CDx Survey

Market volumes growing while new concerns emerge

JAMES BATTERMAN, KRISHNAN RAMADURAI, ERIC ROSENTHAL, FITCH RATINGS

Fitch Ratings comments on key trends, as well as opportunities and challenges facing the credit derivatives (CDx) market in the fifth annual update of its 'Global Credit Derivatives Survey'. Fitch's benchmark survey of the credit derivatives market continues to be unique in that it captures usage and credit flows across geographic regions and specific sectors of the financial community, often operating under separate regulatory umbrellas.

Survey highlights

  • The credit derivatives market continues to expand at a remarkable pace, evidenced by the dramatic increase in total notional amount outstanding over the past year. The total amount of credit derivatives bought and sold combined at year-end 2006 rose to US$49.9trn, an increase of 113% over the US$23.4trn reported for year-end 2005.
  • Leading the charge has been the traded indices, which, notably, surpassed single-name CDS (Credit Default Swaps) in terms of total notional volume outstanding last year. Fitch estimates that US$22.2trn of index products has been bought and sold by year-end 2006, compared with US$20.0trn in single-name CDS.
  • Some of the most cited market challenges going forward include those related to how smoothly the market can deal with a turn in the credit cycle. This includes concerns with regard to liquidity in the event of such a downturn, the impact that the unwinding of system leverage can have on volatility, and settlement following a credit event.

 

Prospectively, most market participants expect the CDx market to continue its expansion, with CDOs (Collateralised Debt Obligations), LCDS (Loan-only Credit Default Swaps), and the traded indices mentioned as the biggest growth vehicles. Some respondents expect single-name CDS and some varieties of CDOs to lag behind other structures in terms of growth.

  • The trend towards lower-quality and unrated reference entities continued last year. Approximately 38% of all CDx referenced at year-end 2006 was either speculative grade or unrated, versus 34% at year-end 2005, and only 18% back in 2003, a consequence of market maturation, as well as investors' continuing search for higher returning risk exposures in a spread-constrained environment.
  • On the surface, banks globally appear to have become somewhat more conservative in terms of their exposure, ending 2006 at US$304 billion net protection bought. However, while continuing to use CDS as a hedging vehicle, banks increasingly cite 'trading' as the leading rationale for employing CDx. As a result, these aggregate results hide significant variation in the position of individual banks, with many actually reporting positions which show them to be major sellers of protection.
  • While banks remain net buyers of protection, the global insurance and monoline industries continue to be key net sellers of protection at US$395 billion and US$355 billion, respectively, at year-end 2006.

This survey covers 65 financial institutions (44 banks and broker-dealers, 13 insurance and reinsurance companies and eight financial guarantors), very similar to the 75 institutions surveyed last year. In Fitch's opinion, the institutions covered represent some of the most important players in the CDx market.
 

FORWARD-LOOKING VIEW

 

Market expects growth to continue

As part of Fitch's annual CDx survey, the agency asks market participants to give a prospective view on the market in terms of expected growth in a general sense, as well as for those specific structures expected to exhibit more, as well as less, rapid growth than the rest of the market. Additionally, Fitch solicits views on any challenges facing the market, along with any predictions for the coming year. As the pie-chart illustrates (Figure 2), survey respondents expect CDx volume to continue increasing at a substantial rate, albeit possibly lower than that experienced in 2006, with approximately two-thirds of respondents expecting between an 11% and 50% increase this year. No participant expected volume to decline. CDOs, LCDS, and the traded indices were most frequently cited as those structures expected to exhibit the most robust levels of growth. While the total notional amount sold to date on LCDS is dwarfed by that of other structures, the rate of increase has been very strong, spurred by the advent (in the US) of the LCDX index and refinements to single-name documentation released in the middle-part of last year.

 

The growth of the indices has been well-documented since their introduction, and as is clear from the figures, this expansion has continued unabated. Figure 3 illustrates those structures that received at least three votes out of the 65 institutions surveyed. Note that some institutions provided multiple answers, while others provided none.

Single-name CDS, some varieties of CDOs, and – perhaps surprisingly – the traded indices, are the structures expected by some market participants to exhibit less robust growth, with no other category receiving more than three votes. In fact, the most common response was "none," indicating that the entire market would continue growing at a rapid pace. Figure 3 shows those structures receiving at least three votes in this category. Please note that both the high- and low-growth product charts show, in the case of single-name CDS and the indices, both structures, reflecting differing views from our respondents.

Market challenges

We also asked market participants what they thought some of the key challenges would be in the future, both in the near-term and out further. Some of these were very specific, and very difficult to categorise. Of those that were possible to classify, the leading categories for the near-term included concerns with regard to infrastructure, the credit cycle in general, documentation, liquidity, and settlement following a credit event.

Figure 4 shows those top 10 categories garnering the most votes, for both near-term and more distant concerns. To put this in context, recall that 65 institutions participated in our survey. Concerns over infrastructure, specifically operations and IT capacity, were most noted as potentially problematic, particularly back-office operations such as those related to trade confirmations. Another category frequently mentioned was documentation. As it turns out, much of the commentary in this regard, at least for near-term concerns, was in relation to LCDS documentation. It is worth bearing in mind that survey results were received, to a great extent, while deliberations as to modifications of the US single-name form and the LCDX were still ongoing. Please refer to Box 1 for a discussion of some of the most significant longer-term concerns.
 

Respondent predictions

Finally, Fitch asked participants to give some surprise forecasts. The greatest number of predictions were related to an increase in spread volatility, followed by an unexpected increase in credit events. Other respondents expect, not unrelated to this, spreads to widen, although others believe that the market will generally hold steady. Several respondents expect greater investor acceptance of credit derivatives in general, and even more complexity, as well as undisclosed product innovations. A few others expect certain changes from the rating agencies with regard to ratings methodology, among other matters.

Hedge funds

Although in-depth data remains elusive, it is apparent that hedge funds' pursuit of credit-oriented strategies and their influence on key segments of the credit markets has continued to grow at a dramatic pace. The growing influence of hedge funds in the credit markets – cash and CDS – is supported by third-party research from Greenwich Associates which reported, last year, that hedge funds are responsible for driving nearly 60% of all CDS trading volume and one-third of trading volume in CDOs. Given the rapid growth of the CDx market and the increasing influence of hedge funds, it is reasonable to assume that trading volumes would have gone up in 2006.

Following recent market events, some high-profile hedge funds have been forced to liquidate positions to meet sharply increased margin requirements and stem portfolio losses. In Fitch's opinion, the uncertain outlook for credit markets, combined with the large positions taken by hedge funds – which is magnified by the leverage strategies adopted by many of them, may well result in a number of hedge funds and banks attempting to close out positions with no potential takers of credit risk on the other side. This is particularly an issue in the structured credit markets which can be hard to value and therefore illiquid. (For more information on the role of hedge funds in the CDx market and credit markets in general, see "Hedge Funds: The Credit Market's New Paradigm", published on 5 June 2007 and available at www.fitchratings.com).

LEVERAGE, LIQUIDITY, AND THE CREDIT CYCLE

As far as the credit cycle is concerned, a small minority of market participants expect either a major default or a general increase in defaults in the near-term, while certain other investors have concerns that liquidity may suffer or disappear in an eventual downturn of the market. Yet other participants are concerned that an unwinding of system leverage will only serve to exacerbate this situation. Note that as the time-frame expands beyond the next 12 months (the chart entitled 'Future Challenges'), these concerns become more acute.

In particular, system leverage, which wasn't anywhere near the top of the list as far the near-term view, is at the top of the longer-term list of concerns, along with the credit cycle and settlement following a credit event. How well the market weathers a major downturn in all these respects remains an unanswered question. While not necessarily a foreshadowing of things to come, the recent lows experienced by the ABX index, as well as recent spread volatility on the corporate side, gives some credence to such concerns, and thus these rankings should be of no surprise. Other areas of concern are succession, market volatility, and pricing/ transparency.

MARKET ACTION

Growth

The CDx market's remarkable growth rate continued last year, rising 110% on a sold basis in absolute terms among survey respondents. In terms of total volume, Fitch identified US$25.2trn of gross protection sold and US$24.7trn of gross protection bought, the difference representing institutional activity not picked up by the agency's survey (see Figure 5). Indices and single-name credit default swaps have served as the driving force behind the nearly USD50trn notional volume bought and sold to date, accounting for approximately 84% of the market. Since Fitch released its inaugural report in 2003, the total notional amount outstanding has climbed a staggering 1,326%. Compared with last year's results, the total notional increased an impressive 113%.

Clearly, the amount of bought positions should equal that sold; however, the figures provided give a net sold position of US$447 billion, compared with US$377 billion at year-end 2005. This net increase can mainly be attributed to the fact that hedge funds, asset managers, and pension funds, which are a substantial part of the market, were not included in the survey.

The fact that this net gap is actually quite small in the context of the overall size of the market attests to the scope of the survey. Please note that the Fitch survey targets the most significant, but clearly not every, financial institution active in CDS, with the exception of the hedge funds, which are generally reluctant to reveal what they view as confidential information. For simplicity, the text that follows will generally refer to the amount sold.
 

As forecasted in last year's report, indices were indeed the highest-growth product at year-end 2006. After tallying US$3.7trn at year-end 2005, indices reached a whopping US$11.1trn on a sold basis (US$22.2trn on a combined bought and sold basis) in 2006, a 198% jump from a substantial base. In terms of a regional breakdown, 55% of the volume came from North American respondents, with the balance coming from Europe/Asia.

For both the US and Europe, the investment-grade series were predominant. For example, the breakdown of the Dow Jones CDX NA (North America) series in terms of the total notional amount outstanding as of year-end 2006 was 91% IG (investment-grade), 2% XO (crossover), and 7% HY (high-yield). The breakdown of the ITraxx Europe series was similar, being 87% IG, although XO at 9% was greater than HY at 4%. The ABX, CMBX, and LevX indices measured only 0.5% of the entire sold volume.

From a country perspective, North America accounted for the majority of index exposure, at 51% of the total protection sold, followed by Europe at 46%, Asia at 2%, and the Emerging Markets at 1%. Finally, untranched index exposure outpaced that of tranched exposure by a 3:1 margin. It is important to note that for equity or some mezzanine tranches, the degree of leverage one can achieve through tranching can provide exposure to the underlying instruments far in excess of an untranched vehicle.
 

Single-name CDS

While last year's survey gave mixed views on the growth potential of single-name CDS vis-à-vis other structures, such as the indices, growth in this space was in fact a robust 69% in 2006, following a 65% increase the prior year. At year-end 2006, single-name CDS totaled US$10.1trn gross sold, or US$20.0trn bought and sold. However, for the first time, single-name CDS volume trailed that of the indices. While LCDS was identified as another growth area last year, this was not evident in year-end 2006 numbers, which show just US$29 billion of total volume, compared with corporate bond CDS of US$19.5trn. However, the 22 May introduction of the LCDX, as well as changes to single-name documentation and generally greater investor understanding/acceptance of this structure is already showing an effect, with trading volumes increasing notably.

Other products

Corporate synthetic CDOs and structured finance synthetic CDOs at US$3.6trn bought and sold made up just 7% of the entire volume, while other portfolio products, at 6%, comprised US$3.1trn. In addition, the combined figures for total return swaps, credit swaptions, recovery swaps, market value products, and other products consisted of less than 2% of the entire volume.

Global banks' net position

Global banks remained net buyers of protection at US$304 billion at year-end 2006. Note, however, that this aggregate position masks significant variance in the positions of individual banks, with 45% of the 44 banks surveyed being net sellers of protection. Furthermore, several of the regions/countries exhibited noticeable swings, in particular, the UK & Switzerland. After maintaining an essentially flat position at year-end 2005, the region, at US$170 billion net long, was the biggest net protection buyer at year-end 2006. Germany's banks collectively were the sole net sellers of protection at year-end 2006, at US$76 billion, a significant increase from 2005; however, this has been driven principally by two large players. 15 institutions saw their net position fluctuate by US$10 billion or greater from the previous year's results.

Ratings quality

Once again, the low default environment, coupled with tight spreads, pushed investors further down the credit curve. Speculative-grade and unrated tranches totaled 40% of the gross sold exposure at year-end 2006 (38% if the bought and sold amounts are averaged), with the bulk of this coming from the unrated facilities.
 

When Fitch started its survey, speculative and unrated exposure as a percentage of the total was relatively small, at 8%. Since then, this segment of the CDx market moved to 18% in 2003 and then 24% in 2004, before reaching 31% in 2005.

This has been the result of negative credit migration, as well as investors reaching for increased spread in an increasingly spread-constrained environment, in addition to the general growth of the CDx market. At the opposite end of the spectrum, the proportion of credits rated at or above 'AAA' minimum thresholds have declined each year, starting at 22% at year-end 2002 and falling to 9% at year-end 2006, although clearly this is due to the rapid expansion of other areas of the market. In notional terms, the 'AAA' sector continues to grow.

Tenor

With the CDx market becoming well established, trading longer (as well as shorter) tenors is becoming more commonplace. For example, at year-end 2006, tenors of seven years (protection sold) or greater accounted for 25% of volume, up from 19% at year-end 2005 and 10% at year-end 2004.

In examining the data on a flow basis, it appears as though volume is moving away from the benchmark five-year point of the curve.

Reference entities

Automotive and telecommunication companies, along with sovereigns, occupied the top 10 slots on both a bought and sold basis for the most cited reference entities. General Motors Corp. (rated 'B') and DaimlerChrysler AG ('BBB+') held the top two spots on both lists. The two automotive companies have maintained a top-four position since Fitch published its initial report. Sovereigns, in particular Italy ('AA-'), Brazil ('BB+'), and Russia ('BBB+'), were the most commonly cited names, with 36% and 28% of these seen on the respective bought and sold top 25 lists. With regard to industrial sectors, telecommunication companies make up 20% of the cited names while automotives comprise 16% of thetotal. In terms of the biggest movers, Telefonica SA ('BBB+'), BT Group plc ('BBB+'), and Time Warner Inc. ('BBB') moved up from the prior survey.

In terms of concentration, the top five reference entities on a sold basis accounted for 13% of those cited, down from 18% at year-end 2005. From a bought perspective, the results are similar, with the figures falling to 17% at year-end 2006 from 21% the prior year. This somewhat lower concentration is also evident when examining the top 20 names, which dropped to 34% of the total universe from 38% on a sold basis.

By sector, non-financial corporate instruments comprised 64% of the volume, followed by financial institutions at 23%, structured finance at 8%, sovereigns at 5%, and others at 1% on a sold basis.
 

Counterparties

Regarding market-making activity, the top 10 counterparties made up 62% of the total exposure on a trade count basis, down from 66% at year-end 2005 and 70% at year-end 2004. However, on a notional basis, concentration has been increasing to ever higher levels, with the top 10 institutions providing 89% of the total notional amount bought and sold. This represents an increase from the 86% experienced at year-end 2005. Morgan Stanley ('AA-'), Deutsche Bank ('AA-'), Goldman Sachs ('AA-'), and JP Morgan Chase ('AA-') were the top four counterparties for the second year in a row, and have held one of the four top slots for the past four years. In terms of trade count and volume (total notional amount traded), nine and eight, respectively, of the top 10 counterparties were the same as in 2005. In addition, 19 of the top 20 names are the same as in 2005, indicative of the lack of change in this area. For better or worse, counterparty concentration appears to remain a feature of this market.
 

Credit events

Credit events noted by respondents fell to a benign 44 in 2006 from 105 in 2005. Automotive part suppliers Dana Corp. and Dura Operating Corp. accounted for 73% of the 2006 credit events cited. Calpine was the next highest referenced name, at just 7%. On 3 March 2006, Dana filed for Chapter 11 bankruptcy, with roughly US$2 billion of outstanding debt. The company experienced financial stress as a result of reduced business from its key domestic customers. On 15 October 2006, Dura failed to make a coupon payment and two weeks later filed for Chapter 11 with roughly US$800m of outstanding debt. Dura cited cutbacks by US automakers and rising raw materials costs for its bankruptcy filing.

Motivation for using credit derivatives

Trading and hedging/credit risk management were given as the dominant motivations for using credit derivatives. The five categories used that attempt to capture the institutional rationale behind using credit derivatives can be seen in the Figs.16 and 17. From a banking perspective, trading served as the dominant purpose, with 58% of the respondents electing this category. This is up from the 51% figure seen a year earlier, and is significant, as it confirms the transition of CDx from a hedging vehicle into primarily another trading asset class. In general, most of the 2006 banking figures were in line with the prior year results. On the insurance side, hedging/credit risk management and the use of credit derivatives as an alternative asset class remain the primary motivations for employing credit derivatives.
 

Market values

Given the difficulties in collating and interpreting market value data, Fitch has not published any specific-market value figures. Although market values clearly add to a better understanding of risk than notional amounts, Fitch would like to highlight that as valuations are largely driven by model assumptions which may not always reflect realisable market prices, institutions may be understating losses or overstating gains. Recent market events in the US sub-prime market reinforce the point that caution must be exercised when analyzing market values.
 

SECTOR RESULTS

Global banks

Globally, a small number of banks and broker-dealers continue to dominate credit derivatives activity. The 44 banks and broker-dealers surveyed had an aggregate of nearly US$24.6trn (2005: US$11.3trn) gross bought positions, which represents a growth rate of 117%, and is largely a manifestation of their role as traders and market makers, as well as risk transfer activity undertaken by banks as part of a broader business strategy which focuses on an 'originate-and-distribute' model of business in contrast to the traditional 'buy and hold' model.

Such a strategy has also helped banks to diversify and reduce concentration risks in their credit portfolios. These banks and broker-dealers also reported a 120% increase in gross sold positions to more than US$24.2trn (2005: US$11.0trn).

The increase in gross sold positions was influenced by the larger intermediation role played by banks and broker-dealers in meeting investors' demand for portfolio diversification, enhanced yield, and general preference for increased structural complexity and leverage. The rapid growth of CDx indices and index-related products (indices exposures constitute 46% of exposures by products at year-end 2006) has been an additional factor in driving growth for the second year in succession. Collectively, the global banking industry remains a net buyer of protection, with US$304 billion of notional credit risk being transferred to other sectors and institutions although 20 of the banks surveyed, or 45%, were net sellers of protection. The net bought or sold position is not necessarily a reflection of true underlying risk being transferred from the banking book by banks to other players in the financial markets, given the growing dominance of trading activities compared with traditional hedging of banking book exposures.

Indeed, the net position of many of these institutions increasingly reflects their current view of the credit markets, and both net bought and sold positions are taken. Gross and net positions were also influenced by market demand and supply factors.

In line with past trends, there were notable swings in the net sold and bought positions within the banking sector, both in Europe and the US; while some large banks shifted from being net protection sellers to net protection buyers, there were an equal number of banks that shifted from being net protection buyers to net protection sellers. This is partially a reflection of the varying views and positions taken by participants in credit as an asset class.

On a cumulative net basis, the European banks bought US$220 billion of protection, North American banks and broker-dealers bought US$70 billion of protection and Asian banks bought US$14 billion of protection, which sums to the aforementioned US$304 billion global figure. As stated before, this overall picture however, masks differences at the country level within the various regions, where some banks have substantial sold positions while others have significant bought positions. Some of the smaller regional banks continue to use CDx as an additional means of originating credit.

Given the relatively benign credit environment in 2006 and the continuing demand from investors for more yield in a yield-constrained environment, the data indicates that banks increasingly tend to trade across the entire ratings spectrum and in longer tenors (25% of gross sold positions were seven years or greater, compared to 18% for the same maturity at year-end 2005).

Global insurance

The global insurance/reinsurance sector, representing principally AIG Financial Products, remained a large seller of protection, registering an aggregate gross sold position of US$503 billion. On a net basis, the sector stood at US$395 billion sold, up slightly from the US$383 billion tallied at year-end 2005. Structured finance synthetic CDOs and corporate synthetic CDOs accounted for 93% of the sold volume. In terms of quality, of the total gross amount sold, 93% was in the super-'AAA' segment, versus 91% reported in last year's survey.
 

In addition, 68% of the tenor sold ranged from one year to four years (compared with 44% at year-end 2005) though that was driven by AIG's dominant 'footprint' in this market. Excluding AIG Financial Products' sizeable position, the global insurance industry had a net position of only US$11 billion (US$21 billion gross sold), down from the US$15 billion (US$29 billion gross sold) compiled at year-end 2005. Some of the decline can be attributed to a smaller sample than in the previous year.

By product on a sold basis, single-name CDS consisted of 63% of the volume, while corporate synthetic CDOs and structured finance synthetic CDOs made up just 16% of the total. Similarly, the credit profile, excluding AIG, of the industry changed, with 'BBB' representing 40%, 'A' at 35%, and 'AA' at 10%, while speculative grade represented 8%, and 'AAA' 6% of the notional amount sold. By product on a sold basis, single-name CDS consisted of 63% of the volume, while corporate synthetic CDOs and structured finance synthetic CDOs made up just 16% of the total. Similarly, the credit profile, excluding AIG, of the industry changed, with 'BBB' representing 40%, 'A' at 35%, and 'AA' at 10%, while speculative grade represented 8%, and 'AAA' 6% of the notional amount sold.

Financial guarantors

The eight financial guaranty companies surveyed had an aggregate of US$407 billion gross sold protection outstanding as of year-end 2006, with a net position of US$355 billion sold. The US$407 billion sold amount represents a growth rate of 34% in synthetic CDS gross sold protection. The significant increase in the yearly growth rate can be attributed to the expansion of the CDx market as well as a generally tight-spread environment, which has increased underwriting hurdles in other market sectors, making the CDx arena more attractive. Like the global insurance sector, corporate synthetic CDOs and structured finance synthetic CDOs were the most popular financial guarantor products, accounting for 76% of the volume sold.

While net sold exposure increased markedly, it should be noted that 'AAA' exposure reached 97% in 2006, up from 94% in 2005, with the majority of this attaching well above the minimum 'AAA' thresholds. Another area that exhibited growth was the amount of activity transacted with tenors of five years or greater. In 2006, 62% of the sold volume possessed this longer tenor, up from 48% in 2005 and 44% in 2004, respectively.

The maturation of the CDx market, coupled with a tight credit spread environment causing financial guarantors to accept additional risk in order to generate acceptable returns, might explain these longer maturities.

Source for all graphs in article: Fitch

 

Appendix

SURVEY RESPONDENTS

Ambac Assurance Corp.
American International Group, Inc.
Ameriprise Financial Inc.
Asahi Mutual Life Insurance Company
Assured Guaranty Corp.
Banca Intesa
Banco Bilbao Vizcaya Argentaria
Banco Santander Central Hispano
Bank of America Corp.
Barclays plc
BNP Paribas
Caixa Catalunya
Caja de Ahorros y Monte de Piedad de Madrid
Calyon Corporate & Investment Bank
CIFG Guaranty
Citigroup Inc.Commerzbank
Credit Suisse Group
Deutsche Bank AG
Deutsche Zentral-Genossenschaftsbank
DexiaDresdner Bank AG
Financial Guaranty Insurance Company
Financial Security Assurance Inc.
Fortis
Goldman Sachs Group, Inc.
HSBC Holdings plc
HSH Nordbank
IKB Deutsche Industriebank
ING Bank NV
JPMorgan Chase & Co.KBC Bank
La Caixa
Landesbank Baden-Württemberg
Landesbank Berlin
Landesbank Hessen-Thüringen
Landesbank Rheinland-PfalzLandesbank Sachsen
Lehman Brothers Holdings Inc.
Massachusetts Mutual Life Insurance Co.
MBIA Insurance Corp.
Meiji Yasuda Life Insurance Company
Merrill Lynch & Co., Inc.
Mitsui Trust Holdings, Inc.
Morgan Stanley
Nippon Life Insurance Company
Nordea
Northwestern Mutual Life Insurance Company
Old Mutual Financial Network
Principal Financial Services, Inc.
Rabobank Group
Radian Asset Assurance Inc.
Royal Bank of Scotland Group plc
Shinsei Bank, Limited
Sompo Japan Insurance Inc.
Sumitomo Mitsui Financial Group, Inc.
Taiyo Life Insurance Company
Teachers Insurance & Annuity Association
The Bank of Tokyo-Mitsubishi UFJ, Ltd.
The Bear Stearns Companies Inc.
The Mitsubishi UFJ Trust and Banking Corporation
Tokio Marine
UBS AG
Wachovia Corporation
XL Capital Assurance Inc.