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Derivatives

European Credit Sees Defaults, Regulatory Changes, Innovation

The European credit derivatives market experienced its first investment-grade defaults, a potentially damaging regulatory challenge and a change in its legal backdrop during an active 2001.

The most significant events of the year were probably the high-profile defaults of Railtrack and Swissair, as credit-default swaps had not been tested on investment-grade names (DW, 10/15). Both occurred in the third quarter shortly after the Sept. 11 attacks, which in the case of Swissair exacerbated its cash shortage. "There were the myths about the credit derivatives market not being up for a default since there had not been one," said Hermann Watzinger, managing director and head of securitization and portfolio credit derivatives at Merrill Lynch in London. "But these defaults were a big test and the market passed that test," he added.

Railtrack's situation was of particular significance given the large number of contracts written on it and ambiguity over the deliverability of convertibles under the International Swaps and Derivatives Association's 1999 definition of credit derivatives. Shortly after the British government's bombshell announcement that it was putting Railtrack into administration, market makers met at Merrill's London office opposite St. Paul's Cathedral in November. Two key issues emerged, whether it is a credit event and are convertibles deliverable. The dealers concluded the situation did constitute a credit event, even though the government had pledged to honor Railtrack's debt, pre-empting a recommendation from ISDA that convertibles should indeed be delivered. However, the issue of deliverability remains somewhat fuzzy and reemerged as a concern later in the year over a France Telecom deal (DW, 12/3). Still, dealers said the fact that they were able to come together was of greater significance than what to do with the convertibles. "Market participants recognized that to have any lack of clarity is not beneficial, that's it's much better to take an overall position that is better for the market as a whole, and that's a very mature decision," said Scott Eaton, head of integrated credit trading at Deutsche Bank in London.

Regulation

Other than the defaults and temporary confusion that ensued, regulatory issues stick out as the significant events of the year. The w-factor, which imposes a ceiling on the amount of regulatory capital relief banks can claim on derivatives positions, being moved from pillar one to pillar two of the proposed Basel Capital Adequacy Accord was one of the most significant, said Jonathan Davies, head of credit derivatives at PricewaterhouseCoopers in London. This move changes the w-factor from a regulatory charge on each trade to a charge based on each regulators assessment of firm's risk management procedures. They saw it as potentially catastrophic for the credit derivatives industry and as a result galvanized dealers to come together and call for it to be dropped (DW, 2/19). And though they were satisfied by the result, market makers said the battle over the w-factor was one they would have preferred not to fight. "We got rid of it, but it cost us a lot of time and distracted us," said Watzinger. He added: "This was coming from the regulators and when regulators come up with stuff like this, you can see there is still a lot of education to be done."

In the structured market, Jérôme Camblain, senior managing director and head of sales, fixed income and derivatives Europe at Bear Stearns in London, said the development of managed collateralized debt obligations was one of the most significant events of last year. The deals took off toward the end of the year with Bear Stearns and Deutsche Bank both bringing deals to market (DW, 10/7, 11/11). Credit structurers were also busy referencing the products to new underlyings, such as aircraft loans, shipping loans and life insurance policies (DW, 4/29, 9/9, 12/17).

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