loan-only credit default swaps

loan-only credit

default swaps

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Loan-Only Credit

Default Swaps

MARTIN BARTLAM

KARIN ARTMANN

2006

Table Of Contents

Introduction to Loan-Only Credit Default Swaps

5

The Documentation for Loan-Only Credit Default Swaps

11

Introduction to Loan-Only Credit Default Swaps

What is an LCDS?

An LCDS is a credit default swap (CDS) where the underlying is a syndicated secured loan rather than any other asset class (e.g. bonds (corporate or sovereign), unsecured loans, asset-backed secu-rities, etc). Even in the fast-growing derivatives market (total notional amount valued at approxi-mately US$283 trillion for the fi rst half of 2006 of which US$26 trillion relates to credit deriva-tives) this is a product which is set to have a signifi cant impact on the fi nancial market.

An LCDS is a contractual arrangement pursuant to which one party (protection seller) promises the other party (protection buyer) to take on the risk of default or non-performance (Credit Event) – usual-ly Failure to Pay, Bankruptcy and sometimes Restructuring - of a specifi ed entity (Reference Entity) in respect of its obligations under an underlying asset or a portfolio of assets (Reference Obligation(s)). Following the occurrence of a Credit Event and the satisfaction of certain pre-determined condi-tions (Credit Event Notice, Notice of Physical Settlement (NOPS) (if any) and Notice of Publicly Available Information (if any)) (Conditions to Settlement), the protection seller is required to make a payment to the protection buyer in accordance with a pre-determined formula. If the LCDS stipulates Physical Settlement - the protection seller pays an amount equal to the notional amount (i.e. the amount of the Reference Obligation to be covered by the LCDS) (Notional Amount) multi-plied by the reference price (Reference Price) which is usually 100%, against delivery by the protection buyer of an obligation with pre-determined characteristics (Deliverable Obligation). If Cash Settle-ment is stipulated - the protection seller pays the protection buyer an amount equal to the Refer-ence Price minus the recovery rate on the ReferRefer-ence Obligation following the Credit Event (Final

Price) multiplied by the Notional Amount.

In return for the protection offered, the protection buyer promises to pay the protection seller a fi xed premium at pre-determined intervals up to the termination date of the LCDS (Termination

Date). It may all sound like insurance but it is not – the contract is based on a formulaic pay out on

the occurrence of certain pre-determined events and does not require the protection buyer to own the assets for which protection is provided, nor to have suffered a loss.

Derivative contracts are generally concluded on the standard 1992 or increasingly the 2002 Master Agreement as amended and supplemented by a Schedule (together, ISDA Master) each as published by the International Swaps and Derivatives Association, Inc. (ISDA). Pursuant to the terms of such ISDA Master, the parties can enter into any number of transactions each of which will be documented by a confi rmation which incorporates the 2003 ISDA Credit Derivatives Defi nitions as amended and/or supplemented from time to time (Credit Derivatives Defi nitions).

This sets out the specifi c terms of each such transaction and any amendment and/or supplements to the ISDA Master. Template forms of LCDS documentation have been prepared for the US LCDS market and were published by ISDA on 8 June 2006. Template forms of LCDS documenta-tion in draft form have been prepared for the European market and were last circulated by ISDA on 2 May 2006.

Protection

Buyer

Protection

Buyer

Periodic payments under CDS prior to a Credit Event. Physical Settlement of a CDS following a Credit Event Cash Settlement of a CDS following a Credit Event

R

eference Price – Final Price x Notional Amount

Notional Amount x R eference Price Premium Deli verable Oblig ation

Protection

Buyer

What are the motivations of participants in the LCDS market?

LCDS provide the same general benefi ts as plain vanilla CDS for bonds, namely, to short credit positions for hedging and speculation, to create “synthetic” long credit positions as an alternative to long cash or loan positions and a combination of long/short portfolio strategies. It is however important to recognise features of the structure of the LCDS that can lead to pricing and return differences compared to the underlying cash instrument. Before examining these aspects in more detail, it is helpful to have a look at the motivations and market forces that relate to the develop-ment of LCDS.

European LCDS and US LCDS are, strictly speaking, not comparable instruments or at least, a strict comparison is not necessarily particularly helpful. The reason for this is that the LCDS in the US was designed as a trading product whereas European LCDS was created to provide banks with a hedging product. The difference in approach may arise from the fact that institutional investors which tend to dominate the US market use LCDS to make a return as part of a particular invest-ment strategy whilst in Europe, the developinvest-ment of the European LCDS is being driven by banks which are still the main users of the products. As originators of syndicated secured loans, banks are focused on ways to manage their loan books and reduce regulatory capital, particularly in light of the introduction of Basel II which potentially increases capital charges for certain classes of syndicated secured loans.

The US LCDS is documented to facilitate liquidity in the market, looking at the creditworthiness of the Reference Entity generally. This enables both sides of the trading market to trade the product effectively and effi ciently to generate income. US LCDS have, e.g., no Restructuring Credit Event or Cancellability. This makes the US LCDS a more commoditised product. The US LCDS – as we shall see later – does not end following the repayment, redemption or other discharge in full of the underlying syndicated secured loan. Whilst this makes perfect sense in a trading context where the derivative is somewhat de-linked from the underlying cash instrument, it is less useful in the end-user market context where participants seek to hedge and/or gain exposure to the actual cash instrument, i.e. look through the Reference Entity to the underlying syndicated secured loan. The latter strategy requires the LCDS to more or less behave like the underlying cash instrument. Whilst the LCDS will never do so perfectly, the desire of end-users is to obtain as good a match as possible. This desire has to be weighed up against the need of participants in the trading mar-ket to fi nd suffi cient liquidity to be able to supply the end-user marmar-ket with the hedge/protection products that they require.

This tension between the end-user market and the trading market is stimulating discussion and negotiation in the European, particularly the London market, and the outcome will shape the fi nal form of the European LCDS. One view is that the European markets will go for a compromise by using the non-cancellable LCDS but quote for the cancellable LCDS as well. This would take the form of an additional premium – to be funded upfront – in respect of the prepayment risk of the Reference Obligation.

What are market forces behind the growth of LCDS?

There are four main factors behind the growth of LCDS: (1) rapid growth in the syndicated se-cured loan market driven by a surge in leveraged buy-outs; (2) the introduction or anticipated intro-duction of standard industry-wide documentation, syndicated secured loan specifi c indices and the focus of fi nancial services providers on the syndicated loan market; (3) new business opportunities and the need to refi ne lending activities to maximise returns following the introduction of regula-tory requirements such as Basel II and (4) the activities of certain market participants such as hedge funds and the managers of collateralised loan obligations (CLOs).

Growth in syndicated secured lending in leveraged buy outs

Syndicated loan volumes have skyrocketed on both sides of the Atlantic in recent years. Global issuances reached a level of approximately €369.4 billion in 2005 and were, by September 2006, already at about €328 billion for the year. Syndicated secured loans make up over one-third of total US syndicated lending. The growth of non-bank lenders is changing the nature of the loan market, with CLOs and hedge funds now consuming the bulk of leveraged loan paper. Even though still small in comparison to bond trading volumes, secondary loan market activity is growing steadily as is the junior debt or second-lien/mezzanine market both in Europe and the US. The holder of a fi rst lien retains priority over the collateral securing a syndicated secured loan which is shared with a second lien holder who in turn retains priority over any third lien holder or any other subordinated debt holders or unsecured creditors to the extent of the available collateral.

Whilst market activity in the secured loan market is increasing, European syndicated secured loans are considered a highly attractive asset class with traditionally high historic recovery rates (de-pending on the relevant jurisdiction’s attitude to debtor/creditor protection) and such assets are therefore closely held by existing market participants. Unless an investor obtains access to these loans as part of a syndicate or in the secondary market, the only other way to obtain exposure is synthetically, through an LCDS.

Standardised industry-wide documentation and loan indices

The new ISDA standard documentation is already existing in the US and is being developed for European LCDS. Whilst the loan credit default swap index LCDX in the US (to contain 100 names) is still awaiting launch, the senior index iTraxx LevX Senior Index, which comprises 35 equally weighted LCDS referencing fi rst lien loans launched on 30 October. Its other component, the iTraxx LevX Subordinated Index comprising 35 equally weighted LCDS referencing second and third lien loans launched on 13 November, 2006. Both, standard documentation and the in-troduction of indices will further improve the trading infrastructure for LCDS and help liquidity, as the experience with indices and index-linked products in the CDS market and a trading volume of US$1.3 billion on the launch date of the iTraxx LevX Senior Index has shown.

The benefi t of indices is that they enable investors to utilise their investment resources more ef-fi ciently by increasing, amongst other aspects, transparency. iTraxx LevX will be split into senior secured (fi rst-lien) and senior subordinated (second-lien and third-lien) debt with about 35 credits in each categories comprising the most liquid high yield European corporate names ranked by trading volumes based initially on dealer polls. The constructor of the LCDX index, CDS Index Co., is also working with DTCC (a matching service providing a solution for derivatives post-trade pro-cessing) to introduce operational effi ciency in the LCDS market. This has already been introduced in the CDS market through DTCC and T-Zero (system enabling investment banks and their clients to affi rm derivatives trade details and incorporate accurate data to support all downstream opera-tional processes). Using the T-Zero platform in conjunction with DTCC and the more recent link-up with Thunderhead (document generation platform for over-the-counter derivative trade confi rmations) gives dealers the ability to produce paper documentation and match derivatives trade confi rmations in real-time, reducing both operational costs and risks. Other contributors to market effi ciency are companies such as Markit Group Limited, a provider of independent pricing, reference data, portfolio valuations and over-the-counter derivatives trade processing for fi nancial and commodities markets.

New regulatory standards

The recent dramatic growth in credit derivatives has partly been generated by banks’ desire to shift risk off their balance sheets to comply with international regulatory standards. With new capital rules for banks coming in next year, the most obvious buyers of LCDS protection (provided the LCDS has a scheduled maturity date of one year or more) may well be banks, since Basel II is designed to better match the capital that banks are required to hold with the risks that they take. Banks’ return on capital may suffer in some cases unless they hedge more of their loans, particu-larly high yield loans for which risk weightings will increase.

Attitudes of CLO managers and hedge funds

The attitude of CLO managers and hedge fund managers themselves in working with synthetic structures to improve effi ciency and fl exibility may also prove to be a signifi cant factor in expan-sion of the LCDS market. Although CLO managers have taken to include in their CLOs syn-thetic buckets for unfunded CDS exposure, such buckets still seem to be unused or under-used. Some of the major advantages of LCDS to CLO managers is the quicker access to a large pool of syndicated loan exposures which will speed up the construction of CLOs through shorter or no warehousing periods and increase diversifi cation of synthetic CLOs compared to cash CLOs. LCDS also provides a route into markets with regulatory restrictions and banking monopoly laws for unregulated hedge funds and managers. The absence of the need to get borrower consents and not having to deal with withholding tax requirements on the underlying asset should also speed up access for CLO managers. CLO managers will, however, have to deal with the lack of informa-tion they receive relative to a holder of the underlying cash instrument. As we shall see later (see “Syndicated Secured Dispute Event”), public information on syndicated secured loans is very thin on the ground in the European markets. Most information is private and only available to syn-dicate members and other indirect investors in such loans. Market participants investing in such loans synthetically will not have access to such information. In spite of the limits to information available in the syndicated loan market, many CLO managers are believed to be looking to take

advantage of the effi ciency and fl exibility the market will provide. The greatest restraint currently is a lack of liquidity. Many CLO managers may remain on the sidelines until we see the develop-ment of a more liquid market.

There has been an explosive growth in hedge fund linked structured products but the move of hedge funds into structured credit products has been even greater. In the US, hedge funds now control approximately 30% or US$210 billion of high yield trading volume, 26% or US$234 billion leveraged trading volume, 30% or US$2.5 trillion of credit derivative trading and an estimated 80% of all distressed debt trading. The current picture in Europe is very different with banks still making up more than half of the market in syndicated secured loans. This seems to be changing though. Hedge funds are big purchasers of equity, other subordinated tranches of CLOs and asset-backed securities and are very active in credit derivative markets as buyers and sellers of protection. Given the volumes, they are increasingly able to infl uence not only pricing but also the structure of credit products, and are becoming a major force in the capital markets.

The Documentation for Loan-Only Credit Default Swaps

On 8 June 2006, ISDA published, for use in connection with US LCDS, the Syndicated Secured Loan Credit Default Swap Standard Terms Supplement (LCDS Supplement) which incorporates the Credit Derivatives Defi nitions. In addition, ISDA published a template confi rmation for use with the LCDS Supplement (LCDS Confi rmation). The LCDS Confi rmation will, in the case of US LCDS be used to document particular transactions and any amendments to the ISDA

Master and the LCDS Supplement.

Documentation for European LCDS is still in draft form. The last discussion draft of the General Terms Confi rmation for Credit Derivative Transactions on Syndicated secured loans (Syndicated

Se-cured Loan Terms), annexing the Loan Transaction Supplement (Supplement) was circulated by ISDA

on 2 May 2006. A revised draft is expected to be circulated very shortly.

In the absence of a European industry-wide standard, some European market participants are using documentation such as the trade confi rmation developed by Morgan Stanley for use with European syndicated secured loans.

The more salient features of both sets of LCDS documentation are set out below. The discussion of the European LCDS is based on the currently available ISDA draft of 2 May 2006.

Callability/Cancellability

Callability is a feature that is common for syndicated secured loans, particularly in Europe where, with the exception of the junior or second lien loans, generally no hard call protection applies. Even in the case of junior or second lien loans call protection is limited to an initial lock-up period of one year or so and/or pre-payment penalties for the fi rst few years. Callability refers to the ability of a Reference Entity to pre-pay or refi nance a loan in accordance with its terms prior to the fi nal maturity of such loan. It enables the Reference Entity to get out of a loan in times of falling interest rates or if the Reference Entity has improved its fi nancial position and is therefore able to obtain a better deal on spreads by reducing the premium over e.g. LIBOR or EURIBOR compared to the existing spread.

European LCDS terminate or cancel upon redemption, repayment or other discharge in full of the Reference Obligation. This achieves a match between the loan exposure and the hedge of the as-sociated credit risk, at least for syndicated secured loans or tranches of such loans which have bul-let repayment. If a loan is amortising, this has no effect per se on the LCDS (unless standard terms are amended) since the Notional Amount of the LCDS is fi xed on inception of the contract. US LCDS do not terminate upon redemption, repayment or other discharge but are subject to sub-stitution in such circumstances. The subsub-stitution process (see “Subsub-stitution” below) built into US LCDS ensures that these contracts are not so cancelled. They can however be called (in whole only) prior to the Scheduled Termination Date through optional termination (Optional Early Termination

of a search notice (Search Notice) delivered by the Calculation Agent provided one of the following conditions have been satisfi ed:

no substitute Reference Obligation is identifi ed as at the Optional Early Termination Date; or the identifi cation of a Substitute Reference Obligation has not, by the Optional Early Ter-mination Date, become binding on the parties as to the Syndicated Secured characteristic be-cause aspects of the Secured Syndicated Secured Dispute have been completed by such date. Whilst the US approach is more desirable for a trading protection seller, given that the premia on the LCDS continue for the duration of Reference Obligation to the original maturity date and be-cause the protection seller keeps any upside at times of declining credit spreads, it does not allow for the matching of exposure and risk. It is to be seen whether the European markets adopt the US-style substitution mechanism and opt for a non-cancellable LCDS.

If it does, one of the issues that will need to be resolved is how the dealer poll (see “Syndicated Se-cured Dispute Event” below) in connection with substitution (see “Substitution” below) under the US LCDS would work in the European market. This is intrinsically linked to the issue of private versus public information which market participants have in syndicated secured loans. Whilst in the US basic information (which is suffi cient for investors in senior tranches but may not be suf-fi cient for investors in the lower tranches) on the structure of syndicated secured loans and their tranches is publicly available on information services such as Loan Connector, the European loan market is much more private with respect to information. Information is only available to lenders of record and, subject to confi dentiality agreements, prospective investors who are proposing to take on direct or indirect rights in the loan in the secondary market. Although the revised draft of the European LCDS is due for circulation shortly (and will include Cancellability), the debate on Cancellability is far from over.

Restructuring

This Credit Event, in the form of Modifi ed Modifi ed (as compared to the US where bond CDS use the form of Modifi ed Restructuring), is adjusted for European LCDS by the addition of the fol-lowing wording: or (vi) any security, guarantee or other collateral relating to one or more Reference Obligations is

released or discharged and as a result thereof any security, guarantee or other collateral relating to one or more Refer-ence Obligations (taken as a whole) is materially diminished (including, without limitation, a waiver of any manda-tory prepayment provisions following a disposal of assets), as determined by the Calculation Agent in consultation with the parties. The rationale for the addition of the above language is to reduce moral hazard.

The inclusion of Restructuring in European LCDS is, as we have seen, one of the concessions granted to the end-users for which this product has been created. Restructurings are common in the leverage loan market and whilst they may not always adversely affect the holder of a syndicated secured loan (e.g. increase in the spread in return for an extended repayment schedule) they cer-tainly have a fairly high level of uncertainty attached and lenders wish to cover such risk through •

a protection buyer cooperate in a restructuring that would adversely affect its rights when it has protection against such event?) and, in addition, is more likely to be easily triggered in the leverage loan market due to the above-referenced tendency to restructure loans frequently.

Following the occurrence of a Credit Event and the satisfaction of the Conditions to Settlement) the buyer of protection can deliver any Deliverable Obligation stipulated in the LCDS whose maturity is not longer than the maximum of that implied under the Restructuring and the longest available tranche prior to the Restructuring.

In the case of US LCDS, no Restructuring Credit Event applies even though it applies for US bond CDS.

Whilst this is likely to lead to wider spreads on European LCDS compared to US LCDS (to com-pensate the protection seller for the additional risk), the inclusion makes the European LCDS more valuable to the protection buyer since it enables it to effi ciently and effectively reduce regulatory capital usage provided the conditions of Basel II relating thereto are satisfi ed.

Basel II introduces higher-risk categories, such as claims on corporate borrowers rated below BB-, which will be weighted at 150 per cent. This may include syndicated secured loans. Besides a multitude of other conditions, full regulatory capital relief under Basel II is only applicable if Re-structuring is included in the derivative instrument. If it is not, then, provided the other relevant conditions of Basel II with respect the derivative instruments are satisfi ed, only partial recognition of the credit derivative will be allowed. If the Notional Amount of the CDS is less than or equal to the notional amount of the Reference Obligation, 60 per cent. of the amount of the hedge can be recognised as covered. If the Notional Amount of the CDS is larger than that of the Refer-ence Obligation, then the amount of the eligible hedge is capped at 60 per cent. of the Notional Amount of the Reference Obligation.

Reference Obligation

For European LCDS the Reference Obligation is all tranche or facility of a syndicated loan of the Reference Entity in existence at the trade date (Trade Date) of the LCDS or as otherwise stipulated in the Supplement. This commonly means the fi rst-lien of a syndicated secured loan but can also be the second-lien or third-lien of a syndicated secured loan. In addition, the Reference Obligation can be comprised of any new tranche (New Tranche) of the Reference Entity which is made avail-able after the Trade Date in accordance with the applicavail-able credit agreement whereby such New Tranche has to rank at least pari passu with the Reference Obligation(s) exiting on the Trade Date (Existing Tranches) and if such Existing Tranches are guaranteed, secured or otherwise collateralised, the New Tranche must benefi t from an equal or better ranking guarantee, security or collateral as the Existing Tranches. Finally, a Reference Obligation can be a credit facility with an undrawn commitment which has not been permanently reduced or cancelled.

In contrast, the Reference Obligation for a US LCDS is a loan or tranche of a Reference Entity (a) specifi cally specifi ed as Reference Obligation or (b) specifi ed by stipulating “Secured List”, in which case it is a loan with a Designated Priority specifi ed, with respect to any day, in the Relevant Secured List (Relevant Secured List). The Relevant Secured List is published by Markit Group

Lim-ited (or its successor) and available from its website. It is worth noting that the Reference Obligation specifi ed under (a) has to be, unless specifi cally excluded, a Loan (as defi ned under the Credit De-rivatives Defi nitions) of the Reference Entity with the Designated Priority on any given day set out in the Relevant Secured List (if any on such day).

In summary, the US LCDS is more restrictive in the choice of Reference Obligation because of the requirement of “Designated Priority” which does not apply to European LCDS where the Refer-ence Obligation can be the entire syndicated loan or a specifi c tranche thereof.

Deliverable Obligation

The Deliverable Obligation for European LCDS is the Reference Obligation and any senior obliga-tion which is secured by a security interest over the same assets as secure one or more Reference Obligations and benefi ts from the same or equivalent guarantees or other collateral as one or more Reference Obligations and in all material respects, ranks senior to the Reference Obligation, as de-termined by the Calculation Agent (Senior Obligation). This means that the protection buyer can, to satisfy its delivery obligation under Physical Settlement, deliver an obligation which is a higher ranking tranche of the Reference Obligation. Whilst this is a more expensive option, it provides fl exibility for protection buyers with a synthetic long position in circumstances where it can not or not fully source the required amount of the Reference Obligation but it holds or can obtain a more senior tranche of the Reference Obligation. A Senior Obligation includes undrawn facilities which if drawn would be a “Borrowed Money” (as defi ned in the Credit Derivatives Defi nitions) obligation of the Reference Entity. A Deliverable Obligation can have funded and unfunded facilities provided however that (a) “Delivery of Undrawn Commitments” is not excluded in the Supplement and (b) the total commitment under the Deliverable Obligation (i.e. unfunded and funded amount) must be specifi ed in the NOPS even though it is acknowledged that such amounts may change prior to delivery.

The Deliverable Obligation for a US LCDS is “Loan” (as defi ned in the Credit Derivatives Defi ni-tions), i.e. any obligation that satisfi es the Deliverable Obligation Characteristics which include, but are not limited to, “Syndicated Secured”, i.e. any obligation (including a contingent obligation) arising under a syndicated loan agreement with a Designated Priority or a priority senior thereto. The Syndicated Secured characteristic disregards any collateral securing the chosen Deliverable Obligation, any subordination of such obligation to other obligations of the Reference Entity and any lien or protection in respect thereof granted or to be granted under the US bankruptcy code or similar insolvency proceedings. If the Deliverable Obligation has a priority which is higher than the Designated Priority it is eligible for deliver provided however that the factors listed in the previ-ous sentence will equally be disregarded. In addition, the protection buyer can deliver Participation Loans which are Participations, Subparticipations or the Assignment of Participations (each as defi ned in LSTA Rider) pursuant to which the protection buyer can create for the protection seller certain contractual rights to payments (for European LCDS see “Settlement” below). Revolving

Although the US LCDS appears to provide more choice in the selection of the Deliverable Ob-ligation as compared to the European LCDS, the choice under the US LCDS may in practice be relatively restrictive since the Deliverable Obligation needs to have the Designated Priority.

Substitution of the Reference Entity

The Reference Entity in a European LCDS is “any person from time to time a borrower (or other-wise entitled to the benefi t of any credit), guarantor, obligor or other surety under or in respect of the Reference Credit Agreement” (as defi ned in the Syndicated Secured Loan Terms). The “Suc-cessor” provisions of Section 2.2 of the Credit Derivatives Defi nitions are disapplied. Whichever entity is “from time to time a borrower” etc. is the Reference Entity. If there is none, this would mean that the Reference Obligation has been repaid, redeemed or otherwise discharged in full and the European LCDS would terminate.

For US LCDS the Reference Entity is stipulated in the LCDS Confi rmation and the “Successor” provisions of Section 2.2 of the Credit Derivatives Defi nitions will apply with an amendment to the “Relevant Obligation” defi nition in Section 2.2(f) thereof which ensures that such Relevant Obligation satisfi es the Syndicated Secured characteristic immediately prior to the Succession Date by reference to the Relevant Secured List or if none, the determination of the Calculation Agent (which is subject to the Syndicated Secured Dispute Resolution).

Substitution of the Reference Obligation or Deliverable Obligation

For European LCDS Section 2.30 of the Credit Derivatives Defi nitions is disapplied, i.e. there is no substitution of the Reference Obligation once it is repaid, redeemed or otherwise discharged in full. This goes hand-in-hand with the Cancellability feature of European LCDS.

In contrast, US LCDS have a very elaborate substitution mechanism which seeks to ensure that the LCDS is only called as a last resort. The substitution mechanic relies on Section 2.30 of the Credit Derivatives Defi nitions with modifi cation to clauses (a) and (b) thereof. If:

“Secured List” is stipulated and the Relevant Secured List is withdrawn; or the Reference obligation stipulated in the Confi rmation:

- is repaid in whole or terminated with unfunded commitments having been repaid in full, in the opinion of the Calculation Agent (a) the Reference Obligation is materially reduced by any unscheduled redemption or otherwise or (b) the Qualifying Guarantee of an Underlying Obligation is no longer valid and binding and enforceable in accordance with its terms or (c) the obligation is no longer an obligation of the Reference Entity other than as a result of a Credit Event; or

- in the opinion of the Calculation Agent such Reference Obligation fails to satisfy the Syndicated Secured characteristic, the Calculation Agent will, in each case, upon request by either party to the LCDS or upon the effective delivery of a Credit Event Notice, deliver a Search Notice which stipulates that the Calculation Agent has commenced its search for a substitute obligation (Substitute Reference Obligation). The Substitute Reference Obligation •

has to satisfy the Syndicated Secured characteristic and be a “Loan” of the Reference Entity Upon completion of the search, the Calculation Agent will issue an Identifi cation Notice which will identify the Substitute Reference Obligation. The choice of such obligation is, absent obvious or manifest error or a Syndicated Secured Dispute.

Event, binding on the protection buyer and the protection seller as to the Syndicated Secured char-acteristic. It is worth noting that if the Reference Obligation changes following the initial publica-tion of the Relevant Secured List or due to a change in the existing Relevant Secured List, this will not trigger substitution of such Reference Obligation.

Syndicated Secured Dispute Event and Syndicated Secured Resolution

European LCDS have no dispute resolution mechanism and do not need one since there is no substitution of the Reference Obligation.

This contrasts with US LCDS which does have a built-in dispute mechanism for Syndicated Se-cured Dispute Events, i.e. a dispute with respect to the Syndicated SeSe-cured characteristic of the Reference Obligation or the Substitute Reference Obligation. Either party to the LCDS may dis-pute the Calculation Agent’s determination that:

the current Reference Obligation failed the Syndicated Secured characteristic; or

the Substitute Reference Obligation satisfi es the Syndicated Secured characteristic which, in either case, it can do by showing that a third party has etered into an LCDS and has commenced the dispute procedure with respect to the same current or Substitute Reference Entity, as ap-plicable.

In addition, the protection seller can dispute whether a particular Deliverable Obligation satisfi es the Syndicated Secured characteristic. Again, it can do so by showing that another protection seller has a dispute with respect to the same Deliverable Obligation.

Following the occurrence of a Syndicated Secured Dispute Event the Syndicated Secured Dispute Resolution operates to resolve the dispute by a dealer poll. The mechanics of the dealer poll are as follows:

The Polling Agent (either the Secured List Publisher or the Calculation Agent (each as defi ned in the LCDS Supplement) conducts a poll.

If the Polling Agent is the Secured List Publisher, a poll will be in accordance with the Secured List Publisher’s polling rules unless a poll under same rules for same Loan, Reference Entity and Designated Priority was completed or commenced prior to a request by the Calculation Agent. The Poll is either (a) “Affi rmative” (i.e. Syndicated Secured is satisfi ed), (b) “Negative” (i.e. Syndicated Secured is not satisfi ed) or (c) where quorum for a poll was not reached or no responses have been received by the relevant deadline “Affi rmative” if the Calculation Agent so •

•

• •

more responses and at least 3/4 agree that Syndicated Secured applies or (b) 2 or 3 responses and all agree that Syndicated Secured applies. Otherwise the poll is “Negative” unless, in the case of one or no response, the Calculation Agent decides the poll is “Affi rmative”.

If the poll is “Negative”, the Calculation Agent chooses another Substitute Reference Obligation in accordance with Section 2.30 (as amended) and if the poll is again “Negative” with respect to the next proposed Substitute Reference Obligation the process is repeated until the earlier of the Scheduled Termination Date or the Optional Early Termination Date (Section 5.2 of the LCDS Supplement) of the US LCDS. If the dispute is initiated by the protection seller with respect to a Deliverable Obligation and the poll is “Negative”, the protection buyer has 3 Business Days to revise the NOPS in respect of such Deliverable Obligation unless such obligation was fi rst identi-fi ed in a NOPS after the NOPS Fixing Date in which case no revision is permitted.

Settlement

Physical Settlement is the default settlement mechanism for European and US LCDS. This seems, at least for the European market, somewhat strange given the banking monopoly issues in the vari-ous European jurisdictions. In addition, one reason for the rise of the LCDS market is the fact that investors cannot source any or suffi cient allocation of syndicated secured loans and thus resort to synthetic exposures. The latter may by far outstrip the amount of Deliverable Obligations available in the market since the Notional Amount of an LCDS may well be in excess of the actual amounts of such Reference Obligation (unless a more senior, albeit more expensive tranche of the Refer-ence Obligation remains available for delivery). Recent bankruptcies (Delphi Corp., Dana Corp. to name but two) in the US clearly showed the diffi culties Physical Settlement can have on the markets. This has precipitated alternative mechanisms to deal with Physical Settlement issues and it may well be that the terms of the European LCDS moves to Cash Settlement and/or a hybrid settlement procedure which may even be capable of selection by either party.

In European LCDS, the protection seller (but not the protection buyer) can elect Cash Settlement: for all or some of the Deliverable Obligations specifi ed in a NOPS. If no fi rm quotations are obtainable for all or some of the Deliverable Obligations which are subject to Cash Settlement, Physical Settlement will then again apply as an automatic fall-back for those Deliverable Obliga-tions. The protection seller makes its Cash Settlement election within 5 business days (BD) after the date that falls 30 calendar days (CD) after the Event Determination Date (i.e. the fi rst date on which the Credit Event Notice and if applicable the Notice of Publicly Available Informa-tion are effective); or because

(a) the Deliverable Obligations specifi ed in the NOPS are not, on the Physical Settlement Date, capable of being assigned or transferred to the protection seller or its designee, because neither is a permitted assignee, transferee or other recipient, (b) required consents to the assignment/ transfer have not been received or (c) the protection buyer has not received the Deliverable Obligations due to be delivered by it and, as a result, the protection buyer gives notice to the protection seller to elect to create participations in the relevant Deliverable Obligations. The protection seller’s election of Cash Settlement has to be made within 5 BD after the date on which the protection buyer’s notifi cation with respect to the creation of participation becomes effective and will apply to those Deliverable Obligations stipulated by the protection seller in •

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The US LCDS documentation is for use in conjunction with the Physical Settlement Terms rider (the LSTA Rider) published by the Loan Syndication and Trading Association (LSTA). This LSTA Rider provides procedures intended to harmonise the standards for physical settlement under an LCDS with existing procedures in the secondary loan market developed by the LSTA and modifi ed to fi t the US LCDS market. A key term of the LSTA Rider is the market standard indemnity which allows the documentation relating to Physical Settlement under an LCDS to accurately mirror, on an on-going basis, evolving credit-specifi c documentation practices in the secondary loan market. Pursuant to the market standard indemnity, the protection buyer promises to indemnify the protec-tion seller for damages actually suffered as a result of an inconsistency between the documents used to transfer the secured loan and the documentation used in standard market practice applicable to the secured loan at the time of transfer. This promotes and facilitates fast and effi cient physical settlement of a US LCDS following a Credit Event. There is currently discussion in Europe as to whether a similar settlement mechanic should also be hardwired into the European LCDS. The terms of the LSTA Rider stipulates physical settlement by:

assignment unless:

- assignment has not occurred on or before the thirteenth Business Day following the Proposed Assignment Settlement Date because third party conditions precedent to such assignment have not been fulfi lled or waived on or before such date. This failure will lead to a settlement fall-back to participations;

- the protection seller does not execute and deliver to the protection buyer the require documentation and does not pay the relevant purchase price as prescribed in the LSTA Rider. Such failure will constitute an Additional Termination Event under the LCDS. participation unless:

- the protection seller elects Cash Settlement by notice to the protection buyer on or before the fi fth Business Day following the Proposed Fall-Back Participation Settlement Date; - participation fails because the protection seller does not execute and deliver to the protection buyer the required documentation and does not pay the required purchase price, or it has, but any third party condition precedent has not been fulfi lled or waived, in each case on or before the fi fteenth Business Day after the Proposed Fall-Back Participation Settlement Date. Such failure will constitute an Additional Termination Event under the LCDS unless the protection seller has elected a Cash Settlement; or

- the protection seller has executed and delivered all relevant documentation on or before the 5th Business Day following the Proposed Fall-Back Participation Settlement Date and a third party condition precedent has not been fulfi lled or waived on or before the fi fteent Business Day following the Proposed Fall-Back Participation Settlement Date. This will trigger partial Cash Settlement in accordance with Section 9.8 of the Credit Derivatives Defi nitions as amended by the LSTA Rider.

In addition, the LSTA Rider enables the protection seller and the protection buyer to mutually elect alternative settlement structures or other settlement arrangements which refl ect the economics of •

the trade. The LSTA Rider also deals specifi cally with the situation where the protection buyer is a lender under a Deliverable Obligation or holds a participation or subparticipation therein.

In terms of timing, for both, the European and US LCDS, the NOPS has to be delivered within 30 calendar days (CD) of the Event Determination Date. Deliverable Obligations have to be de-livered by the protection buyer to the protection seller within 30 BD of the day that is 30 CD after the Event Determination Date (in the case of European LCDS) and within 30 BD of the satisfac-tion of the Condisatisfac-tions to Settlement (in the case of US LCDS).

Outlook

The two sections above highlight the different motivations of the participants in this fast develop-ing credit market and some of the similarities and differences that apply with respect to how the US market and the European markets are dealing with documentational issues that refl ect those motivations.

Whilst there are still obstacles and unresolved issues such as the discussion of private versus public information, cancellability and the inclusion of Restructuring as Credit Event, these obstacles are unlikely to constitute a bar to the development of this market. LCDS fi ll the gap satisfying more or less the needs of end-users who require a hedging tool and investors who see LCDS as a trad-ing product. LCDS can be employed for (1) capital structure arbitrage (the relative value of senior loans versus high yield bonds or second lien or mezzanine loans); (2) credit risk management; (3) regulatory capital relief; (4) provision of credit exposure to bank loans from obligors located in jurisdictions having strict bank monopoly laws; and (5) circumvention of possible adverse tax con-sequences arising from a direct investment in a syndicated secured loan. Finding an agreed docu-mentational approach is not far away even if it involves an agreement to differ on certain specifi c issues. It is simply a matter of understanding what those issues are and amending the documents appropriately.

Loan-Only Credit Default Swaps And Basis Risk

Basis Risk - General

This section looks at Basis risk which arises from structural differences between holding a position in a syndicated secured loan and holding a “synthetic” position in the same syndicated secured loan through a Loan-Only Credit Default Swap. Basis risk arises from the potential difference between the return on the LCDS referencing a particular borrower (the “Reference Entity”) and the return on a syndicated secured loan (the “Reference Obligation”) granted to such Reference Entity as a result of factors affecting each of the instruments differently. Basis risk is only one of several aspects that an investor will need to take into account to make a meaningful investment decision between the two instruments when looking to hedge risk or identify investment opportunities. Other factors include, for example, the fact that derivative instruments used to obtain a “synthetic” position may have no initial funding costs.

Basis risk arises due to the factors that affect the return on the syndicated secured loan and the return on the derivative instrument referencing the loan not being constant and thereby allowing variances between the return on the holding of the syndicated secured loan and the derivative to increase or decrease over time. This prevents the derivative instrument from acting as a complete hedge to the underlying reference loan. This may or may not be important depending on the mo-tivation of the parties involved in the trade.

By way of example, some factor relevant to Basis risk are set out below:

If the cash instrument is more liquid than the derivative instrument the latter would tend to have a higher spread and may be more diffi cult to transfer than the cash instrument as a result of the lesser liquidity;

The investor who is long the cash instrument holds an interest with certain payment character-istics whereas the protection buyer under the derivative instrument may have a cheapest-to-de-liver option pursuant to which it can decheapest-to-de-liver a cheaper obligation than the Reference Obligation provided such obligation is pari passu with the Reference Obligation;

The investor who is long the cash instrument is subject to default on that cash instrument if any event of default occurs whereas the protection seller under the derivative instrument is not liable to pay for default other than in respect of a specifi ed Credit Event, typically “Failure to Pay”, “Bankruptcy” and, for European LCDS, “Restructuring”; and

The investor who is long the cash instrument is exposed to the credit risk of the Reference Entity whereas the protection buyer under the derivative instrument is exposed to the credit risk of the Reference Entity and is, in addition, exposed to the credit risk of the protection seller. Market participants’ motivation for using a CDS will shape its terms, to the extent this is possible in light of standard documentation in this market, and thus affect pricing of such derivative in-struments. Motivation depends on whether the entity is a buyer or seller of protection looking to manage individual loan or portfolio credit risk (and, related thereto, regulatory capital) or whether the entity is a dealer in a dealer market viewing CDS as a separate trading instrument.

•

•

•

In the fi rst case the protection buyer seeks protection to reduce the risk of certain Credit Events occurring in exchange for giving up part of its actual or notional return on the Reference Obliga-tion (which it may or may not hold). The protecObliga-tion seller’s intenObliga-tion is to noObliga-tionally extend credit to such Reference Entity on a leveraged (i.e. unfunded) basis for the fee (or premium) paid by the protection buyer and/or to enhance yield through a notional investment in a Reference Obliga-tion which it is unable to acquire directly. Here the protecObliga-tion buyer and seller are likely to want to replicate as closely as possible a holding of the loan itself. In the dealer market the parties are less concerned with replicating the loan which is more a reference point for pricing and settlement. The dealer market is more concerned with liquidity, ease of transfer and refl ecting differential pric-ing as a result of movements in credit risk generally.

Reasons for using credit derivatives

Derivatives technology provides an essential tool to market participants to manage credit exposure on a portfolio basis. Through the use of derivatives banks can maintain customer relationships whilst separating funding and credit risk, trade those components separately and potentially more profi tably and, provided all applicable conditions are satisfi ed, release capital previously tied up for capital adequacy purposes. Other benefi ts derivatives provide include access to assets which may not otherwise be available, ease in relation to settlement, documentational and operational aspects over those of the corresponding cash instrument. Investments through derivative instruments are particularly benefi cial to funds and non-regulated entities which would otherwise be subject to “banking monopoly” requirements and potentially disadvantageous bank requirements. Derivative instruments do not require the holding of the underlying cash instrument (e.g. loan) thus avoiding potential registration/authorisation under the relevant banking regulatory regime. Further, they do not, leaving aside tax consequences resulting out of any payment following a Credit Event, involve tax issues associated with the holding of a tranche in a loan, such as withholding tax and increased costs. Also, they benefi t, at least prior to the delivery of obligations (if any) following a Credit Event, from not requiring consent to transfer and/or the payment of any transfer fees normally associated with the transfer of the cash instrument.

Derivative instruments can also be used to split up features of an underlying loan asset and thereby take exposure to some but not all of these features. For example, a protection buyer, if long the underlying cash instrument, can dispose of the credit risk but retain benefi ts such as voting rights, increasing coupons due to a step-up pricing grid (if applicable) and/or non-recurring fees for changes in or breaches of covenants, in each case up to the delivery of a Notice of Physical Settle-ment following a Credit Event under the CDS. A CDS can be used to hedge a position in a cash instrument for a desired tenor which does not need to match the maturity of the loan and/or take exposure to a particular part of the capital structure of such cash instrument, the latter enabling the protection buyer to effectively target and reduce or eliminate specifi c recovery risk. A protec-tion seller can “lock-in” certain terms of a cash instrument for a particular period of time: there is, unless standard terms are amended, no change in the notional amount of the CDS as a result

who receives a fi xed premium on the CDS benefi ts from receiving the fi xed premium on the CDS notwithstanding the improved credit profi le of and reduced interest paid by the borrower under the cash instrument. On the other hand, in an environment of widening spreads and a step-up pricing grid a protection buyer benefi ts since it has “locked-in” the fi xed premium of the CDS at its inception notwithstanding the deteriorating credit of the borrower making the protection more valuable. In each case, the affected party can of course trade out of the contract, but this is associ-ated with additional costs.

Creating a market in credit derivatives

In order for an effective CDS market to develop which will enable end-user participants to take advantage of the benefi ts provided by derivative technology described above it is necessary that the CDS market develops a level of dealer participation suffi cient to provide depth and liquidity in the CDS product. This will involve the development of a dealing market where participants can profi t from the bid-offer spread in the CDS product and enable a level of activity to ensure that participants can hedge risk on single asset and/or a portfolio basis. One effect of this development in the CDS market is the continuing standardisation of documentation for derivative products in the form of the documentation published by the International Swaps and Derivatives Association, Inc. (ISDA).

The ability to trade credit risk in the dealer market requires documents that minimise the differ-ences in the structures of the underlying loans (e.g. differdiffer-ences in covenants between one loan and another) and focuses on the credit of the applicable Reference Entity with the effect that dealers are, in respect of documentation, driven by liquidity considerations rather than a particular risk analysis. More standardisation of terms and more uniformity in selecting such standardised terms will lead to less variation in pricing and thus greater liquidity, less administrative costs in negotiat-ing and monitornegotiat-ing transactions and less room for documentation mismatch. Ultimately, the risk for a dealer in CDS is documentational in nature, i.e. the risk that the terms on both sides of its portfolio are un-matched.

This requirement for consistency of approach in order to create liquidity will inevitably mean that end-users looking to the dealer market to obtain or reduce exposure to individual or portfolio credits will have to accept some element of standardisation of documents leading to some level of Basis risk. No protection provided by a CDS will be a perfect hedge and a protection buyer will have to factor this into its investment consideration. For example, the ISDA documentation only contains a limited set of uniform Credit Events. Whilst the parties are free to determine other events which may have a material effect on the Reference Entity, the need for some degree of uniformity in the dealer market is unlikely to permit a major departure from standard terms set out in the ISDA documentation. Protection sellers in the dealer market using CDS as trading instruments would not want to be exposed to risks which they are not able to hedge, which leaves protection buyers exposed to events which do not constitute Credit Events under the ISDA docu-mentation. Other factors that will need to be taken into account will be the buyer’s ability to deliver an obligation in a physically-settled CDS. If it does not own a deliverable obligation, it will need to source it in the market at market price which in some circumstances may make the protection

economically unviable. A protection buyer also needs to take into account the maturity mismatch of the CDS. If the CDS terminates prior to the maturity of the cash instrument, the protection buyer is exposed to the risk of the cash instrument for the period remaining after the termination of the CDS.

For protection sellers it is important to understand the actual risks incurred under a CDS. The broader the terms (with respect to the Reference Obligation, Credit Events, obligations) of a CDS, the greater the risk that the CDS behaves differently from the cash instrument and thus leads to greater and/or more complex risks than those incurred with respect to the actual cash instrument. Other risks are inherent in the nature of the CDS product. These include lack of access to non-public information that may be available to the protection buyer, lack of voting rights in respect of the underlying credit and the reduced opportunity for detailed due diligence on the underlying credit. This exposes the protection seller to the risk of obtaining, upon physical delivery, a cash instrument which has faulty or unfavourable enforcement terms. Whilst deliverable obligation characteristics somewhat mitigate this risk, they do not eliminate it in a market where the terms of the relevant cash instrument are not themselves standardised and, in addition, give the protection buyer the ability to select the cheapest (and therefore potentially more risky) obligation to deliver. Protection on a Reference Entity may make the protection buyer less concerned to monitor the Reference Entity and/or to take steps to minimise loss following the occurrence of a Credit Event or, in a restructuring, agree to terms that diminish the value of the underlying credit. In fact, a failed restructuring may be advantageous to a protection buyer if it leads to “Bankruptcy” under a CDS which does not include “Restructuring” as a Credit Event.

Specifi c features to consider

Some of the more signifi cant differences that participants need to take into account in combining LCDS and the related secured leverage loan are features such as Callability, Cancellability, Cov-enants, Pricing, Deliverables and Restructuring each, as highlighted below.

Callability

This feature is common for syndicated secured loans, particularly in Europe where, with the excep-tion of the junior or second lien loans, generally no hard call protecexcep-tion applies. Even in the case of junior or second lien loans call protection is limited to an initial lock-up period of one year or so and/or pre-payment penalties for the fi rst few years. It refers to the ability of a Reference En-tity to pre-pay or refi nance a loan in accordance with its terms prior to the fi nal maturity of such loan. It enables the Reference Entity to get out of a loan in times of falling interest rates or if the Reference Entity has improved its fi nancial position and is therefore able to obtain a better deal on spreads than previously. Since spreads on syndicated secured loans are usually calculated on a fl oating rather than fi xed rate basis, this feature is less signifi cant than for example for a CDS on a fi xed rate bond. However, so long as the Reference Entity has the ability to pre-pay and refi nance at a lower margin, the potential effect of this features on the Basis is negative, i.e. the spread on

Cancellability

European LCDS terminate upon the redemption, repayment or other discharge in full of the Reference Obligation, which puts them more in line with actually holding the syndicated secured loan and eliminates Basis risk, at least for syndicated secured loans or tranches thereof which are subject to bullet repayment. In contrast, US LCDS can only be terminated in whole at the election of the protection buyer or the protection seller, to the extent that no substitute for the Reference Obligation with the requisite Deliverable Obligation Characteristics is identifi ed. The inclusion of the Cancellability feature in European LCDS increases, all other things being equal, the value of protection to the protection buyer but also its cost since the protection seller will need to be com-pensated for the risk of losing the premium if the underlying loan terminates prior to the maturity date of the LCDS. European markets show high levels of prepayment with an increased likelihood of full repayment prior to the maturity of a syndicated secured loan. The ability to cancel the Eu-ropean LCDS should drive spreads on such LCDS higher than for the equivalent US LCDS.

Covenants

Covenant packages, tend to be substantial for syndicated secured loans, they are maintenance based (as opposed to incurrence based for bonds) and generally include a negative pledge, change of control provisions and fi nancial covenants ensuring that, inter alia, profi tability and leverage ratios are kept within pre-determined bands. Investors who are long such loans may benefi t more from the restrictive covenants than protection sellers since breaches, potential breaches of, or changes in, such covenants may generate consent fee income for such investors. The relevance of this factor however depends entirely on the covenant package. This may lead to a higher spread on the LCDS as compared to the spread on the syndicated secured loan.

Pricing

The premium payable by the protection buyer to the protection seller under an LCDS is a fi xed amount whereas the interest on a syndicated secured loan is invariable of a fl oating nature and may have certain other variable features such as step-up or step-down provisions. Investors who are long loans with a step-up provision obtain a potential upside on the syndicated secured loan in the form of a higher coupon in the event of the deteriorating creditworthiness of the Reference En-tity or a deterioration in other parameters identifi ed by the covenant. The protection seller of an LCDS would not receive such upside. Investors in the syndicated secured loan will accept a lower spread (than that of the related LCDS) because of such step-up provisions.

A step-down pricing grid will enable the Reference Entity to pay less spread over time. In the US this is usually tied to the fulfi lment of conditions on a particular date whereas in Europe the avail-ability of step-down provisions is tied to a reduction in net leverage. The protection seller will receive the same fi xed premium for the currency of the LCDS. All other things being equal, the effect of this feature would be that the investor in the syndicated secured loan would need to be compensated through a higher initial spread for the step-down provisions.

Deliverables

The cheapest-to-deliver option is available to all protection buyers unless the deliverable obligation is limited to the Reference Obligation only. Currently European LCDS usually require the deliver-able obligation to the Reference Obligation only. The choice of deliverdeliver-ables under US LCDS is wider. Unless the protection buyer is long the deliverable obligation, it will have to source such obligation following a Credit Event to fulfi l its obligations under a physically-settled LCDS. It will do so by purchasing the cheapest available cash instrument that satisfi es the deliverable obligation characteristics. The protection seller is, as a result, getting the potentially least valuable obligation and/or an obligation with less favourable enforcement terms than it would have received had the protection buyer chosen the Reference Obligation or a more expensive cash instrument. The mag-nitude of Basis risk relating to this aspect will depend entirely on the size of the pricing differential between the deliverable obligation and the cash instrument to which the LCDS is compared. In the current environment where even defaulted loans can trade at or very close to par, the effect of the cheapest-to-deliver option may be negligible.

Restructuring

This Credit Event, typically “Modifi ed Modifi ed Restructuring” (subject to one modifi cation) is commonly applicable in the European markets whilst “Modifi ed Restructuring” is used in the US bond CDS market. Generally no Restructuring Credit Event is applied in US LCDS. Given that syndicated secured loans are frequently amended, one would expect a higher premium for the European LCDS (to the extent it includes this Credit Event) to compensate the protection seller for an additional and relatively vague trigger event for payment. The investor with a long position may, as a result of an event that would under a European LCDS constitute a “Restructuring”, not actually suffer any economic disadvantage (or even reap a windfall) whereas the protection seller would have to make a payment to the protection buyer. In the case of the US LCDS an investor with a long position is more likely to be worse off by being negatively impacted by a restructuring event which does not constitute a Credit Event with the result that the protection seller would not have to make a payment under a US LCDS.

Voting Rights

To the extent the protection buyer is long the Reference Obligation it is able to exercise voting rights with respect to the Reference Obligation which the protection seller is not able to exercise until such time as the Reference Obligation (assuming this to be the Deliverable Obligation) is transferred into the name of the protection seller or its nominee. The protection seller would need to be compensated for the lack of voting rights.

Funding

LCDS are unfunded, i.e. the protection seller does not have to fund its exposure to the Reference Obligation since its obligation to pay only arises once the Conditions to Settlement upon the

oc-Summary

In summary, the structural differences between the cash instrument, i.e. the syndicated secured loan, and the related derivative instrument, i.e. the LCDS, result in pricing and return differences which may vary over time making it diffi cult, if not impossible to achieve a perfect hedge in the credit of the underlying asset. Even between LCDS contracts themselves structural differences (e.g. the inclusion of “Cancellability” and “Restructuring” in the European LCDS) mean investors have to be careful about the extent to which LCDS provides an adequate hedge to portfolio or individual asset risk.

Martin Bartlam

Finance Partner

Orrick, Herrington & Sutcliffe Tower 42, Level 35

25 Old Broad Street London EC2N 1HQ Tel: +44 (0)20 7422 4777 Fax: +44 (0)20 7628 0078 Email: [email protected] Jim Waddington Finance Partner

Orrick, Herrington & Sutcliffe Tower 42, Level 35

25 Old Broad Street London EC2N 1HQ Tel: +44 (0)20 7422 4612 Fax: +44 (0)20 7628 0078 Email: [email protected] Karin Artmann Finance Associate

Orrick, Herrington & Sutcliffe Tower 42, Level 35

25 Old Broad Street London EC2N 1HQ Tel: +44 (0)20 7422 4683 Fax: +44 (0)20 7628 0078 Email: [email protected] Alper Deniz Finance Associate

Orrick, Herrington & Sutcliffe Tower 42, Level 35

25 Old Broad Street London EC2N 1HQ Tel: +44 (0)20 7422 4613 Fax: +44 (0)20 7628 0078 Email: [email protected]

If you have specifi c questions regarding this article, please contact any of

the lawyers below or any of your usual contacts.

Martin Bartlam

Partner, European Finance London Offi ce

+44 0 20 7422 4777 [email protected]

Mr. Bartlam is a qualifi ed solicitor in England and Wales, is a partner in the Finance Group of Orrick in London, and is the partner in charge of Orrick’s London offi ce. Mr. Bartlam has extensive experience in U.K. and international fi nancing activities.

Mr. Bartlam specialises in structured fi nancial products including cash and synthetic structures for a variety of underlying asset classes such as RMBS, ABS and CDOs as well as acting on tailored structured fi nancings and tax enhanced products. Previous experience includes hands-on banking transactional work as head of structured products at Credit Lyonnais in London (now Calyon) and as a member of the debt structuring team of Greenwich Natwest (now RBS)

Mr. Bartlam has written on a number of topics, including:

• Contribution to the sections on “Structured Finance and Securitisation” for Practical Law Company’s web based guide to fi nance practitioners.

• “Securitisation, an overview” First part of a two part series on secured fi nance for Practical Law Company (July 2006).

• “Securitisation, The options available” Second part of a two part series, outlining the different types of securitisation for Practical Law Company (August 2006).

• “Finding the Law in European ABS” – an analysis of receivables fi nancing in Europe for Finance 2003, a Legalease special report

Mr. Bartlam’s speaking engagements include:

• The 2004 European Securitisation Forum on “Capital Market Instruments and Infrastructure

Project”

• The 2005 Global ABS Conference in Barcelona on “State-Backed Infrastructure & Regulated

Utility Structured Bond Transactions: A market in the fast lane.”

• The 2006 Euromoney Leveraged Finance Conference on “Hedge Funds the new playmaker in

Karin Artmann

Finance Associate London Offi ce +44 0 20 7422 4683 [email protected]

Karin Artmann is a qualifi ed solicitor in England and Wales and is an associate in the fi nance department of Orrick in London. Ms. Artmann’s practice focuses on structured fi nance (in particular, securitisations), capital markets and derivatives. Prior to joining Orrick Ms Artmann worked with international British and US law fi rms in London and New York. She gained considerable in-house legal and transactional experience during a secondment to Deutsche Bank AG, London’s structured products and transaction management groups and, more recently, prior to joining Orrick, through her position as in-house counsel to KBC Financial Products (UK) London and KBC alpha Asset Management.

This article, which has been prepared by Orrick, Herrington & Sutcliffe, London, is intended as a general guide to the topic that it covers. It does not purport to address all the issues that may arise and it should not be relied upon in relation to any actual or potential transaction. If you have specifi c questions regarding this article, please contact any of the lawyers on the previous page or any of your usual contacts.