No more than six deals with the same master servicer
X Issued within the prior six months
X Offering size of at least $500 million
X At least 90% of deal’s assets in first lien mortgages
X Weighted average FICO score of less than 660
th
X Pays on the 25 of each month
X Pays interest at a floating rate benchmark of one-month LIBOR
X Has AA, A, BBB, and BBB- indices with a weighted average life longer than 4
years, and a AAA index with an average life longer than 5 years
X Must be rated by Moody’s and S&P. The lesser of the two ratings applies.

The Decline of ABX


The ABX indices served Since February 2007, record weak performance in subprime mortgages has driven
as a gauge for ABX prices down, to single digits in some cases. See Figure 141. The ABX indices
performance of securities also have served as a gauge for overall performance of securities backed by subprime
backed by subprime mortgages, especially for participants in other markets who are less familiar with ABS
mortgages and RMBS securities.

118
Unlike single-name CDS of ABS, the protection Buyer does not have the option to force physical settlement following a soft Credit Event.

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Figure 141. ABX 07-1 Price Performance


“07-1” Means First ABX Series Issued in 2007, Covering Deals Issued in the Second Half of 2006

120 AAA A BBB-

100

80
Index Price ($)
60

40

20

0
Jan-07 Mar-07 May-07 Jul-07 Sep-07 Nov-07 Jan-08 Mar-08
Sources: Markit; Banc of America Securities LLC estimates.

Owing to the collapse in subprime securities, not enough reference deals were issued in
the second half of 2007 to create the ABX 08-1 (first series of 2008) index under
current rules. Dealers decided to postpone the creation of a new index until more
securities become available as opposed to changing the criteria for inclusion in the
index.

Key Features of CMBX Indices


Similarly, CMBX is an Similarly, the CMBX index references 25 commercial mortgage-backed securities.
index of commercial Similar to ABX, there are six separate indices by rating: AAA, AA, BBB, BBB-, and
mortgage-backed 119
BB, which roll approximately every April and October 25. However, unlike ABX,
securities CMBX is quoted in spread, not price. Reference Obligations must meet the following
criteria:
X Must be a debt or pass-through security referencing a pool of fixed-rated securities
X Must be secured by obligations from at least 50 separate mortgages among at least
10 unaffiliated borrowers
X Issued within the prior two years
X Offering size of at least $700 million
X No more than 40% of underlying obligations from the same state
X No more than 60% of underlying obligations of the same property type
X Factor of 1.0

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The BB index began with the 06-2 series; that is, the second CMBX series issued in 2006.

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X AAA index references the bond from each deal that is composed of the most credit
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enhanced tranche, with the longest average life.
X AAA index must reference publicly issued securities. AA, A, BBB, and BBB-
indices may reference publicly or privately issued securities.
X Must be rated by at least two of Moody’s, S&P, and Fitch. The weakest of all
ratings applies.

Soft Credit Event Example: Interest Shortfall


Example of a soft Credit On November 27, 2006, the BBB- tranche of the ABX 06-1 Series had an Interest
Event Shortfall of $117.86 per $1 million of index notional. “06-1” means the first ABX
series issued in 2006. This shortfall resulted from losses on the M9 bond of Structured
Asset Investment Loan Trust 2005-HE3 and the M9 bond of Long Beach Mortgage
Loan Trust 2005-WL2.
On the next monthly coupon date, December 25, 2006, the Seller of the index
(effectively, the protection Buyer) normally would pay $2,150.83 per $1 million of
index notional. This comes from a coupon of 267 bps per annum, multiplied by a factor
of one, times 29 actual / 360 total days in the coupon period.
To monetize the Interest Shortfall, the Seller of the index will pay just $2,032.97
($2,151 regular payment – $117.86 interest shortfall, multiplied by a factor of one).
Note that, technically, the coupon date and the Interest Shortfall reimbursement are two
separate cash flows. In practice, they are netted in one payment. Should the shortfall
later be repaid, the protection Buyer must reimburse the Seller, with interest
compounded at LIBOR.
Going forward, the protection Buyer will continue to pay a coupon of 267 bps per
annum (paid monthly) on a notional of $1 million, multiplied by a factor of one. The
notional and factor are not affected by an Interest Shortfall.

CDS on CLOs
CDS on CLOs also Traditionally, risk exposure on CLOs was limited to long positions, by either holding a
focuses on soft Credit cash position or using a total return swap. CDS on CLOs allows an investor to take an
Events unfunded long or short position and focuses on soft, Pay As You Go Credit Events.
CDS on CLOs largely focuses on recent vintage single-A to double-B tranches.
Protection Sellers include CLO asset managers, hedge funds, principal finance groups,
and trading desks.
Protection Buyers include dealers, to hedge new issue origination and pipeline risk;
traditional cash CLO buyers, to hedge tranche-specific risk; and hedge funds, principal
finance groups, and trading desks.

Preferred CDS (“PCDS”)


Preferred CDS adds a Preferred CDS references Preferred Securities, meaning obligations that:
Credit Event called
“Deferral of Payment,” X Are subordinated to other debt obligations, and
which affords protection X Provide for deferral of interest or other scheduled payments on an optional or
against missed dividend mandatory basis, and
payments
120
In addition, the AAA index must reference bonds with a weighted average life of 8-12 years, based on 0% constant prepayment yield at
issuance and an initial issuance size of at least $100 million.

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X Receive at least partial treatment as equity from at least one U.S. nationally
recognized ratings agency.
The protection Buyer pays quarterly coupons in exchange for protection against hard
Credit Events, which include Bankruptcy, Failure to Pay, Modified Restructuring (for
selected Reference Entities), and Deferral of Payment. “Deferral of Payment” means
that, after any applicable Grace Period expires, the Reference Entity or any Related
Trust Preferred Issuer:
X Fails to pay a dividend or other distribution, in whole or in part, or
X Fails to pay a dividend or other distribution in cash, but instead pays the dividend
in additional Preferred Securities, common stock, or other equity interests, or
X Otherwise defers a scheduled dividend or other distribution, in whole or in part.
Deferral of Payment applies only to Preferred Securities but occurs regardless of
whether any terms of the securities permit them to transpire. For example, Trust
Preferred (TruP) and recently issued hybrid securities typically allow the issuer to miss
20 dividend payments before the issuer is deemed to be in default. By contrast,
Preferred CDS triggers a Credit Event three Business Days after the first missed
dividend payment. As such, the PCDS protection Buyer has a benefit not afforded by
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the underlying security.
For a Bankruptcy, Failure to Pay, or Modified Restructuring, Deliverable Obligations
are Preferred Securities, Bonds, and Loans. For a Deferral of Payment, Deliverable
122
Obligations are Preferred Securities only.
Not surprisingly, PCDS Succession criteria are limited to Preferred Securities
outstanding rather than the Bonds and Loans used in senior unsecured CDS. For more
details on Succession language, please see Chapter VI – CDS Case Studies and Legal
Issues on page 132.

Accounts Receivable CDS


Accounts Receivable CDS Standard CDS contracts require that the protection Buyer deliver a Bond or Loan.
allows the protection While extremely useful to the overall financial market, these contracts may be less
Buyer to assign Accounts useful to suppliers of physical goods (inventory), who are more concerned about the
Receivable, rather than recovery rate on Accounts Receivable. For example, the suppler of inventory to a
deliver a Bond or Loan grocer may wish to protect against a potential Credit Event at that grocer, using the
recovery rate on the inventory. To this end, Accounts Receivable CDS allows the
protection Buyer to assign Accounts Receivable to the protection Seller, at a pre-
determined price. This process effectively eliminates basis risk between the recovery
rate on a Bond or Loan, versus Accounts Receivable.
The terms of these contracts are customized, primarily to help suppliers to maintain
shipments during periods of financial stress or alleviate concentration risk. Accounts
Receivable CDS typically matures after three months – two years and may involve
running coupons or a single up-front payment.

121
Indentures for Preferred Securities typically do not specify a Grace Period for missed dividend payments, because the issuer is allowed to
miss them. In this case, Preferred CDS triggers a Credit Event three Business Days after the first missed dividend payment. However, if the
indenture specifies a Grace Period, that period must be breached before Preferred CDS triggers a Credit Event.
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Assuming the protection Buyer triggers the contract and the only Credit Event is a Deferral of Payment, only Preferred Securities are
deliverable. The reason is that only the price of Preferred Securities (not senior unsecured bonds, for example) should be affected by a
Deferral of Payment. However, if the protection Seller triggers the contract, this limitation does not apply. The logic is that, because the
protection Seller forces the Buyer to settle, the protection Buyer should have the option to deliver obligations across the capital structure
(Preferred Securities, Bonds, and Loans). As such, the protection Seller islikely to prefer not to trigger a Deferral of Payment Credit Event.

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Private Institutional CDS


Private Institutional CDS Private Institutional CDS allows investors to obtain exposure to companies that issue
allows investors to obtain 123
private placement, rather than publicly traded, debt. This debt may be rated or
exposure to companies unrated, secured or unsecured. Credit Events are Bankruptcy and Failure to Pay.
that issue private Private Institutional CDS typically matures in three to seven years.
placement, rather than
publicly traded, debt Unlike standard CDS, Private Institutional CDS is typically callable, by the protection
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Buyer, with the exact details negotiated at the time of the trade. The Settlement
mechanism is chosen at trade inception, and may use Physical Settlement, Fixed
Recovery Settlement, or Modified Physical Settlement. Fixed Recovery settlement is
similar to cash settlement, with a recovery rate pre-determined at trade inception.
Modified Physical settlement refers to Physical Settlement, with Cash Settlement as a
backup, in case the Counterparties are unable to locate a Bond or a Loan to deliver into
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the trade.

Appendix VII – Other Credit Derivatives Products


Structured Credit Market Basics
This section provides an overview of the structured credit market. For a more detailed
explanation of correlation products, please see our Guide to Single-Tranche CDOs:
Correlation Products in Plain English, December 21, 2004.

Single-Tranche CDOs (STCDOs)


Perhaps the most prominent product in structured credit is the single-tranche CDO. In a
single-tranche CDO, investors buy or sell protection on a pool of credit default swaps
instead of single names. That pool is then “tranched” in a way similar to ABS securities
and cash CDOs so an investor has subordination before suffering a potential loss of
principal. Figure 142 shows the liquid tranches of the CDX IG index.

123
Specifically, Private Institutional CDS affords protection against debt that falls under section 4(2) of the Securities Act of 1933, which states
that transactions by an issuer that do not involve any public offering are exempt from SEC registration requirements.
124
Under specific circumstances, such as a Succession Event, the protection Seller may be able to terminate a trade.
125
After delivery of a Notice of Physical Settlement, the protection Buyer has 30 Business Days to deliver a Bond or Loan. If the Protection
Buyer does not deliver a Bond or Loan, a 60 Business Day flip-flop procedure begins, in which the protection Seller and Buyer alternate every
10 Business Days as being the party responsible for locating a Bond or Loan. If neither party has located a Bond or Loan by this time, then a
poll is conducted across three secondary traders. The average of at least two quotes is used as a Cash Settlement price. If fewer than two
quotes are obtained, then protection becomes worthless.

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Figure 142. Tranches on CDX IG, or More Generally, STCDOs


Senior
Tranches
Standardized CDX
Selected
Tranche IG Tranches

CDX IG 0% - 3% (First Loss)


Subordinated 3% - 7% (Jr Mezzanine)
Tranches 7% - 10% (Mezzanine)
10% - 15% (Senior)
15% - 30% (Senior)
30% - 100% (Senior)

Source: Banc of America Securities LLC estimates.

An investor who sells protection on the 7%–10% CDX IG tranche has 7%


subordination. He suffers no loss of principal until 7% of the underlying CDX IG index
is wiped out. See Figure 143. Assuming an equally-weighted portfolio and 40%
recovery rate, 7% subordination implies that 11.66% of Reference Entities in the
underlying portfolio would need to suffer a Credit Event before the 7%-10% tranche
126
investor lost principal. If the CDX IG index loses 10% of principal, the 7%-10%
CDX IG tranche will be wiped out. In structured credit lingo, 7% is known as the
“attachment” point and 10% is known as the “detachment” or “exhaustion” point.

126
7% subordination / 60% loss rate per Credit Event. 60% loss rate is par – 40% recovery rate.

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Figure 143.
How CDX IG 7%–10% Tranche Principal Losses Compare with CDX IG Principal Losses
Dollar Losses on 7% − 10% Tranche vs. Dollar Losses on CDX IG
Assumes Notional of $100 million

CDX IG Index
CDX IG 7% - 10% Tranche
100

Loss ($ Millions) 80

60

40

20

0
0 10 20 30 40 50 60 70 80 90 100
LCDX Index Loss ($ Millions)

Source: Banc of America Securities LLC estimates.

Investors with a high risk appetite and desire for yield may prefer tranches with little or
no subordination, while those with lower risk appetites may prefer higher levels of
subordination. Higher levels of subordination decrease the likelihood of principal loss,
and correspondingly, spread.
Market Participants
At senior level attachment points, longer-term, hold-to-maturity investors such as
insurers are large protection sellers. By contrast, at the equity (first loss) level, hedge
funds are large protection sellers. Equity tranche investors may hedge risk by buying
protection on single-name CDS, the credit default indices, or more senior tranches.

The Correlation Crisis of May 2005


Mezzanine-hedged equity In May 2005, mezzanine-hedged equity strategies (long equity risk, short mezzanine
strategies backfired in risk) backfired. Spreads on equity tranches widened greater than model estimates,
May 2005 while mezzanine tranche spreads actually tightened, even as spreads in the underlying
portfolio widened.
The mismatch in the mezzanine-hedged equity strategy began with an increase in
The mismatch began with fundamental risk to the equity tranche, as idiosyncratic risk—that is, significant
an increase in individual issuer spread risk—increased. As the first loss investor, almost all this
fundamental risk to the increase in idiosyncratic risk hit the equity tranche. A forced unwind followed,
equity tranche, as prompting a second leg lower, as illustrated in Figure 144:
idiosyncratic risk
increased

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Figure 144. Mezzanine-Hedged vs. Index-Hedged Equity P&L


Delta-Hedged with the Index (Red Line) or Mezzanine (3% – 7%) Tranche (Gray Line)
1 Apr 05—10 May 05, Opening Marks

0-3 Hedged with Index 0-3 Hedged with IG 3-7

-200

-700
P&L (000) Initial leg lower reflected risk of
significant single-credit spread widening,
-1200
from LBOs, autos, and auto parts
-1700
Forced unwind accelerates losses in
mezzanine-hedged equity
-2200
1-Apr-05 10-Apr-05 19-Apr-05 28-Apr-05 7-May-05

Source: Banc of America Securities LLC estimates.

The amount of spread One way to think of spread movements across the tranches is as follows. With the
available to other dramatic move lower in equity, more and more of the overall index spread widening
tranches declined, was allocated to the equity portion of the tranche structure. The total spread change
allowing mezzanine across the tranches must add up back to the index level. Hence, the amount of spread
tranche spreads to available to other tranches declined, allowing mezzanine tranche spreads to actually
actually tighten tighten. In reality, the move toward tighter mezzanine tranches in the face of wider
index spreads probably reflected the unwind of existing correlation trades that were
long equity risk and short mezzanine risk.
Spillover to the Broader Credit Market
We also saw clear spillover to the credit index markets. To see this impact, consider the
following chart:

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Figure 145. Model Error: Model Forecasted vs. Actual Spread Widening in 7% – 10% Tranche
Investment Grade (CDX IG) Indices
Dealers and hedge funds rehedged to reduce the mismatch between expected and actual

Expected Spread: IG 7-10 Hedged With Index


110 Actual Spread: IG 7-10

Expected or Actual Spread (bps)


IG Index Spread
100
90
80
70
60
50
40
16-Mar-05 26-Mar-05 5-Apr-05 15-Apr-05 25-Apr-05 5-May-05

IG index spread reflects on-the-run five-year index (Series 3 until 20 Mar 05, Series 4 beginning 21 Mar 05).
Source: Banc of America Securities LLC estimates.

The thin red line indicates the model forecasted spread change for the 7%–10%
(indicative AAA) tranche. The thick gray line indicates the actual 7%–10% tranche
spread, and the broken line illustrates the underlying investment grade index spread.
Based on model estimates, from March 16, 2005 to May 10, 2005 the expected spread
widening in the 7%–10% tranche was 54 bps (from 55 bps to 109 bps). During the
same time period, the underlying investment grade index widened 24 bps, implying an
expected leverage of about 2.25 times (54 bps divided by 24 bps). Now look at what
actually occurred. The 7%–10% tranche tightened, creating negative leverage, a highly
unexpected result.
Typically, long positions in higher-quality (senior) portions of the tranche market are
held by longer-term, hold-to-maturity investors such as insurers. The corresponding
short position is typically held by dealers and hedge funds. To offset their risk, dealers
127
(or hedge funds) typically sell protection on the CDX index. For example, at an
anticipated model leverage of 2.25x, dealers sold protection on about $22.5 million of
index protection for every $10 million in senior (7%–10%) tranche exposure. As a
source of positive carry, this position was naturally attractive to the dealer and hedge
fund community.
However, it turned out that rather than being 2.25x the risk of the index, the 7%–10%
At the extreme, not only tranche tightened as spreads widened. Hence, not only did dealers and hedge funds lose
was the hedge ratio off money on the short position in the tranche, they also lost money on the hedge position.
(too high), but it was the At the extreme, not only was the hedge ratio off (too high), it was the wrong sign. See
wrong sign Figure 146. On days when the overall market moved wider, senior tranches widened
less than expected, causing hedge mismatches on correlation books.

127
In reality, there is a mixture of index and single-name hedging. For simplicity, we focus on CDX index hedging.

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Figure 146. The Hedging Mismatch


Model-Predicted versus Empirical Leverage
1 Apr 05 – 25 May 05

Model-Predicted Empirical
40
35
30

Leverage (x)
25
20
15
10
5
0
-5
-10
Equity (0% - Mezzanine Senior (7% - 10% - 15% 15% - 30%
3%) (3% - 7%) 10%)

Model-predicted leverage shown as of April 1, 2005.


Source: Banc of America Securities LLC estimates.

Dealers and hedge funds To adjust for the mishedge, the hedge ratio needed to be reduced. That is, dealers and
needed to reduce their long hedge funds needed to reduce their long position in the index, which led to significant
position in the index, which buying of protection. This is why we saw investment grade spreads move wider.
led to significant buying of
protection Leveraging Credit
Following the May 2005 correlation crisis, dealers examined the strategies that led to
losses. Some dealers turned their attention to traditional, hold-to-maturity investors and
more conservative hedging strategies. The then-extremely tight credit spread
environment, illustrated in Figure 147, caused traditional investors to search for yield
without hurting the ratings quality of their portfolio. Figure 148 illustrates that
structured credit appeared to offer that opportunity.

Figure 148. …Sending Investors to Structured Credit


Figure 147. High Grade Corporates Offered Limited Spread… 10y CDX IG Index Indicative Rating: BBB+
10y Sector 10y CDX IG 7%-10% Tranche Indicative Rating: A-

700 700 10y CDX IG Index


Cash Spread to Swaps (bps)

10y CDX IG 7%-10% Tranche


600 600
500 500
10y Spread (bps)

Structured Credit
400 Offers Yield Pick Up
400
300
300
200
100 200

0 100
Mar- Sep- Mar- Sep- Mar- Sep- 0
05 05 06 06 07 07 Mar-05 Sep-05 Mar-06 Sep-06 Mar-07 Sep-07

Banc of America Securities High Grade Broad Market Index Source: Banc of America Securities LLC estimates.
Source: Banc of America Securities LLC estimates.

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The search for yield while maintaining (then-) ratings led to the development of new
products. These products tended to mitigate default risk and increase mark-to-market
risk by adding leverage. Two such important products are the leveraged super senior
and Constant Proportion Debt Obligation (CPDO).
Leveraged Super Senior
A leveraged super senior breaks down risk into two components, default risk and mark-
A leveraged super senior to-market risk. Default risk works the same as the typical tranche subordination
breaks down risk into two structure—for example, the tranche begins to lose principal after 15% of the underlying
components, default risk portfolio has suffered losses. Mark-to-market risk is based on the weighted averaged
and mark-to-market risk spread of the underlying portfolio. If the underlying portfolio spread reaches a
predetermined threshold, either the trade is terminated at mark-to-market levels or the
investor increases cash collateral. If spreads then tighten back through the mark-to-
market trigger, the investor gets back the extra collateral. The mark-to-market trigger is
typically set so that the overall structure has a triple-A rating. Figure 149 shows a
sample structure:
Figure 149. How a Senior Tranche Compares to a Leveraged Super Senior Tranche
Leveraged Super Senior Has Both Loss Rate and Mark-to-Market Triggers
Initial underlying portfolio spread is 80 bps

400 Loss to Leveraged Loss to


Underlying Portfolio Spread (bps)

350 Super-Senior Only Both Loss to Leveraged


300 Structure Super Senior.
250 s 7% - 10% Already
200 Mark-to- Lost All Notional.
Market Trigger
150 Loss
100 to 7% -
50 Original Portfolio Spread 10% Only
0
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Loss Rate (%)
Sample portfolio structure. Mark-to-market trigger shown at trade inception.
Source: Banc of America Securities LLC estimates.

In the senior (7%–10%) tranche, losses begin at 7% of the underlying portfolio and all
tranche notional is exhausted after losses in 10% of the underlying portfolio. Similarly,
the leveraged super senior (15%–30%) tranche suffers losses due to default risk at 15%
and exhausts all notional at 30% of the underlying portfolio.
In addition, the leveraged super senior has a mark-to-market trigger identified by the
downward-sloping line. If in the first year there are no losses in the underlying
portfolio and the weighted average spread exceeds 320 bps, the investor loses principal.
Similarly, if losses are 4% in the first year, the investor loses principal if the weighted-
average spread exceeds 250 bps. The triggers are set so that the overall mark-to-market
loss on the portfolio is roughly constant throughout.
Particularly between 2005 and early 2007, Canadian conduits issued commercial paper
and used the proceeds to buy then-highly rated assets like triple-A CMBS, cash CDOs,
and leveraged super seniors. The commercial paper’s interest cost was less than the

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Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

spread paid by the assets held in the conduit, with the difference taken as a fee for the
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conduit sponsor.
Figure 150 illustrates the underperformance of the CDX IG super senior (30% -100%)
tranche during the credit crunch. The underperformance of the senior portion of the
tranche capital strucucture caused some leveraged super seniors to breach or
renegotiate unwind triggers.

Figure 150. Super Senior Spreads Widen Significantly… Figure 151. … Causing Leveraged Super Seniors to Approach
Market Value Triggers
If the Leveraged Super Senior trips a market value trigger, the investor
may have to post more collateral
80 CDX IG 30%-100% Tranche
10y 10y CDX IG170
Index Leveraged Super Senior Price
70 Market Value Trigger

10y CDX IG Index Spread (bps)


150 100
10y CDX IG 30% - 100%
Tranche Spread (bps)

60

Super Senior NAV ($)


90

Estimated Leveraged
130
50
40 110 80
30 70
90
20
70 60
10
- 50 50
Jun-07 Aug-07 Oct-07 Dec-07 Feb-08 Jun-07 Aug-07 Oct-07 Dec-07 Feb-08
On-the-run CDX IG series. Example leveraged super senior product beginning March 22, 2007 with 10x leverage. We
Source: Banc of America Securities LLC estimates. estimate the tranche P&L by using the on-the-run 10y CDX IG index 30%-100% tranche
spread.
Market value trigger is an example; actual triggers vary by deal.
Source: Banc of America Securities LLC estimates.

Constant Proportion Debt Obligations (CPDOs)


A CPDO is a rolling five-year combination of the US and European investment grade
CDS indices (CDX IG and iTraxx Main). This product often has 15 times initial
leverage with a ten-year maturity. In the first round of issuance (2H06), CPDOs offered
a triple-A rated spread of approximately Euribor+200 bps.
The CPDO investor always has the five-year on-the-run index even though the
structure has a ten-year maturity date. In other words, every six months, any credit that
suffers a downgrade to high yield (split-rated or worse) would be dropped out of the
index and therefore dropped out of the structure. This resulted in an S&P triple-A
rating on the logic that the main risk was that an investment grade-rated credit could
default within a six-month interval.
Additionally, CPDOs achieved their high credit rating through the expected
accumulation of reserves (the excess of coupon income earned over coupons paid out).
For example, in late 2006, the average spread for five-year IG and iTraxx was roughly
30 bps. At 15 times leverage, the funded structure therefore earned three-month
Euribor+450 bps. Now subtract a coupon of Euribor+200 bps and fees of roughly 20

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There were also costs associated with creating and servicing the conduit.

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Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

bps, for net income (reserves) of approximately 230 bps. Reserves were made available
for potential losses from future defaults.
However, Figure 152 shows the historical 5 year CDX IG, 5 year iTraxx and the
blended spread between the two indices. When CPDOs were initially issued, the
blended spread was around 30 bps, but that during the wides in March of 2008, spreads
were closer to 175 bps. Figure 153 shows that the significant widening in IG and
iTraxx caused CPDOs to approach and, in some cases even breach, their forced unwind
triggers, which were set to an NAV of $10.

Figure 152. Historical 5y CDX IG, iTraxx and Blended CDX IG Figure 153. CPDOs Approached Unwind Levels
and iTraxx Spread
CPDOs performance based on the blended spread of CDX IG and iTraxx
From October 2, 2007 to April 15 , 2008

250 5y CDX IG NAV


Blended Spread Unwind Trigger

Blended 5y Index Spread (bps)


200 5y iTraxx 120 Blended Spread 200
5y CDS Spread (bps)

100
150 150
CPDO NAV ($)
80
100 60 100
40
50 50
20
0 0 0
Oct-06 Feb-07 Jun-07 Oct-07 Feb-08 Oct-06 Feb-07 Jun-07 Oct-07 Feb-08
Source: Banc of America Securities LLC estimates. Source: Banc of America Securities LLC estimates.

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Glen Taksler 646.855.7559
Credit Strategy Research 35
May 27, 2008

Chapter VIII – Glossary


ABX (page 175) – Index of credit default swaps on asset backed securities.
Assignment (page 110) – A trade transferred by an investor to another party. From the investor’s perspective, the trade is
terminated. In reality, the trade continues between the original Counterparty and the new party. Same as novation.
Asset Swap Spread (page 36) – Spread over LIBOR that an investor earns to swap a fixed-rate corporate bond to LIBOR-
based floating payments. Discounts the premium or discount portion of cash flows at LIBOR flat. Also see Par CDS
Equivalent Spread, Z-Spread, and I-Spread.
Attachment Point (page 179) – The level of cumulative losses in an underlying portfolio, at which a tranche begins to
suffer princ