What lies beneath?

The bespoke credit products business is a big money spinner for sophisticated dealers. Are investors getting a fair deal? Navroz Patel reports

Dealers pitch portfolio credit products to investors as a safe way to stay afloat in the market, distant from the dire straits of equities and bonds. And some dealers’ sophistication – combined with growing default swap liquidity – has enabled their desks to sell individual tranches of credit risk without issuing the remainder of the capital structure. During the past 18 months, these so-called bespoke mezzanine and equity tranches have become popular among yield-hungry investors such as banks, insurers and funds. But some are suspicious of what lurks beneath the calm surface: “When certain dealers pitch to us, we know they’re axed in terms of names, or are offering tranches that are riskier than the rating suggests,” says a trader at a European credit hedge fund, who spoke on condition of anonymity.

Risk spoke to a number of investment managers, several of whom echoed this sentiment. Risk also spoke to a handful of dealers – all of which denied that bespoke mezzanine tranche investors are getting saddled with more risk than they are aware of.

Though single tranches are tailored products, dealers often guide investors. “Clients usually approach dealers with a target yield rating, subordination or maturity in mind, rather than a complete list of required names,” says Mitch Braselton, London-based head of credit derivatives sales for Europe at Bank of America. Typically, negotiation about specific names then follows.

Some firms are committed to transparency though. Braselton clams his team explains to clients how prices are calculated, even going so far as to explain how the bank hedges itself. But investors remain suspicious that some dealers are involved in a kind of ratings arbitrage. In addition to a large flow business, many desks now run sizable exotics books and also use information from the equity derivatives market – enabling traders to price total credit risk and its components such as default correlation risk more accurately. Some investors claim that, essentially, these desks are able to put together structures that they know will get a rating of triple-B, for example, but are actually much riskier according to their own internal pricing models. So, for example, an investor purchases a tranche and books it at 350 basis points – a price consistent with rating agencies’ assessments. Meanwhile, the dealer knows that fair price – as implied by its trading book – is actually equivalent to a 500bp spread.

“It’s generally true that the risk-neutral default probabilities calculated from the default swaps market are higher than the default rates rating agencies estimate from their historical data,” says Rachel Elliott, London-based head of structured products at London-based credit derivatives brokerage CreditTrade.

But surely the rating agencies would be wise to any such systematic arbitraging by dealers? Rating agency Standard and Poor’s did not respond to requests for comment on this issue. However, Fitch Ratings is frank about the bespoke business: “In the past, there has clearly been some ratings arbitrage. But compared with one year ago, we are now much wiser to this possibility,” says Andrew Jackson, London-based senior director in the credit products group at Fitch Ratings. “We now go through portfolios in immense detail and are on the lookout for arbitrage,” he adds.

Jackson points to a recent deal as an example. The ratings agency’s committee discussed the fact that the transaction appeared adversely selected. Fitch asked the client to explain the name selection. Satisfied that the client’s explanation was plausible and logical, Fitch modified its normal rating approach to account for the adverse selection by assuming that certain names had defaulted, while other names were notched down. Fitch always errs on the side of caution, Jackson says.

Other independent third parties are getting involved in the bespoke business – claiming to bring a little more transparency to the market to give investors a better handle on consensus, if not fair, market price. Creditex – the New York-based inter-dealer credit derivatives broker – was one of the first firms to provide an intermediary role between dealers and investors in 2001, says John McEvoy, New York-based co-founder of Creditex. “There can be a discrepancy between spread-based models, which are widely used by dealers and investors, and ratings-based models,” McEvoy says.

According to McEvoy, Creditex is well positioned in the market to give clients access to competitive pricing. Via its flow-trading brokerage and its contact with dealers’ structured product and correlation traders, it is privy to a lot of information. So, for example, Creditex claims to have a better handle on how dealers and end-users may be biased regarding particular transactions.

Creditex says client interest in bespoke tranches has increased significantly in 2002. One London-based trader at a US bank said intermediaries work on a “handful” of deals each month – with typical total notional portfolio sizes of around $1 billion. CreditTrade’s Elliott agrees that interest among investors in bespoke products picked up in 2002. “Transparency is the most important issue – some investors just don’t know the fair price of the tranches they want to buy,” she adds.

Whereas CreditTrade requires clients to submit prospective portfolios then runs its own internal model, Creditex also offers a commercially available model for clients called PriceTracker. Launched in February 2002, the tool allows clients to optimise portfolios according to a variety of factors, such as target spreads, for example.

But what about default correlation and other thorny issues associated with credit risk models? Both CreditTrade and Creditex declined to give details of their own models. So while it is reasonable to believe that these intermediaries can help clients achieve competitive pricing, whether this is the same as fair pricing remains an open question.

Despite this, the bespoke credit risk product business looks set for continued growth. Classic synthetic collateralised debt obligations (CDOs) offering the entire capital structure have many drawbacks when compared with single tranche deals. To create and close a single tranche deal requires a small team compared with the ranks of structurers, marketers and sales staff needed for traditional synthetic portfolio deals. Putting CDOs together is also time consuming, and deals can collapse if it becomes difficult to distribute the entire capital structure.

Concerns among investors about traditional synthetic CDOs may also help boost bespoke tranche business further. During the last six months, a number of large monoline insurers have decided to pull back from taking super-senior risk on CDOs. Super-senior risk is at the very top of the capital structure. Writing protection on it is equivalent to supplying the CDO with catastrophic risk protection – and the tranche’s size is typically equivalent to between 80% and 90% of the notional value of the entire deal.

Speaking in October 2002 at Risk’s Credit Risk Summit 2002 Europe in London, Jeff Huffman, a London-based executive director in Goldman Sachs’ credit derivatives group, told delegates that the superior economics of managed synthetic, versus cash CDOs, are largely due to super-senior risk being laid-off to counterparties such as monoline insurers. He also said that some monolines had recently been “taking a breather” from writing super-senior protection, leaving credit derivatives dealers trading default swaps with the CDO to bear the risk. “Dealers are not natural super-senior risk takers, though,” he added.

Maximum capacity

Fitch’s Jackson says that, surprisingly, some banks even appear to be close to reaching their maximum capacity for super-senior risk taking. “Given this development, it seems likely that single-tranche deals will become more prevalent in the market,” he adds.

So the increased difficulty of placing super-senior risk could motivate dealers to structure more bespoke mezzanine and equity tranche structures to bypass any potential roadblocks. But others aren’t convinced that the traditional synthetic CDO business is reaching an impasse: “There continue to be super-senior risk takers in the market – it’s simply that they may now be more selective in terms of contract language pertaining to restructuring,” says Brad McKinnon, London-based head of structured products for Europe at Creditex.

One contentious feature from whole-capital-structure CDOs that has carried over to the single-tranche business is dealers’ right to substitute credits. Fitch’s Jackson says around a quarter of bespoke deals include substitution rights. And, according to dealers, it’s these deals that investors – unhappy with their performance or risk profile – are typically asking to be restructured (Risk October 2002, page S6).

But investors are slowly wising up to what, theoretically at least, could be a way for dealers to increase a deal’s credit risk leverage, and are looking for ways to counter it. “For managed synthetic CDOs – where up to 10% trading of names is typically allowed per year – investors are beginning to request veto power against substitution,” says CreditTrade’s Elliott. Meanwhile, single-tranche products have just entered a new phase of their evolution, as dealers create independently managed structures (see box).

Independent management may help safeguard investors from the kinds of hits taken on some of the earlier bespoke single tranche deals. One of JP Morgan Chase’s early 2001 client brochures for its bespoke equity piece products, called Credit-Linked Investment Protected Note (Clip), makes for interesting reading, with now notorious names such as WorldCom and Marconi included in the sample portfolio. The performance of these credits is a strong advertisement for managed deals.

Managing innovation

JP Morgan Chase created its first manager enhanced return increasing tailor-made (Merit) structure in September 2002. Merit products are independently managed credit derivatives baskets that allow investors to tailor their credit exposure to a high degree. “The combination of independent active management and a highly tailored credit risk profile is attracting new investors,” says Christian Spieler, London-based managing director in the financial institutions derivatives marketing group at JP Morgan Chase. The US dealer’s first transaction using Merit technology was more akin to a collateralised debt obligation (CDO) tranche restructuring rather than an outright creation of a new exposure from scratch. An investor client asked JP Morgan Chase to capital-protect a 14-year tenor European CDO equity note that it owned. Initially, JP Morgan Chase was not sure that it could structure a solution that met the client’s complex requirements. For example, the investor wanted euro-denominated capital protection via US names, to avoid credit risk correlation. The investor also demanded independent third-party management of the credit portfolio. But JP Morgan Chase was able to structure a deal acceptable to the client using its proprietary derivatives hedging technology. In practice, the hedging strategy is quite intricate. In more general terms, it involves monitoring which names are trading with spreads that would make them the underlyings that, on default, would eat into the investors’ tranche. Morgan’s credit derivatives desk then moves in and out of different default swaps as different names’ spreads widen and narrow so that it can synthetically replicate the single tranche sold. Deutsche Asset Management – the asset management arm of Deutsche Bank, which also has a managed bespoke single tranche product, called Credit Select – was selected as the independent manager of the first Merit product. According to JP Morgan Chase, there have been several subsequent transactions linked to the basket of US investment grade names managed by Deutsche. The US bank is also in negotiation with two other investment managers about participation in future Merit deals.