Structured Credit Handbook

ARVIND RAJAN, PHD, is a Managing Director at Citigroup, where he engages in proprietary trading of credit, structured credit, and emerging markets. He was previously co-head of U.S. Fixed Income Strategy (2004–2005) and global head of Structured Credit Research and Strategy (2003–2005). Rajan was twice ranked first and once second in the All-America Fixed Income Research poll by Institutional Investor magazine. He has more than two decades of experience in modeling and quantitative analysis. GLEN MCDERMOTT, JD, is a Director in the Structured Credit Sales Group at Citigroup Global Markets. Previously, McDermott was a highly ranked research analyst and global head of CDO Research and Strategy at Citigroup for five years (2000–2005). Prior to joining Citigroup, McDermott worked for six years (1994–2000) at Standard & Poor's Ratings Services where he analyzed many structured finance asset classes. McDermott's work has been published in numerous scholarly journals, and he is also a contributor to the Salomon Smith Barney Guide to Mortgage-Backed and Asset-Backed Securities, also published by Wiley. RATUL ROY is Head of CDO Strategy for Citigroup Global Markets. Before taking on his current role in 2005, Roy was head of European CDO Strategy—a position he occupied in 2003 after spending the prior seven years in structuring or analyzing CDOs and other structured credit products. This included positions in UBS Capital Markets (1995–1997), Chase Manhattan Bank (1997–1999), Standard & Poor's (1999–2000), and finally, as a cash CDO structurer in Citigroup's London office (2000–2003). Roy holds a PhD in chemical engineering from Cambridge University, England.

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