The market for loan-only credit default swaps has grown to a notional value over $500 million, one estimated it to be closer to $1 billion, of trades per week and is picking up speed, propelled by two key administrative initiatives. The trade confirm approved by the International Swaps and Derivatives Association and the physical settlement rider published by the Loan Syndications and Trading Association have cleared up most of the stickiness of trading LCDS. But it took some unprecedented teamwork and close to a year to get to the point where the industry groups had something to approve.
"Loan CDS in the U.S. was trading in a cancelable form for the better part of two to three years, primarily dominated by a couple of dealers and one-off transactions," said Mike Weir, LCDS trader at Morgan Stanley. "Banks, hedge funds, CLOs and portfolio groups are the predominant players in the product right now, using loan CDS in various capital structure trades, negative basis trades, loan hedging trades and structured products, in addition to what is now viewed as the most efficient way to go short the secured loan class."
Lehman Brothers had been hedging its exposure both on the leveraged loan side and the investment grade side for a few years before it did its first LCDS trade about three years ago. Around the end of October 2003, Credit Suisse structured the SAMI product, which is a loan default swap index comprised of 50 CDS referencing par loans. CS launched a second basket in March 2004 and a third in October 2004. The firm still trades all three. Lehman licensed the SAMI in mid-2004 and also traded it for a while.
In early to middle of 2004, Doug Grossberg, the LCDS trader at Credit Suisse, then focused on high-yield bond CDS, received interest from clients looking to hedge their loan positions via a more precise loan-referenced CDS. He described this type of structure as a "Ref-Ob Only" trade because it referenced a specific tranche and only that tranche would be delivered from a buyer to a seller following a credit event.
By the spring of 2005, the big issue was that Lehman and CS were trading on different contracts; the primary difference related to what could be delivered following a credit event.
Grossberg and Jeremy Vogelmann, formerly the LCDS trader at Lehman, soon to be the LCDS trader at Barclays Capital, began to discuss the issue. But it wasn't until last October when Jeff Kushner of BlueMountain Capital Management contacted both traders and explained that he thought this product could be big and BlueMountain wanted to be involved, but LCDS could not get off the ground until all dealers were trading on the same document. He suggested that not only CS and Lehman take part in talks, but that other dealers should be invited as well.
Kushner anticipated the "BlueMountain Group," as it became known, would comprise four or five dealers. But as word spread, 30-40 players, between individuals in the room and on the phone, participated Nov. 1.
The original meetings included representatives from Lehman, CS, Morgan Stanley, Wachovia Securities, Goldman Sachs, Merrill Lynch, Royal Bank of Scotland, Bear Stearns, Deutsche Bank, JPMorgan, Citigroup, Bank of America and Toronto Dominion.
"I think the meetings were probably the most constructive process I have ever been involved in, in this business," Kushner said. "There are a lot of egos and vested interests, and I think for the most part that was checked at the door and everyone came with the goal of creating a product that worked for everyone. There isn't one constituency that thinks it's a perfect document. There are some things I would prefer to see differently, but I realize in order to see liquidity, everyone had to make sacrifices." He said one example is that as a seller of protection, (though BlueMountain acts as both a seller and a buyer), the option of cheapest delivery means you could end up with something very different from the trade you entered into. "I think the tradeoff is it makes it more interesting for people to play," he said.
During the next two meetings, held Nov. 17 and Dec. 1, callability became one of the biggest issues as participants decided whether the document should be written like a total return swap, where a specific loan is referenced and if that loan goes away the trade goes away, or whether it should be similar to a vanilla CDS.
The banks that were general buyers of protection wanted the document to be tied to a specific loan so that if the loan was refinanced, the loan and the CDS would go away. The group ended up agreeing to write it like a standard CDS contract where its life is not tied to a specific loan, but rather it is given a maturity date. Therefore it would be unlikely for the trade to be terminated early, even if the reference went away, because it would get replaced by a new first-lien loan.
"It took a lot of time, but everyone was very concerned with making sure we got the best product to start with," said Rob Milam, head of par loan and LCDS trading at JPMorgan. "The committee was very constructive on negotiations and the thoughts and the detail that went into designing the contract and the standardization."
Subcommittees were set up, one specifically focused on the settlement process. That group included: Dan Kamensky from Lehman; Lisa Opoku from Goldman; Ian Sandler from Morgan Stanley; Howie Shams from CS; Anne-Marie Kim from Anchorage Capital; and Elliot Ganz, executive v.p. and general counsel at the LSTA. The group probably went through about 10 ideas that were shot down before Shams suggested the physical settlement rider.
After those initial meetings where the commercial terms were ironed out, the document was turned over to the lawyers where the issue of physical settlement came up. It was decided that for the product to work, especially in a distressed scenario, the group had to make sure that loans settled as quickly as possible. Last week there was a call to discuss cash settlement, a potential long-term goal, with the timing related to the development of a tradable index comprised of CDS referencing loans. As the market players develop the index, which will be cash settled, an alternative cash settlement may eventually be carried over to the LCDS market. The group is not dropping physical settlement at this point.
Around January/February, another subcommittee consisting of Vogelmann and Weir began speaking with the ratings agencies about a form-approved confirm for CLOs to include LCDS in their portfolios. "In the past, any time a CLO wanted to do a CDS trade, it had to get approved by the ratings agencies," said Vogelmann when interviewed by CIN a month ago, while he was still at Lehman.
Yuri Yoshizawa, head of collateralized debt obligation ratings at Moody's Investors Service, previously told CIN that Moody's will not have one form-approved set of documents for use in all CLOs, but rather it will be a case by case basis. Some in the dealer group, however, are still optimistic that one generic form, tweaked from the existing confirm, could be possible for the majority of CLOs. The ratings agency will be issuing a report on the subject in the near future.
In February, the working group turned the document over to ISDA, which held a number of conference calls and meetings as it ironed out the confirm. Some criticized the association for the length of time it took them to approve and issue the confirm, but others thought the time period was reasonable. "I think four months for an ISDA process is pretty darn good," said Kimberly Summe, general counsel at ISDA. "I think that period of time is remarkable compared to other generations of templates."
The confirm, published by ISDA, states that it is callable only if there are no longer any loans of that seniority trading in the market. The physical settlement rider, put out by the LSTA, recognizes the physical delivery of loans after a credit event; so the seller of protection must pay par to the buyer of protection in return for an asset that may have fallen in price. Settlement must be kept to T+30.
Deutsche Bank began active market making mid-March. JPMorgan began trading in April and opened general market making May 1. Morgan Stanley began trading May 8. Goldman Sachs did its first LCDS trade in 2005, said Tim Milton, cash and LCDS trader, and its first LCDS trade per the working group documentation in late-May. BofA began trading June 21, said Tim FitzPatrick, LCDS trader. Bear Stearns and Merrill Lynch also trade the product. While it can vary by shop, general estimates put the number around 30-40 trades per week, per desk.
On May 18, a number of the dealers and a few index specialists met at Lehman for the first loan index meeting. The group has been exchanging ideas over email and has decided it will be cash settled and that LCDX, as it is anticipated to be called, could consist of 100 names, although some members said there may only be liquidity in 70.
While Kushner would not predict how big LCDS will become, he thinks it will be highly liquid. "If we start getting defaults, I think people will have a much larger incentive to play in the product," he said. "I think there will be good liquidity. I'm not sure how good, but time will tell."
