Credit Default Swaps (eBook)

Christopher L. Culp, Ph.D., is a Research Fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise, an Adjunct Professor at both the Swiss Finance Institute and Universität Bern, a Senior Affiliate with Compass Lexecon, and Managing Director of Financial Economics Consulting, Inc. Andria van der Merwe, Ph.D., is a Senior Vice President at Compass Lexecon and a  Research Fellow at the Johns Hopkins Institute for Applied Economics, Global Health, and the Study of Business Enterprise. Bettina Stӓrkle, M.Sc., is an Economist with Compass Lexecon. 

Additional Praise for Credit Default Swaps 6
Foreword 9
Preface 15
Contents 24
About the Authors 29
Abbreviations and Acronyms 31
List of Figures 33
List of Tables 35
Part I The CDS Market and Product Mechanics 36
Chapter 1 Overview of CDS Products and Market Activity 37
1.1 Primary CDS Product Types 37
1.1.1 Single-Name CDSs 37
1.1.2 Multi-Name CDSs 38
1.1.2.1 Portfolio and Basket CDSs 38
1.1.2.2 Index CDSs 39
1.1.2.3 Tranched Index CDSs 39
1.1.3 Asset-Backed CDSs 40
1.2 Aggregate Market Activity 41
1.2.1 CDS Notional Amounts Outstanding 41
1.2.1.1 Single-Name, Multi-Name, and Index CDSs 41
1.2.1.2 Single-Name Corporate and Sovereign CDSs, LCDSs, and ABCDSs 44
1.2.2 CDS Trading Activity 45
References 47
Chapter 2 Single-Name CDSs 48
2.1 Standard Single-Name CDS Terms and Conventions 50
2.1.1 Underlying Reference Name 50
2.1.1.1 Market Composition by Type of Underlying Reference Entity 50
2.1.1.2 Market Composition by Credit Risk of Underlying Reference Entity 51
2.1.2 Maturity/Tenor 53
2.1.3 Coupon/Spread/Premium 54
2.1.4 Credit Events 56
2.1.4.1 The 1999 and 2003 Definitions 57
2.1.4.2 The 2009 “Big Bang Protocol” and Supplement to the 2003 Definitions 59
2.1.4.3 The 2014 Definitions 61
2.1.5 Settlement Methods 63
2.1.5.1 Physical Settlement 63
2.1.5.2 Cash Settlement 65
2.1.5.3 Auction Settlement 66
2.1.6 Deliverable Obligations for Single-Name CDSs with Physical or Auction Settlement 70
2.2 Selected Credit Event Determinations 72
2.2.1 The Argentine Republic (2001) 72
2.2.2 The Hellenic Republic (2012) 73
2.2.3 Noble Group Ltd. (2017) 78
2.2.4 Blackstone-Hovnanian (2017–2018) 81
2.2.4.1 The July 2017 Secured Hovnanian Debt Restructuring 82
2.2.4.2 Rumors of an Unsecured Hovnanian Debt Restructuring 82
2.2.4.3 The December 2017 Unsecured Hovnanian Debt Refinancing 84
2.2.4.4 Litigation-Related Controversy 87
2.2.4.5 The April 2018 Second Hovnanian Restructuring 89
2.2.4.6 Proposed “Fixes” to Strategic Defaults like Hovnanian 90
References 97
Chapter 3 Loan-Only CDSs 99
3.1 The Syndicated Leveraged Loan Market 100
3.1.1 Syndication and Loan Facilities 101
3.1.1.1 Revolving Credit Facilities 102
3.1.1.2 Term Loans 103
3.1.1.3 Letters of Credit 104
3.1.1.4 Bridge Loans 105
3.1.2 The Commoditization of the Leveraged Loan Market 106
3.2 Distinctions Between LCDSs and CDSs 109
3.2.1 Triggering Credit Events 109
3.2.2 Coupon/Spread 110
3.2.3 Deliverable Obligations and Settlement Methods 111
3.2.4 Early Terminations and Bullet LCDSs 113
3.2.4.1 Pre-2010 Legacy LCDSs 113
3.2.4.2 Post-2010 and Bullet LCDSs 114
References 115
Chapter 4 Multi-Name and Index CDSs 116
4.1 Portfolio and Basket Multi-Name CDSs 116
4.1.1 Portfolio CDSs 116
4.1.1.1 Coverage Period 117
4.1.1.2 Settlement Mechanisms 117
4.1.1.3 Costs of Portfolio CDSs—the Whole Versus the Sum of the Parts 118
4.1.2 Nth-to-Default Basket CDSs 120
4.1.3 Excess-of-Loss Basket CDSs 121
4.2 Index CDSs 124
4.2.1 Underlying Reference Portfolios 125
4.2.2 Index Series and Roll Dates 125
4.2.3 Pricing and Settlement 127
4.3 Tranched Index CDSs 127
References 128
Chapter 5 Asset-Backed CDSs 129
5.1 Structured Finance and ABSs 130
5.1.1 Special Purpose Entities 131
5.1.2 Types of Securitizations 132
5.1.2.1 Motivations for Securitizations 132
5.1.2.2 Mechanics of Risk Transfer in Securitizations 132
5.2 Typical ABSs 133
5.2.1 RMBSs and Home Equity Loan-Backed ABSs 135
5.2.2 CDOs 140
5.2.2.1 Cash ABS CDOs 142
5.2.2.2 Synthetic ABS CDOs 144
5.3 Asset-Backed CDSs Under the 2003 Definitions 145
5.3.1 SPE Issuers and Credit Events Under the 2003 Definitions 146
5.3.2 Complications Arising from ABS Structures 147
5.4 The ISDA PAUG Template 148
5.4.1 ABCDSs 149
5.4.2 CDSs on CDO Tranches 151
References 153
Chapter 6 CDS Execution and Clearing Mechanisms 155
6.1 CDS Clearing 157
6.1.1 USA 158
6.1.2 E.U. 159
6.1.3 Market Activity 160
6.2 CDS Trade Execution 162
6.2.1 USA 162
6.2.2 E.U. 164
6.2.3 Market Activity 164
References 168
Part II Potential Benefits and Costs of CDSs 169
Chapter 7 Potential Benefits of CDSs 170
7.1 Credit Risk Transfer 170
7.1.1 Realized Default Risk 171
7.1.2 Mark-to-Market Risk 172
7.2 Increased Supply of Loanable Funds 173
7.3 Synthetic Bond Investments 173
7.4 Price Discovery and Information Aggregation 174
References 174
Chapter 8 Potential Costs of CDSs 175
8.1 Increased Risk-Taking and Diminished Monitoring by Banks 175
8.2 Empty Creditors, Negative Economic Interests, and Strategic Defaults 176
8.3 “Excessive” Volatility Arising from Speculation 179
8.4 Systemic Risk 181
References 181
Part III Empirical Evidence on the Benefits, Costs, and Inter-Market Relations of CDSs 183
Chapter 9 The Informational Content of CDS Spreads 184
9.1 Reference Entity Credit Risk 185
9.1.1 CDS Spreads and the Greek Restructuring Event 185
9.1.2 CDS Spreads and the Lehman Credit Event 187
9.2 Determinants of CDS Spreads 189
9.2.1 CDS Spreads and Expected Credit Losses 190
9.2.2 The Term Structure of CDS Spreads 192
9.2.3 Determinants of CDS Risk Premiums 195
9.2.3.1 Reference Entity-Specific Risks 195
9.2.3.2 Both Reference Entity-Specific and Systematic Risk Factors 196
9.2.3.3 Systematic Risk Factors 199
9.3 Single-Name CDS Event Studies 200
9.3.1 Credit Rating Actions 202
9.3.2 Spillover Effects from Adverse Credit Events 204
9.3.2.1 Corporate Reference Entities 204
9.3.2.2 Sovereign Reference Entities 205
9.3.3 Other Corporate Performance Announcements 206
9.3.4 Other Announcements and Information 207
References 209
Chapter 10 Implications of CDS Listings for Reference Entities and Creditors 220
10.1 The Impact of Single-Name CDSs on Bank Lenders 221
10.1.1 Determinants of Bank Usage of Single-Name CDSs and Implications for Monitoring 221
10.1.2 Single-Name CDSs and Risk-Taking by Banks and Insurers 225
10.1.3 Single-Name CDSs and Loan Syndicates 226
10.2 The Impact of the Availability of Single-Name CDSs on Reference Entities 228
10.2.1 Impact on the Supply of Credit 229
10.2.2 Impact on Reference Entity Borrowing Costs 230
10.2.3 Impacts on Reference Entity Corporate Financing Decisions and Capital Structure 232
10.2.4 CDS Externalities 234
10.2.5 The Empty Creditor and Negative Interest Problems 236
References 240
Chapter 11 Inter-Market Basis Relations 245
11.1 Price Discovery 245
11.1.1 CDSs vs. Bonds 246
11.1.2 CDSs vs. Equities 248
11.2 Impacts of Single-Name CDS Trading on Bond Market Quality 251
11.3 Impacts of Single-Name CDS Trading on Equity Market Quality 255
11.4 The CDS-Bond Basis 257
11.4.1 Measuring the CDS-Bond Basis 258
11.4.2 Economic Factors Affecting the Basis 259
11.4.3 Empirical Examinations of the CDS-Bond Basis 261
References 268
Chapter 12 Interconnectedness and Systemic Risk 275
12.1 Credit Default Swap Volatility and Correlation 276
12.2 Measuring Interconnectedness Using CDSs 278
12.3 Sovereign CDSs and Spillover Effects 282
12.3.1 Evidence from the Eurozone Crisis 282
12.3.2 Lehman Brothers and the Credit Crisis 285
12.3.3 Sovereign CDSs and Currency Market Linkages 285
12.4 Interrelated Sovereign and Banking/Corporate Credit Risks 286
References 289
Appendix A: Research Methodology 297
Appendix B: Additional Tables 300
Index 348