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History of Credit Derivatives



-NYSE ended fixed commissions, leading to dropping commission rates and broker consolidation.
-Large number of boutique investment banks.
-Severe recession and oil price shock.
-Collapse of New York City real estate market.
-New York City defaults on its municipal bonds.
-Major banks hover on the edge of bankruptcy and crush of non-performing loans.


-Glass Steagel Act passed.
-Mutual funds and money market funds start growing rapidly.
-U.S. dollar declines.


-Oil price boom.
-Gold and precious metals prices on a huge bull run.
-Political instability.


-High inflation, Prime Rate at 20%+.
-Iran conflict.
-Inverted yield curve signaling future recession.
-Approach = Buy and hold loans, mortgages, bonds.
-Limited secondary credit trading.
-No synthetic credit structures or credit risk transfer instruments. 
-Leveraged leasing is big business.
-Height of "relationship banking."  Large loan syndication and private placement businesses (Chase, Citibank, Morgan Stanley). 
-Long credit training programs (1-3 years long) required for fixed income bankers.
-No counterparty risk -- bond issues are syndicated then sold off at the end of the syndication period. 
- Secondard trading in bonds almost exclusively a U.S. market.  No market in the U.K.  Some German government debt trading.
-Products includ bankers acceptances, repos, commercial paper, Fed Funds interbank loans.
-U.S. investors heavily restricted -- pension funds, insurance companies, etc. cannot invest outside the U.S. or Canada.
-U.S. banks begin lending to third world banks backed by sovereign debt guarantees and financing (Latin America, Poland). 
-Project Finance is a major business for U.S., U.K. and French banks (Lloyds, Societe Generale, etc.)
-Interest rate swaps are born from high inflation, interest rate volatility, and foreign currency volatility.
-Banks start seeking ways to transfer risk off their books, leading to the rise of the "trader bank."
-Consolidation of the banking sector begins.


-Product innovation accelerates with the first interest rate swaps, currency swaps, zero coupon bonds, and variable rate financing.
-Secondary market expands to include short dated bank paper.
-Savings and Loans borrow at 3% and lend at 6%, giving rise to the 3/6/3 Rule (borrow at 3%, lend at 6%, golf at 3:00).  But this makes S&L's highly susceptible to interest rate volatility.
-No ISDA standards for interest rate derivatives contracts. Transactions are highly customized.
-Trading desks are formed to trade interest rate products, requiring capital to hold trading portfolios, and setting off a wave of bank consolidations.


-Oil prices fall, causing rapid defaults of petroleum-backed loans.
-Foreign emerging market governments "de facto default" by suspending payments (Eastern Europe, Latin America).  U.S. banks refuse to write the loans off based on the theory that governments can always print money to pay off sovereign loans.
-U.S. Savings & Loan Crisis begins. S&Ls begin defaulting en masse.
-Mortgage Backed Securities (MBS) market starts at Solomon Brothers (read Liars Poker). 
-First pooling of credits sold to institutional investors.  First synthetic credit comprised of repayments from MBS loan pool, rather than single borrowers.
-Asset Backed Securities (ABS) market starts with credit card and auto loan portfolios.
-Rise of Michael Millkin, junk bonds, and synthetic high yield debt.
-Joel Stern & Stewart, University of Chicago, Economic Value Added: Quest for Value introduces the concept of EVA.  Debt is treated like equity, encouraging companies to borrow as much as possible if the value generated is positive.  Gives rise to the concept of unlimited capital and calculated use of leverage and aggressive capital structures.  Increased leverage and risk follows.


-U.S. banks forced to recognize losses on emerging markets loans (Argentina, Brazil, Poland, Chile, Asia). 
-Banks respond by creating new loan structures and trading and swapping bad debts (e.g. bad Chile for bad Argentina). Banks begin trading debt with their own foreign subsidiaries. 
-Marshall Carter at Chase Manhattan Bank pioneers foreign subsidiary debt transfer program. 
-New York and London banks try to get out of defaulted sovereign debt market, but also need to generate yields, so often re-lend to the same foreign defaulted borrowers.
-BASEL I creates control over pricing and accounting for credit risk.
-Future flow deals appear.  The premise is "if the South African government is in default, loan directly to companies in South Africa (e.g. Anglo American) because the government would be crazy to interfere with the flow of hard asset exports to overseas markets."  The strategy has varying success.
-Rise of Synthetic Ratings -- belief that an "A" rating means the same regardless of whether the borrower is a corporate, municipal, or sovereign.  All borrowers with the same rating are assumed to have the same risk of default. Strategy has varying levels of success.


-Inflation gone.
-U.S.S.R. falls and splits into many separate countries.
-Rise of high yield products such as structured notes, inverse floaters.
-Orange County default due to high leverage and misunderstanding of risk dynamics inherent in derivative instruments.  Results in push for greater risk control and transparency.  Many municipals and pension funds prohibit investment in derivatives.
-FASB 133 requires mark-to-market of securities positions.  Debate about whether mark-to-market is effective for investor protection or simply an added cost.


-First Credit Default Swaps (CDS) and Collaterized Debt Obligation (CDO) structures created by JPMorgan, led by Blythe Masters.
-JPMorgan leads industry transformation away from relationship banking towards credit trading.  Goal is higher returns without assuming buy and hold risk.
-Accounting and regulatory arbitrage generates significant revenues.
-Shifting of credit risk off bank balance sheets by pooling credits and remarketing portfolios, and buying default protection after syndicating loans for clients. 


-Single name CDS market takes hold and starts to grow.
-KMV model (quantitative correlation analysis) relates balance sheet debt vs. market value of debt vs. probability of default.  In 2001 KMV model shows Enron is BBB-C rated when S&P rating shows AA.  KMV model proves to be more accurate than preceding default models.
-Rise of Financial Guarantors.
-New strategy = build portfolios of debt securities, then package and sell off tranches based on default probabilities.  Slice and dice to generate revenue for bank, customized risk/return profiles for investors. 
-ABS, CDS, emerging market debt all wrapped and sold off in tranches.


-Basket portfolio trading begins.
-Buying and selling the entire debt capital structure takes hold.
-New CDS contracts allow hedging below-investment grade and high yield loans.
-ISDA updates its CDS confirmation document and supplements to reflect market needs.
-CDS market becomes increasingly standardized and volume increases significantly.


-Volume of CDS contracts trading ($100 billion) far exceeds volume of cash bonds ($30 billion), creating a risk of price squeeze on defaulted bonds used for physical delivery.
-First cash settlement CDS terms used to avoid dangers of physical settlement.
-End of boom causes waves of growth company defaults.  Investors realize the increasing importance of credit protection.
-Rating arbitrage strategies gain popularity, taking advantage of time delay in rating agency downgrades and upgrades using CDS contracts for speculation.
-Credit Linked Note (CLN) market in Europe grows rapidly, paving the way for rapid CDS growth.


-CDX index created by dealers. 
-JP Morgan and Morgan Stanley issue CDS indexes.
-Creation of CDS on tradeable credit indices causes massive leap in transaction volumes (100%+ per year).
-Internet revolution and the rise of distributed computing makes complex mathematics easier.  Structured credit can now be done from anywhere on the planet, reducing capital demands and allowing smaller players and emerging markets to enter the sector.
-Rise of Hedge Funds: Number of funds increases from 4000 in 2002 managing $2 trillion to 8000+ managing $4 trillion.  This creates intense demand for new structured products with higher yields. 
-Quiet deconsolidation wave begins with "outsourcing" of risky strategies by investment banks to separate entities formed for the purpose of generating higher yields.  Also exposes the industry to potential wave of credit default risk.
-Greater number of products, but less liquidity means higher transaction revenues but potential liquidity crises ahead. 
-Questionable risk management of complex strategies, interlocking ownership, high leverage, and secrecy of hedge fund industry lays the groundwork for potential market shocks.


-ISDA definitions now the market standard.
-Collaterized Debt Obligation (CDO) market expands. 
-Fleet Bank middle market group first to package illiquid private company loans and sell off tranches to investors.  Industry follows by packaging everything possible.
-Accounting vs. Auditing vs. Sarbanes-Oxley (SOX) issues.
-Systematic Risk becomes apparent:  Huge restatements due to vendor/buyer revenue accounting, Enron balance sheet/special purpose vehicles used to securitize assets.  FASB 113 Financial Insurance regulation leads to MBIA earnings restatement.


-ISDA creates definitions on CDS of ABS.
-Delphi default uncovers significant counterparty risk and problems with price squeeze on defaulted bonds used for physical delivery.  Several hedge funds and broker-dealers take large losses as buying of defaulted bonds for physical delivery creates a "price squeeze".  Back office processing and documentation failures cause long delays in settlement. Systematic risks become highly evident and fear of future financial crises rises.
-U.S. Fed Chairman issues edict to major credit market players to clean up documentation and settlement procedures or face halt in trading.  Industry responds with positive and intense efforts.
-CDS contracts are still an over-the-counter (OTC) market only, except for limited retail market in Australia.
-Dramatic rise in pooling, tranching and re-marketing risk using CDO, CDO-squared (CDO^2), Nth-to-Default, and other Special Purpose Vehicles.  Extremely lucrative business for major broker-dealers and specialty fund managers.


-Industry-specific indexes developed:  CMBS, ABS (ABX), High Yield (100 names)
-Counterparty risk expands to include broker-dealers, multinational corporations, hedge funds, insurers.
-Large money center banks with huge balance sheets no longer needed to anchor new debt issues due to the broad availability of credit derivative risk transfer products.
-Credit derivative volume has expanded exponentially to roughly $26 trillion, according to ISDA.
-BASEL II drives increasing compliance to minimize credit risk, market risk, and operational risk.
-FASB 133 and IAS 39 compliance emphasizes high dependence on credit default models.
-Consolidation of Guarantors drives up competition and drives down risk premiums in new bond issues.
-Increasing movement toward cash settlement/auction pricing of defaulted credits upon credit event to "avoid the squeeze."
-Markit, CDX, and iTraxx are now standard pricing sources, further enabling broad trading of credit derivatives.
-Chicago Mercantile Exchange (CME) considers listing standardized single name CDS contracts to create the first large retail market.
-DTCC clearing system development increases speed of trade clearing and settlement, reduces costs and operational risks.
-Notional value of single name CDS outstanding now $19-25 trillion versus $40 trillion in bonds.
-Dura default and auction in November 2006 goes smoothly, showing the value of improved standardized industry procedures and clear documentation.
-Hedge fund counterparty risk remains.  Large broker-dealers still exposed, as they lend to hedge funds through their prime brokerage arms.
-Permanent Capital Vehicles (PCVs) are formed to invest in credit markets.  Investment money is locked up for 5 years or more, which allows managers to do longer term arbitrage, capital structure, and cycle plays.

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