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Derivatives

CDO Houses Plan Single Tranche Cookie Cutter

The major credit derivatives houses, including JPMorgan, Merrill Lynch and Deutsche Bank are putting together a standard document for single-tranche collateralized debt obligations with the aim of increasing liquidity in the inter-dealer market. The largest stumbling block is which valuation method to pick, but lawyers involved in the process said the document would likely be finished before year-end.

Bankers want to have a standardized template, rather than follow the usual International Swaps and Derivatives Association route of having multiple choices that traders can elect, as it does in the 2003 credit derivatives definitions for the restructuring credit event. By eliminating such differences it will reduce the basis risk in dealers' portfolios, noted lawyers.

The dealers are likely to opt for a valuation method that seeks market prices on several different days. This reduces the chance of opting for a price that is affected by outside factors, such as an election or terrorist attack. The downside is that traders will have to spend more time giving or collecting prices for contracts they know they are not going to trade. "Nobody likes a fire drill," noted one derivatives professional.

The move appears to have the backing of at least one rating agency. A Moody's Investors Service report earlier this summer stated, "Moody's believes that standardization in the reporting of the valuation process will contribute to a greater consistency of settlement prices in cash settled synthetic securities." Ebo Coleman, senior credit officer at Moody's in London, said, "Generally, the longer you wait to get the valuations the better and two or three valuation dates is better than one." In addition, structures that incorporate long valuation processes for defaults that occur early in the transaction and short, but not less than 30-day, valuations for defaults near maturity are less onerous on ratings.

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