Overview
The number of credit derivative product companies is expected to increase significantly over the next year. This Learning Curve looks at how CDPCs work and how they compare to other vehicles including traditional derivative product companies, structured investment vehicles, managed synthetic collateralized debt obligations, and CDOs squared.
The sponsor of a CDPC may be an investment bank, asset manager, or private equity company. These vehicles can be structured in a variety of ways. However, generally, the sponsor--along with its partners and proposed management--will establish a limited liability company. They contribute capital to the company in exchange for ownership of equity. The company also issues one or more classes of debt or preferred shares, which are sold to third-party investors. The company will sell credit protection by entering into credit-default swaps with different counterparties. The proceeds of the debt and equity issues are invested in eligible investments and held by a custodian, primarily to support the credit quality of the company and make payments, as needed, on the company's portfolio of CDS.
The management team provides managerial, investment advisory, operational, and technological services to both the holding company and the operating company. The vehicle is managed in accordance with operating guidelines that limit the company's activities and specify the company's policies and procedures and portfolio limits. Management will utilize a capital model, which is run periodically, to determine that the capital adequacy of the company is sufficient to meet its rated liabilities. The capital model will simulate loss payments on the CDS portfolio, among other risks, and project the future cash flows of the company. Failure to follow the operating and portfolio guidelines or failure of a capital adequacy test, if incurred, ultimately results in a suspension event that leads to a wind-down of the vehicle.
When Fitch Ratings, for example, reviews a CDPC proposal, it closely examines the legal structure of the company, experience and business plan of management, operating guidelines, operational and risk management infrastructure, and capital model.
Capital Management
For any CDPC, the initial capital structure and ongoing capital management will be important rating considerations. Fitch will closely examine the planned capital structure, including the mix of hard equity versus other sources of long-term funding, limitations of total leverage and similar factors. Some minimum amount of hard equity in proportion to the business risks will be necessary. Typically, an in-house capital model will be a critical component of the capital management and risk allocation process.
The capital model is the risk management software developed by company management to measure capital adequacy. Fitch prefers management run the capital model at least weekly to determine the company has sufficient capital to meet obligations to pay losses incurred in its CDS portfolio and pay interest and principal on the rated liabilities in accordance with transaction documents. Management may also run the model to determine the effect of a potential new transaction on capital adequacy or see the impact of a potential downgrade or default of a reference entity.
The model takes as inputs the characteristics of the company's reference obligations, counterparties, cash and eligible investments, liabilities and projections of ongoing expenses. Additional inputs include default rates, recovery rates, correlation assumptions and assumptions about interest rates and foreign exchange rates. The model performs a Monte Carlo simulation, which projects future cash flows until the maturity of its longest obligation. In each simulation path, the model simulates the frequency and timing of credit events, recoveries, and loss payments on its reference portfolio, the receipt and payment of premiums to counterparties, counterparty defaults, interest received on eligible investments, interest and principal paid on liabilities, dividends paid to equity holders, and operating expenses, including taxes. Interest rates and fx rates are also simulated.
Operating Guidelines
The operating guidelines specify the policies and procedures of the company and limit its activities. They describe the types of allowed CDS transactions, how transactions are documented, and the eligibility restrictions for counterparties. Additionally, they list permitted types of securities for investment of available cash, along with haircuts for each type of asset. They include portfolio guidelines that place constraints on the composition of the reference portfolio based on rating, tenor, asset class, specified trigger events, limits on overall leverage, and other criteria. Additionally, the operating guidelines detail how valuation of assets will be performed. They define how the vehicle will be managed in terms of interest rate and currency risk, as well as outlining management of liquidity.
The operating guidelines also describe the capital requirement and the tests that are performed to ensure capital adequacy. They describe the cure period and wind-down procedures that would occur if the capital adequacy tests are breached, or if the company is in violation of the portfolio guidelines or other provisions of the operating guidelines.
The operating guidelines also describe the corporate governance of the company, including the role and makeup of the board of directors and key management positions. The guidelines detail the operational procedures for the company, including the procedures for approving, surveilling and reporting transactions. They also describe the management reports provided to Fitch to assist the agency in its surveillance.
Management
Reviewing the management of a CDPC is a core part of the rating process. Fitch conducts an on-site review of the processes; personnel; and front-, middle-, and back-office operations. Areas of focus include management experience, staffing, procedures and controls, administration, technology and performance.
Surveillance
To assist in its surveillance process, the rating agency will receive ongoing reporting from management and agreed-upon procedures from an independent accounting firm. It will also have periodic discussions with management and conduct on-site operational reviews.
Comparison With Managed Synthetic CDOs
CDPCs have some similarities to managed synthetic CDOs in that both are vehicles that sell protection on actively managed portfolios of reference obligations.
Managed synthetic CDOs have a fixed maturity date. They have a single counterparty for their CDS portfolio and issue tranches of rated and unrated debt and equity. CDPCs are set up to be permanent companies with broader operating flexibility than for managed synthetic CDOs. CDPCs are going concerns with the ability to enter into CDS with multiple counterparties.
Comparison With Traditional DPCs
CDPCs also have some similarities with traditional DPCs. Both vehicles are limited purpose entities that enter into derivative transactions with multiple counterparties. Both have operating guidelines that specify permitted transactions, a dedicated independent staff, capital models to measure capital adequacy and liquidity and wind-down conditions that are specified in operating guidelines.
Traditional DPCs, which are typically wholly owned subsidiaries of financial services companies, focus primarily on plain vanilla interest rate and currency swaps and options, as opposed to CDS. The financial service companies that sponsor traditional DPCs establish them to provide customers with an AAA-rated counterparty. CDPCs, on the other hand, focus on CDS, retain the risk of their derivative portfolios and can operate independently of their sponsors.
Comparison With Financial Guarantors
Financial guarantors, or bond insurers, also have some similarities to CDPCs. In fact, CDPCs will sometimes compete directly with financial guarantors when selling protection on pools of reference obligations. Like CDPCs, financial guarantors sell such protection predominantly at the highest rating levels (AAA and above), although they maintain flexibility to underwrite at lower investment-grade attachment points. Unlike CDPCs, financial guarantors also provide financial guarantees or CDS protection on a broad array of municipal and structured finance transactions, both within the U.S. and internationally.
Financial guarantors are licensed as monoline insurance companies and regulated in accordance with Article 69 of the New York State Insurance Department in the U.S. and by local regulators in non-U.S. jurisdictions in which they are licensed to conduct business. That said, financial guarantors have far broader operating flexibility than CDPCs to underwrite different types of risk and manage their investment portfolios.
Comparison With Structured Investment Companies
SIVs, like CDPCs, are limited-purpose operating companies that are run in strict accordance with policies and procedures that are defined in operating guidelines. SIVs also use capital models to measure risk exposure and have a set of more restrictive states that they enter if they breach guidelines or capital requirements.
While they have some important structural similarities, the type of risk they take is different. CDPCs assume risk synthetically by selling CDS on reference obligations to counterparties. SIVs purchase loans and securities and fund them with commercial paper and medium-term notes. While some SIVs have the ability to enter into CDS, they have been slow to do so. SIVs, unlike most CDPCs, are exposed to market risk to the extent there is a mismatch between the maturity of assets and the maturity of liabilities.
This week's Learning Curve was written by Alan Dunetz, a senior director in the credit product group at Fitch Ratings in New York.
