Credit Derivatives: Current Markets and Supervisory Issues

1. Credit Derivatives: Current Markets and Supervisory Issues February 24, 2000 David Dudley Federal Reserve Bank of New York

2. Importance of Credit Derivatives? • Credit derivatives and similar structures have changed credit risk from “hold to maturity” risk to risk that can be readily traded or transferred. • Credit derivatives now reference assets such as bonds, asset backed securities, loans and derivatives-related credit exposures in either single name or basket (more than one reference name/obligation) forms. • With this “flexibility,” banks’ internal controls, risk management processes and capital must capture, measure and manage inherent risks. • Regulatory capital requirements vs. economic incentives.

3. Credit Derivatives Counterparties • Protection Buyers • Foreign Banks: Larger banks already are involved in structured deals and are increasing use of single name products. Extension of structures to smaller banks covering pools of middle market borrowers. DB already completed 2 structured deals in this area. • U.S. Regionals: Fleet and Wachovia are active on hedging side. Increased interest on structures by Mellon, KeyBank and BancOne -- traditional loans and consumer-related products. • Protection Sellers • Re-insurance Companies: Excess capital and falling premia result in search for non-traditional forms of risk. • Life Insurance: Yield enhancement to replace existing non-performing products (e.g., GICs). U.S. regulatory environment a sizable obstacle.

4. Products CREDIT DERIVATIVE PRODUCTS CREDIT DERIVATIVES REPLICATION CREDIT DEFAULT PRODUCTS PRODUCTS TOTAL RATE OF RETURN CREDIT LINKED CREDIT DEFAULT SWAPS SWAPS NOTES & CLOs

5. Credit Default Swap REFERENCE ENTITY/OBLIGATION (Bond or Loan) PROTECTION BUYER DEFAULT PAYMENT UPON CREDIT EVENT FEES PROTECTION SELLER

6. Credit Default Swap • Most prevalent and liquid credit derivative product. • No funding requirements. • Provides an effective way of “shorting” issuer names. • Confidentiality of transactions (reference issuer names). • Standardized documentation (ISDA). • Generally avoid “workout” period after default.

7. Credit Derivatives: Key Legal Risk Issues

8. Key Legal Risk Issues: Documentation • The Russian market disruptions in 1998 had a significant impact on the credit derivatives markets. They revealed weaknesses in standardized documentation used at the time. • In response, ISDA issued the 1999 ISDA Credit Derivative Definitions, which are designed to facilitate timely deal execution and to reduce the potential for legal disputes. • Many institutions are using the 1999 Definitions to document credit default transactions. • OTC credit derivatives are documented under the ISDA master agreement or proprietary documentation that borrows from the 1999 Definitions.

9. Disputes over whether Russia's “forced reinvestment” plan triggered a “restructuring” credit event. Contract required a subjective determination of materiality of economic impact. Disputes over whether defaults on GKOs triggered credit events under contracts that referenced external Russian debt. Parties to resolve dispute by consulting with “knowledgeable disinterested third party dealer.” Sovereign credit events, including restructuring, repudiation, and moratorium, have been more clearly defined to reduce (but not eliminate) subjectivity. A matrix permits parties to select or exclude classes of obligations, such as local or supranational government obligations. ISDA may sponsor an arbitration panel to resolve disputes on a multilateral or bilateral basis. Key Legal Risk Issues: Documentation Then: 1999 Definitions:

10. Key Legal Risk Issues: Legal/Regulatory Due Diligence • Objective: Do the institution’s processes for documentation and review of credit derivative transactions promote up-front identification and analysis of legal and regulatory issues? • Issues: Credit derivatives are relatively new to the markets and have presented novel legal and regulatory issues for practitioners, many of which have not yet been resolved with definitive statutory or regulatory guidance. As a result, legal due diligence often requires a case-by-case review. • Legal characterization of a credit derivative transaction. • Appropriateness of a particular credit derivative transaction for a counterparty. • Legal ability to net credit derivatives with other derivatives under a close-out master netting agreement.

11. Key Legal Risk Issues: Legal Basis Risk • Objective: Does the institution have standards for determining whether a hedge is effective under operative legal terms and for assessing the extent to which it is exposed to “legal basis risk”? • Hedge Effectiveness: • Operative legal terms include definitions of default events, cash or physical settlement terms, first-loss deductibles, and provisions transferring country risk. • Terms of credit derivative compared to terms of reference obligations (in a portfolio) or the “matched” transaction. • Mismatches raise the potential for loss or reduction of hedge coverage. • Industry: Documentary basis risk was identified as an issue in the Counterparty Risk Management Policy Group’s Report (June 1999).

12. Key Legal Risk Issues: Borrower Confidentiality and Chinese Walls • Confidentiality: How do institutions strike a balance between the need for information on reference obligations and the need to protect confidential borrower information? • Protection Seller: An institution that sells protection on a loan portfolio would need sufficient information to measure and monitor credit risk and to confirm a credit event has occurred. • Protection Buyer: An institution that buys protection on a loan portfolio would need to protect confidential borrower information. • Chinese Walls: Do institutions that trade in credit derivatives have Chinese Wall policies and procedures for credit derivatives?

13. The End