The Structured Credit Handbook

<p>Acknowledgments xix</p>
<p>About the Authors xxi</p>
<p>About the Contributors xxiii</p>
<p>Introduction: A Roadmap of the New World of Structured Credit 1</p>
<p>How Structured Credit Completes Markets 2</p>
<p>Enabling Technology 3</p>
<p>Improved Liquidity, Transparency, and Customizability 3</p>
<p>Growth of Structured Credit Markets 4</p>
<p>Asset Classes 4</p>
<p>Products 4</p>
<p>Participants 7</p>
<p>Core Uses of Structured Credit 8</p>
<p>Nonrecourse Leverage 8</p>
<p>Diversification 8</p>
<p>Customization of Risk Profiles 9</p>
<p>Separating Legal from Beneficial Ownership 9</p>
<p>Separating Funding from Risk Transfer 9</p>
<p>Isolating and Hedging Risk 10</p>
<p>Representative Examples of Structured Credit Solutions 10</p>
<p>Who Should Read This Book? 11</p>
<p>How This Book Is Organized 11</p>
<p>PART ONE Index and Single–Name Products</p>
<p>CHAPTER 1 A Primer on Credit Default Swaps 17<br />Arvind Rajan</p>
<p>The Market for Credit Default Swaps 17</p>
<p>Transaction Terminology and Mechanics 22</p>
<p>Prerequisites for Credit Derivatives Transactions 22</p>
<p>What Happens in Case of a Credit Event? 23</p>
<p>Unwinding Default Swap Transactions 25</p>
<p>The DV01 of a Credit Default Swap 25</p>
<p>The Default–Cash Basis 26</p>
<p>Some Uses of Default Swaps 26</p>
<p>Buying a Note versus Selling Default Protection 26</p>
<p>Freeing Up or Using Bank Credit Lines 27</p>
<p>Filling a Maturity Gap 28</p>
<p>Expressing Curve or Forward–Rate Views 28</p>
<p>Barbell–Bullet Trade 29</p>
<p>Taking Advantage of Tight Repo Levels without Financing 29</p>
<p>Case Study: Relative Value Cashing In on the Curve Steepness in Telecoms 30</p>
<p>How to Blend CDs and Cash in Long–Maturity–Curve Trades 30</p>
<p>Implementing Credit Curve Flatteners Two Basic Approaches 33</p>
<p>Appendix: Equivalence of a Bond Spread and Default Swap Premium 35</p>
<p>Specialness of the Underlying 36</p>
<p>Effect of Accrued Default Swap Premium 36</p>
<p>Accrued Interest on the Underlying Risky Security 37</p>
<p>Accrued Interest on the Underlying Risk–Free Security 37</p>
<p>CHAPTER 2 Credit Default Swaptions 39<br />Arvind Rajan and Terry Benzschawel</p>
<p>Payer Options 40</p>
<p>Example When to Buy a Payer 41</p>
<p>Example When to Sell a Payer 42</p>
<p>Receiver Options 42</p>
<p>Example When to Buy a Receiver 43</p>
<p>Effect of DV01 on Credit Swaption Payoffs 43</p>
<p>Example When to Sell a Receiver 44</p>
<p>Credit Swaption Payoffs in Default 46</p>
<p>Credit Swaption Implied Volatility 47</p>
<p>Conclusion 47</p>
<p>Case Study: Are Tight Spreads Giving You Butterflies? 49</p>
<p>Introduction 49</p>
<p>Float Like a Butterfly, Sting Like a Bee 50</p>
<p>Butterfly versus Payer 50</p>
<p>Variations 54</p>
<p>Details of Butterfly Construction 54</p>
<p>Conclusion 54</p>
<p>CHAPTER 3 Constant Maturity Credit Default Swaps 57<br />Olivier Renault and Ratul Roy</p>
<p>Basics of CMCDSs 57</p>
<p>Participation Rate 58</p>
<p>Behavior of CMCDSs 59</p>
<p>Impact of Spread Level 60</p>
<p>Impact of Spread Volatility 64</p>
<p>Capped CMCDS 66</p>
<p>Hedging CMCDSs 68</p>
<p>Trading Strategies with CMCDSs 69</p>
<p>Selling CMCDS Protection 69</p>
<p>Buying CMCDS Protection 70</p>
<p>Combination Trades and Index CMCDSs 70</p>
<p>Conclusion 72</p>
<p>Case Study: Taking Curve Views with CMCDSs 72</p>
<p>Features of CMCDSs 73</p>
<p>Trade Ideas 73</p>
<p>Appendix: Computing the Participation Rate 76</p>
<p>CHAPTER 4 Credit Derivatives Indexes 79<br />Jure Skarabot and Gaurav Bansal</p>
<p>Introduction 79</p>
<p>Family of Credit Derivatives Indexes 80</p>
<p>Structure of the CDX/iTraxx Index Family 81</p>
<p>Administration of Indexes 83</p>
<p>Basket of Credit Default Swaps 83</p>
<p>Trading Example The Index 84</p>
<p>Up–Front and Running Payments 84</p>
<p>Trading Example Premium Payments 85</p>
<p>What Happens in Case of a Credit Event? 86</p>
<p>Trading Example Credit Event 87</p>
<p>Settlement Process after Credit Event 87</p>
<p>Physical Settlement (Indexes and Tranche Products) 88</p>
<p>Cash Settlement (Tranche Product Only) 88</p>
<p>Recent Defaults in CDX Indexes 88</p>
<p>Index versus Intrinsics 90</p>
<p>Investment Strategies with Credit Derivatives Indexes 91</p>
<p>Investors 92</p>
<p>Index–Related Structured Credit Products 92</p>
<p>Issues and Concerns 93</p>
<p>Conclusion 93</p>
<p>Case Study: DJ CDX HY and DJ CDX EM Conversion of Price Level into a Spread Level 94</p>
<p>Case Study: Using iTraxx to Replicate Bond Portfolios 94</p>
<p>Motivation 94</p>
<p>Typical Portfolio Risks 95</p>
<p>Replicating Interest Rate Risks 96</p>
<p>Using iTraxx to Replicate Broad Credit Market Risk 96</p>
<p>Adjusting for Single–Name Risk through Default Swaps 99</p>
<p>Performance 100</p>
<p>Conclusion 104</p>
<p>Appendix: Description of the Roll Process 106</p>
<p>Risky PV01 of a CDS Contract 106</p>
<p>Calculation of Intrinsic Spread of the Index 107</p>
<p>Risky PV01 of an Index 108</p>
<p>Mark–to–Market Estimation of an Index Position 108</p>
<p>CHAPTER 5 The Added Dimensions of Credit A Guide to Relative Value Trading 111<br />Matt King and Michael Sandigursky</p>
<p>Overview of Curve Trades 111</p>
<p>Learning Curves 112</p>
<p>Drivers of Curve Steepness 113</p>
<p>Putting on a Curve Trade 115</p>
<p>Cross–Currency Trades 116</p>
<p>Cross–Currency Opportunities in Bonds 117</p>
<p>Cross–Currency Trades in CDSs 117</p>
<p>Basis Trades 118</p>
<p>Back to Basis 118</p>
<p>Drivers of Basis 122</p>
<p>Why CDSs and Bonds Are Two Sides of the Same Coin 122</p>
<p>Trading the Basis 126</p>
<p>A New Spread Measure: C–Spread 129</p>
<p>Debt–Equity Trades 129</p>
<p>Meet the Models 129</p>
<p>The Debt–Equity Cycle 130</p>
<p>A Practical Hurdle or Two 131</p>
<p>Debt–Equity Trading in Practice Arbitrage or Mirage? 132</p>
<p>Deciding What to Trade 133</p>
<p>A Recovery Trade 134</p>
<p>iTraxx Credit Indexes 134</p>
<p>Truly Global 135</p>
<p>You ve Got to Roll with It 136</p>
<p>iTraxx Intrinsics 137</p>
<p>What Happens When a Name Defaults? 139</p>
<p>Equiweighted or Not 139</p>
<p>Second–Generation Products: iTraxx Tranches 139</p>
<p>Credit Options 140</p>
<p>It s a Knockout 140</p>
<p>Effect of Convexity on Credit Option Payoffs 141</p>
<p>Delta–Exchange 143</p>
<p>Why Sell an Option (Riskier Strategy) Rather</p>
<p>Than Buy One? 143</p>
<p>Option Strategies 144</p>
<p>PART TWO Portfolio Credit Derivatives</p>
<p>CHAPTER 6 Single–Tranche CDOs 149<br />Jure Skarabot, Ratul Roy, and Ji–Hoon Ryu</p>
<p>Overview of Single–Tranche CDOs 149</p>
<p>Advantages of Single–Tranche CDOs 150</p>
<p>Key Features of Single–Tranche CDO Transaction 150</p>
<p>Description of the Product and Basic Structure 151</p>
<p>Main Decision Steps for Investors 153</p>
<p>Key Issues in Modeling and Valuation 155</p>
<p>Single–Tranche CDO Risk Measures and Hedging 158</p>
<p>Substitution of Credits 164</p>
<p>Single–Tranche CDO Market 166</p>
<p>Investment Strategies 167</p>
<p>Case Study: Dispersion Trades and Tranches 180</p>
<p>Traditional Bull–Bear Trade 180</p>
<p>Not Just Another Bull–Bear Tranche Trade 181</p>
<p>Who s Afraid of Blowups? 181</p>
<p>Buy Protection on 10–Year 3 to 7 Percent CDX IG</p>
<p>Tranche, Sell Protection on 5–Year 10 to 15 Percent CDX IG Tranche 183</p>
<p>Effect of Blowups in CDX IG on the Dispersion Trade 184</p>
<p>Trade Sensitivity Analysis 184</p>
<p>How to Choose the Most Efficient Tranches 187</p>
<p>Conclusions 190</p>
<p>Case Study: Attractions of Hedged Mezzanines 190</p>
<p>Motivation 191</p>
<p>The Trade 191</p>
<p>Comparing Delta–Hedged Equity and Mezzanines 192</p>
<p>Time–Decay Profile 194</p>
<p>Conclusion 195</p>
<p>CHAPTER 7 Trading Credit Tranches: Taking Default Correlation out of the Black Box 197<br />Ratul Roy</p>
<p>The Credit Tranche Market 197</p>
<p>Importance of Default Correlation in Tranches 199</p>
<p>Problems with Traditional Correlation Measure 199</p>
<p>Skew in Default Correlation 201</p>
<p>Further Flaws in Tranche Correlation 201</p>
<p>Correlation Skew Is Like a Volatility Surface 201</p>
<p>Skew Is Market s Risk Preference 204</p>
<p>Investor Risk Appetite May Scale Across Markets 207</p>
<p>Greeks: Managing Correlation and Delta Risk 209</p>
<p>In Summary: Why Skew Is a Better Model 213</p>
<p>Trading Opportunities for Investors 214</p>
<p>Tranche Correlation Can Still Provide Insight 214</p>
<p>Pricing Off–Market Tranches 217</p>
<p>Conclusion and Future Agenda 219</p>
<p>Case Study: Curve Trades in Tranche Markets 220</p>
<p>Curve Trades, Tranche Markets, and Technicals 220</p>
<p>Trade Recommendation 221</p>
<p>Market Drivers for the Tranche Curve Trades 221</p>
<p>Base Correlation Analysis and Market Technicals 223</p>
<p>Technicals Driving the Flattening of Tranche Curves 224</p>
<p>Analysis of Investment Strategy 225</p>
<p>CHAPTER 8 Understanding CDO–Squareds 229<br />Ratul Roy and Matt King</p>
<p>CDOs versus CDO2 230</p>
<p>Value of CDO2s Derives Broadly from Inner CDOs 232</p>
<p>CDO2 versus Inner CDO 234</p>
<p>Like Mezzanine, but with Tails 235</p>
<p>CDO2 versus Master CDO 236</p>
<p>Economic Value versus Rating Quality 238</p>
<p>Uses of CDO2: Long, Short, and Correlation! 239</p>
<p>Structures: Good, Bad, and Ugly 239</p>
<p>Inner CDO Tranche Seniority and Thinness 240</p>
<p>Overlap of Credits 242</p>
<p>Nonuniformity of Portfolios 243</p>
<p>Fungible and Tradable Subordination 244</p>
<p>How Managers Can Add Value 246</p>
<p>Not Just Credit Selection 246</p>
<p>Manage to the Structure 248</p>
<p>Conclusion 249</p>
<p>Case Study: Term Sheet 249</p>
<p>CHAPTER 9 CPPI: Leveraging and Deleveraging Credit 253<br />Olivier Renault</p>
<p>Product Mechanics 253</p>
<p>Managed CPPIs 256</p>
<p>When Is CPPI Suitable? 257</p>
<p>Choice of Trading Strategies 257</p>
<p>Case Study: Performance Comparison of Strategies 258</p>
<p>Baseline: Unlevered Strategies 258</p>
<p>Simulations 258</p>
<p>Results 259</p>
<p>Performance Comparison in CPPI Setup 263</p>
<p>Other Strategies 264</p>
<p>Appendix: Our Methodology 265</p>
<p>Our Estimations and Simulations 265</p>
<p>PART THREE Collateralized Debt Obligations</p>
<p>CHAPTER 10 Collateralized Loan Obligations 269<br />Glen McDermott, William E. Deitrick, Alexei Kroujiline, and Robert Mandery</p>
<p>Leveraged Loan Market Overview 270</p>
<p>Strong Primary Market Growth 270</p>
<p>Broadening Investor Base 272</p>
<p>Increasing Secondary Market Liquidity 273</p>
<p>Continuing Challenges to Loan Market Liquidity 275</p>
<p>Key Loan Characteristics 276</p>
<p>Loan Structures 281</p>
<p>Revolving Credit Facilities 281</p>
<p>Amortizing Term Loans 281</p>
<p>Institutional Term Loans 282</p>
<p>Pro Rata Loans 282</p>
<p>Overview 282</p>
<p>Key Characteristics 283</p>
<p>Investment Opportunities 284</p>
<p>Middle–Market Loans 285</p>
<p>Overview 285</p>
<p>Key Characteristics 285</p>
<p>Investment Opportunities 288</p>
<p>European Leveraged Loans 289</p>
<p>Overview 289</p>
<p>European Mezzanine Bank Loans 290</p>
<p>Key Characteristics 292</p>
<p>Investment Opportunities 292</p>
<p>Collateralized Loan Obligations 293</p>
<p>Efficient Access to Loan Market Investment Opportunities Introducing CLOs 293</p>
<p>Basic CLO Structure 293</p>
<p>CLO Asset Manager 296</p>
<p>CLO Market Today 297</p>
<p>Key Drivers of CLO Outperformance 298</p>
<p>Conclusion 303</p>
<p>Middle–Market CLO Handbook 303</p>
<p>Middle–Market Size and Definition 304</p>
<p>Growing Investor Demand 305</p>
<p>Dominance of Institutional Term–Loan Debt 305</p>
<p>Second–Lien Loans Emerge 306</p>
<p>Investment Considerations for Middle–Market Investors 307</p>
<p>Legal Considerations 312</p>
<p>Middle–Market CLOs 312</p>
<p>CLO Investment Considerations 320</p>
<p>Conclusion 324</p>
<p>Appendix A: Middle–Market Loan Characteristics 325</p>
<p>Floating–Rate Coupon 325</p>
<p>Maturity 325</p>
<p>Callability 326</p>
<p>Covenants 326</p>
<p>Structure of a Middle–Market Loan 326</p>
<p>Appendix B: The Basic CLO Structure 327</p>
<p>Case Study: CDO Combination Securities Tailoring Risk/Return Profiles 329</p>
<p>Introduction 329</p>
<p>Equally Rated CDO Combination Securities Are Not Equal 330</p>
<p>Value in Baa3–Rated CLO Combination Securities 332</p>
<p>Conclusion 334</p>
<p>CHAPTER 11 ABS CDOs 335<br />Ratul Roy and Glen McDermott</p>
<p>Overview of the Structured Finance Market 335</p>
<p>Basic Structure 335</p>
<p>Roles of Multiple Parties in a Securitization 336</p>
<p>ABS Market Fundamentals 336</p>
<p>Major Characteristics of Structured Finance Securities 344</p>
<p>Relative Value 344</p>
<p>Structural Protection 346</p>
<p>Collateral Stability 346</p>
<p>Challenges 348</p>
<p>CDOs of Structured Finance Securities 350</p>
<p>Investor Motivation 350</p>
<p>A Customized Investment 350</p>
<p>Relative Value 351</p>
<p>Major Considerations in CDO Investing 351</p>
<p>Leveraging Stability Performance of SF CDOs 354</p>
<p>CDOs of SFSs Take Many Forms 354</p>
<p>Conclusion 358</p>
<p>Case Study: Relative Value in High–Grade Structured Finance CDOs 358</p>
<p>Transaction Overview 359</p>
<p>High–Grade SF Securities: A Strong Track Record 361</p>
<p>Cash Flow Analysis 363</p>
<p>Conclusion 364</p>
<p>Case Study: Untangling Mezzanine and High–Grade Structured Finance CDOs 364</p>
<p>Collateral Composition 365</p>
<p>Collateral Risk 366</p>
<p>Expected Loss 366</p>
<p>Correlation Views 368</p>
<p>Other Differences 368</p>
<p>Conclusion 369</p>
<p>Appendix: Rating Transition Matrices of Common Structured Finance Collateral 369</p>
<p>CHAPTER 12 CDO Equity 371<br />Glen McDermott and Alexei Kroujiline</p>
<p>Cash Flow CDO Income Notes 373</p>
<p>Return Analysis 377</p>
<p>Defaults 378</p>
<p>Recoveries 380</p>
<p>Interest Rate Risk 382</p>
<p>Collateral Manager 384</p>
<p>Collateral Manager Review 384</p>
<p>Asset Selection 385</p>
<p>CDO Investment Guidelines 386</p>
<p>CDO Manager Types 388</p>
<p>Investment and Trading Philosophy 389</p>
<p>Asset Characteristics 391</p>
<p>Collateral Mix 391</p>
<p>Time Stamp or Cohort 392</p>
<p>Diversification 393</p>
<p>Structure 394</p>
<p>Trigger Levels 394</p>
<p>Senior Costs, Swaps, and Caps 395</p>
<p>Manager Fees and Equity Ownership 396</p>
<p>Credit–Improved Sales Treatment of Premium 396</p>
<p>Conclusion 397</p>
<p>Case Study: Diversifying Credit Risk Using a CDO Equity Fund 397</p>
<p>Introduction 397</p>
<p>Modeling Assumptions and Analytical Techniques 398</p>
<p>Results 399</p>
<p>Conclusion 400</p>
<p>CHAPTER 13,Commercial Real Estate CDOs 403<br />Darrell Wheeler and Ratul Roy</p>
<p>CRE CDOs by the Numbers 403</p>
<p>Slow Start, but Growth Now Strong 403</p>
<p>Relative Value: Spread Pickup Often Gives CRE CDOs an Edge 405</p>
<p>CRE CDO Performance Has Been Strong 406</p>
<p>Collateral Mix: Diverse and Evolving 407</p>
<p>Building Blocks of a CRE CDO 409</p>
<p>B–Notes and Rake Bonds 411</p>
<p>Second Lien Loans 412</p>
<p>Mezzanine Loans 412</p>
<p>Preferred Equity 413</p>
<p>Whole Loans 413</p>
<p>CMBS First Loss Positions or B–Pieces 413</p>
<p>CRE CDO Managers and Sponsors 415</p>
<p>Who s Who 415</p>
<p>What to Look for in a CRE CDO Manager 415</p>
<p>CRE CDO Investors: A Diverse Group 416</p>
<p>Key Events in the CRE CDO Market 417</p>
<p>A Market Is Born 417</p>
<p>The Rise of CRE CDOs as a Source of Financing 418</p>
<p>The Push for Flexibility 420</p>
<p>The Current State of the CRE CDO Market 421</p>
<p>Investor Analysis of CRE CDOs 422</p>
<p>CRE CDO Analysis for Traditional CDO Investors 423</p>
<p>CRE CDO Analysis for Traditional Real Estate Investors 423</p>
<p>Additional Suggested Collateral Analysis 428</p>
<p>Analysis of CMBS Certificates 428</p>
<p>Analysis of Uncertificated Securities 429</p>
<p>Appendix: List of CRE CDOs 432</p>
<p>Glossary 437</p>
<p>Term Sheet 439</p>
<p>Notes 443</p>
<p>Index 457</p>