U.S. firms racing to structure the next big thing in credit have hit on preferred securities as likely raw material. Dealers, including JPMorgan and Lehman Brothers, have already traded single-name credit-default swaps referenced to preferred securities. Lehman is structuring more complex trades and is in talks with other dealers about an index for the product, which it expects to publish in the coming weeks. JPMorgan, which launched its preferred CDS product a few weeks ago, is now looking into more complex structures.
Lehman has traded six first-to-default baskets referencing between five and 17 names in preferred CDS since it began trading single-name contracts in February. It expects to have the swaps featured in synthetic collateralized debt obligations within three months, said Tom Corcoran, managing director and head of hybrid capital at Lehman in New York, adding an index referencing a diversified basket of names will hit the market first.
Preferred credit-default swaps work in much the same way as traditional CDS, except the underlying is, obviously, a preferred security and failure to pay the dividend constitutes a credit event. Lehman has already traded USD1.2 billion in preferred CDS contracts this year, but non-U.S. investors, including offshore hedge funds, were not tapping the preferred share market because the securities are subject to a 30% withholding tax due to the dividend payment.Ashish Shah, co-head of credit strategy at Lehman, noted that in swap form, there is no tax because there is no dividend being paid out.
Officials at Banc of America, Bear Stearns and Deutsche Bank said they are waiting to see if the market gains traction before jumping in. So far the market has been characterized by one-off transactions, said one player, adding, "We're still reviewing the viability of the market for this product as we do will all new products." Once documentation for preferred CDS has been tested by a credit event and more contracts begin to be traded, which will reduce liquidity risk, more dealers are expected to begin trading it.
