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SPV: Special purpose vehicle
Collateral securities
FIGURE 3.5 Schematic of a credit-linked note.


to a long-dated risk-free reference rate of interest (e.g., a five-year Treasury
bond yield) in exchange for receiving a cash flow linked to a floating rate
of interest (e.g., six-month Libor). In practice, the two parties to a swap typ-
ically net the relevant cash flows such that only one payment actually is
made. Thus, if investors believe that credit spreads may widen, an interest
rate swap may be just the ticket. Investors will want to set up the swap such
that they are paying the risk-free rate (the Treasury rate) and receiving the
credit rate (as with Libor).
Accordingly, swap investors will benefit under any one of these five sce-

1. The level of both the relevant Libor and Treasury rates rise, but Libor
rises by more.
2. The level of both the relevant Libor and Treasury rates fall, but Libor
falls by less.
3. The level of Libor rises while the Treasury rate stays the same.
4. The level of the Treasury falls while Libor stays the same.
5. The level of the Treasury falls while Libor rises.

Examples to correspond to each of these follow:

1. In a bear market environment (rising yields) that is exacerbated by eco-
nomic weakness, as was the case in 1994, yield levels of all bonds will
tend to rise, though the yields on credit-sensitive securities will tend to
rise by more as they are perceived to have less protection for enduring
2. In a rallying market (falling yields) for Treasury bonds, non-Treasury
products may lag behind Treasuries in performance. This stickiness of
non-Treasury yields can contribute to a widening of spreads, as during
3. A unique event unfavorable to banking occurs, as with the news of
Mexico™s near default in August 1982.
4. A unique event favoring Treasuries occurs, as with the surprise news in
1998 that after 29 years of running deficits, the federal government was
finding itself with a budget surplus.
5. Investors rush out of non-Treasury securities and rush into the safety of
Treasury securities. This scenario is sometimes referred to as a flight to
quality, and occurred in August 1998 when Russia defaulted on its sov-
ereign debt.

Figure 3.6 presents the basic mechanics of an interest rate swap.
The above-referenced type of interest rate swap (Constant Maturity
Treasury swap, or CMT swap) is a small part of the overall swaps market,


Pays a floating rate
linked to Libor

Swap provider/seller Purchaser
Pays a fixed rate
linked to a
Treasury yield

FIGURE 3.6 Interest rate swap schematic.

with the majority of swaps being fixed versus Libor without reference to
Treasuries. It is this latter type of swap that is most commonly used for credit
Often credit spreads widen as yield levels rise. There are at least three
reasons why this could be the case.

1. As yields rise, credit spreads may need to widen so as to keep pace on
a relative basis; a credit spread of 20 basis points (bps) when the rele-
vant Treasury yield is 6 percent amounts to 3.3 percent of the Treasury™s
yield (20bps/600bps), while 20 bps when the relevant Treasury yield is
8 percent amounts to 2.5 percent of the Treasury™s yield.
2. As alluded to above, in times of economic weakness, when all bond
yields have an upward bias, credit-sensitive securities can be especially
vulnerable since they are perceived to be less insulated against the chal-
lenges of adverse times.
3. Demand for credit-sensitive products weakens since they are not
expected to be strong performers, and this slack in the level of interest
depresses price levels (and widens spreads).

A total return swap is another example of a credit swap transaction. A
total return swap exists when an investor swaps the total return profile of one
market index (or subset of a market index) for some other market index (or
subset of a market index). For example, an investor may have a portfolio that
matches the U.S. investment-grade (Baa-rated securities and higher) bond
index of Morgan Stanley. Such a bond index would be expected to have U.S.
Treasuries, mortgage-backed securities (MBS), federal agencies, asset-backed
securities, and investment-grade corporate securities. Investors who are bear-
ish on the near-term outlook for credit may want to enter into a total return
swap where they agree to pay the total return on the corporate (or credit) por-
tion of their portfolios in exchange for receiving the total return of the
Treasury (or noncredit) portion of their portfolios. In short, the portfolio man-
agers are entering into a forward contractual arrangement whereby any pay-
out is based on the performance of underlying spot securities.


A credit default swap is still another example of a credit risk transfer
vehicle. A credit default swap can be structured to trade to one or more
underlying spot securities. In brief, if the underlying security (or basket of
securities) goes into default, a payment is made that is typically equal to par
minus any recovery value. Figure 3.7 presents an overview of the cash flows
involved in a common credit default transaction (or financial guarantee).
Parenthetically, there are some investors who view credit default swaps
and total return swaps as being close substitutes for bonds. That is, a swap
is seen as comparable to buying a generic coupon-bearing bond and funding
it at Libor on a rolling basis. The strategy can be summarized as follows:

Fixed-coupon par bond = Par swap + 3- (or 6-) month Libor cash

At the end of the first quarterly (or semiannual) period, the floating part
of the swap is again worth par and pays interest at the rate of Libor refer-
enced at the start of the swap. This is precisely the case with the cash Libor
investment; the cash investment precisely matches the floating part of the
swap at each successive 3- (or 6-) month interval. Thus, the total return of
a swap may be viewed as the return on a portfolio consisting of the swap
and the cash investment in Libor; the return is equivalent to the total return
of the fixed part of the swap considered to be economically equivalent to a
There are many diverse considerations embedded within a credit deriv-
ative, not the least of which involve important legal and tax matters. From
a legal perspective, an obvious though long-elusive requirement was for a
clear and unambiguous definition of precisely when and how a default event
is to be defined. The resolution of this particular issue was significantly aided
with standardized documentation from the International Swaps and
Derivatives Association (ISDA). In 1999 the ISDA presented a set of defin-
itions that could be used in whole or in part by parties desiring to enter into
complex credit-based transactions. However, even though the acceptance and

Financial guarantor
Reference credit
Credit event payments
Swap provider/seller Purchaser

Premium payments

FIGURE 3.7 Financial guarantee schematic.


use of common terms and definitions is a large step in the right direction,
different interpretations of those terms and definitions when viewed by var-
ious legal entities are likely. When interpretations are given, they often reflect
the particular orientation and biases of the legal framework within the
national boundaries of where the opinions are being rendered.
For example, in Western Europe, France is generally regarded as a
debtor-friendly nation, while the United Kingdom is widely seen as a credi-
tor-friendly country. Germany is sometimes viewed as being somewhere in
the middle of France and the U.K. Thus, while the euro and other shared gov-
ernmental policies within the European Community have gone a long way
toward creating a single common approach to business practices, this is far
from having been fully achieved. Presumably one way that this process of a
more homogeneous legal infrastructure can be achieved is through the
European courts. Court decisions made at the national level can be appealed
to a higher European level (if not with original jurisdiction residing within
certain designated European courts at the outset), and over time an accu-
mulated framework of legal opinions on credit and related matters should
trickle back down to the national level to guide interpretations on a coun-
try-by-country basis. This being said, as is often the experience in the United
States, it is common to have participants in a default situation sit down and
attempt to arrive at a particular solution among themselves. Again, and per-
haps especially in this type of setting, which is somewhat distanced from more
formal and constraining requirements of a judicially rooted approach, local
customs and biases can play a more dominant role. Chapter 6 provides more
detail on tax and legal implications for credit derivatives.
Finally, a popular instrument among credit derivatives is the synthetic
CDO. CDO stands for collateralized debt obligation, and it is typically struc-
tured as a portfolio of spot securities with high credit risk. The securities
generally include a mix of loans and bonds. A portfolio comprised pre-
dominantly of loans may be called a CLO, and a portfolio comprised pre-
dominantly of bonds may be called a CBO. Generally speaking, when a
CDO, CLO, or CBO is structured, it is segmented into various tranches with
varying risk profiles. The tranches typically are differentiated by the prior-
ity given to the payout of cash flows, and the higher the priority of a given
class, the higher the credit rating it receives. It is not unusual for a CDO to
have tranches rated from triple A down to single B or lower. These instru-
ments are comprised of spot securities. A synthetic CDO necessarily involves
an underlying CDO of spot securities, though it is also comprised of a credit-
linked note and a credit default swap. Figure 3.8 presents a schematic
overview of a synthetic CDO.
With a synthetic CLO, the issuer (commonly a bank) does not physically
take loans off its books, but rather transfers the credit risk embedded within
the loans by issuing a credit-linked note. The bank retains underlying spot


Originating bank

Reference portfolio

Swap premium Proceeds
CDO swap counterparty SPV
(Bank affiliate) Notes
CDS protection


Protection payments/interest

CDO: Collateralized debt obligation
SPV: Special-purpose vehicle
CDS: Credit default swap

FIGURE 3.8 Schematic of a synthetic balance sheet structure.

assets as loans. Since the credit risk in the loans is transferred to a special-
purpose vehicle (SPV), a company specifically established to facilitate the cre-
ation of the CLO, it is the SPV that then transfers the credit risk to investors
who are willing to take on the risk for the right price. As a result of having
successfully transferred the credit risk off its books in this synthetic fashion,
the bank is not required to hold as much capital in reserve. This freed-up cap-
ital can be directed in support of other business activities.
When the SPV sells the credit-linked notes, the proceeds of the sale do
not revert back to the bank but are invested in low-risk securities (i.e., triple-
A rated instruments). This conservative investment strategy is used to help
ensure that repayment of principal is made in full to the holders of the credit-
linked notes. The SPV originates a credit default swap, with the issuing bank
as a counterparty. The bank pays a credit default swap insurance premium
to the SPV under terms of the swap arrangement. Should a default occur
with any of the loans at the originating bank, the bank would seek an insur-
ance payment from the SPV. If this happens, investors in the SPV would suf-
fer some type of loss. Just how much of a loss is experienced depends on the
depth and breadth of default(s) actually experienced. If no default event


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