Collateralized debt obligation houses, including JPMorgan, Deutsche Bank and BNP Paribas, are planning to securitize equity risk by referencing a CDO structure to a basket of equity options. Ratings for an equity version of a CDO will help investors to compare these two asset classes, said Martin Bertsch, head of the financial engineering group at JPMorgan in London.
All three rating agencies have been approached to rate deals, but they point out that there are certain hurdles that need to be overcome. Nik Khakee, director at Standard & Poor's in New York, said portfolios of swaps can be compared to the historical volatility levels of indices such as the S&P 500, as credit events on the so-called equity-default swaps are similar to strikes on options. Market prices on the swaps, however, are reflective only of historical volatility, not implied, which may cause some challenges in rating the products, he said.
Richard Gambel, managing director and head of synthetic CDOs at Fitch Ratings in London, said some of the pure equity-default swap structures that CDO houses have approached it with do not have the characteristics of a credit product, so it may not be appropriate to give it a credit rating. In a synthetic CDO the ability to repay the notes is directly linked to the credit performance of the reference entities, whereas in these products the ability to repay the notes is linked to the equity performance. He added, however, that if it was presented with structures that are more similar to debt instruments it may rate them.
The firms could use equity default swaps to structure a synthetic collateralized equity obligation, in much the same way that a synthetic CDO is constructed from credit-default swaps, according to an official at BNP Paribas.
In a typical equity-default swap, the investor receives a coupon unless the value of the equity falls by 70%, in which case the investor gets 50% of the initial investment back and losses the coupon.
