March 05 2008
Credit derivatives originated in 1999, yet there are just over 10 credit derivative product companies (CDPCs). CDPCs have been described as highly rated, capital-efficient and successful managers of diverse and complicated risk, but why have so few made it to market?
CDPCs are AAA-rated companies whose sole purpose is to make a profit for their investors from the premiums received from selling credit protection. This credit protection is usually highly leveraged against the CDPC’s assets, sometimes up to sixfold, making a AAA rating for a new company with obligations far in excess of its assets both essential to attract business and difficult to achieve. The road to market is long and hazardous and few arrive.
Established sponsors or parent companies create a CDPC and inject vast sums of capital to provide it with an attractive capital base. Further investment - enough to ensure that the CDPC obtains a AAA rating - comes from debt and capital investors. Once the CDPC is writing credit default swaps, the incoming credit protection premiums boost its reserves, especially since the CDPC can leverage itself by selling credit protection on low-risk reference entities for many times the CDPC’s capital value. The capital is invested in highly rated securities, much as it would be in a synthetic collateralized debt obligation. The core CDPC strategy is 'buy to hold' - sell credit protection, but do not trade it. The strategy is intended to buffer the CDPC against market volatility and provide the rating agencies with modelling certainty in return for the AAA rating that drives the CDPC model. Credit default swap counterparties can obtain full regulatory capital relief and be confident that if a credit event occurs, their credit derivative contract will be honoured. However, the permitted levels of leverage mean that CDPC investors make a good return on their investments.
In 1999, when the idea of CDPCs was first devised, derivative product companies were not new. Entities dedicated to trading interest rate risk had existed since the early 1990s.
Primus Financial Products was the first credit derivative product company in the market, attaining its AAA rating in 2002 after three years of negotiation. After going public in 2004, Primus diversified from selling single-name, highly rated credit default swaps into non-investment grade credit default swaps and more complex credit derivative products.
In contrast, Athilon Structured Investment Advisers launched at a time of wide credit spreads in December 2004 and focused on selling protection on super senior tranches of collateralized debt obligation debt. This trend towards selling credit protection through more complex structured products was the result of growing market confidence in CDPCs, the CDPCs' increased expertise and the rating agencies' willingness to maintain a AAA rating.
CDPCs depend on their AAA rating and rating agencies understandably set strict criteria for a new entity with no trading history and liabilities in excess of its assets. In order to obtain a AAA rating, CDPCs must pass rigorous modelling, disclosure and risk framework tests.
A CDPC’s principal selling point is its rating, in terms of both the debt it issues to fund its capital base and its counterparty rating when selling credit protection. The rating agencies are involved at many levels and much of their scrutiny during the structuring stage focuses on the CDPC’s capital funding structure. CDPC sponsors must develop intricate capital models, business models, operational structures and infrastructure plans complying with stringent rating agency criteria - a lengthy and costly process involving planning, structural analysis and hard negotiation.
An obligation to provide transparent reporting is closely related to avoiding collateral posting requirements. Credit protection buyers want to ensure that they will be paid if a credit event occurs. The AAA rating ensures that the CDPC will not have to enter into credit support arrangements with its counterparty in order to support such potential obligations, as to do so would destroy the leverage provided by selling credit protection far in excess of the capital base, which is the element of the business model that makes CDPCs so attractive. CDPCs must justify their rating by maintaining market and counterparty confidence, offering investors and counterparties access to performance and trend information on their portfolio. If they do so, counterparties will be prepared to enter into credit default swaps with CDPCs without credit support.
Rating agencies seek evidence that the CDPC is independent of its sponsor, especially if the sponsor is an established institution. When analyzing the CDPC’s infrastructure and the operative guidelines, rating agencies look for indications that the CDPC has sufficiently robust systems to handle portfolio management, manage exposure and carry out risk analysis. The CDPC must also be competent to manage the day-to-day operations of trade settlement, documentation, credit event mechanics and accounting. These infrastructure requirements may be more easily met if the CDPC has an institutional sponsor with sophisticated back-office expertise, but the rating agencies will be keen for such a relationship to be kept at arm’s length.
Characteristics and risks
The key characteristics of a successful AAA CDPC structure are:
The key risk factors in a CDPC structure are:
The CDPC road to market is time consuming and costly. Rating agencies and the market require CDPCs to have at least a $100 million capital base. Setting up the trading and portfolio management infrastructure involves operational costs and complexities, as well as the lengthy rating agency approval process and legal and other third-party costs.
The future is uncertain. In the fallout of structured credit product downgrades, rating agencies may feel that they are suffering a confidence crisis and may react by scrutinizing CDPCs more closely. However, if spreads widen, market conditions may favour the creation of new CDPCs, several of which are in the pipeline.
For further information on this topic please contact Ed Parker or Melanie Barrow at Mayer Brown International LLP by telephone (+44 20 7248 4282) or by fax 44 20 7248 2009) or by email (email@example.com or firstname.lastname@example.org).
An earlier version of this update first appeared in Derivatives Week.
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