Equity Default Swaps: An Overview
Like credit-default swaps, equity-default swaps are bilateral contracts. In both types of arrangement, a protection buyer pays a fixed, periodic premium to a protection seller over the term of a swap in exchange for the right to receive a floating payment from the protection seller upon the occurrence of one or more pre-determined events. The main structural differences between an equity default swap and a CDS are that:
* Payment of the protection amount under an equity-default swap is triggered not by a credit event with respect to a reference entity, but rather by a sharp drop in the value of a reference entity's publicly traded stock. This is typically defined as a 70% decline from an initial price level;
* The protection amount payable under an equity-default swap is established by reference to a fixed amount, typically 50% of the swap notional amount or the final price of the stock. Consequently, recovery rates under equity-default swaps are fixed at the outset and can be significantly lower than recovery rates experienced under CDS;
* Unlike CDS, which provide for the option of cash settlement, physical delivery with a cash fallback or simply physical delivery of a reference obligation, equity-default swaps always provide for cash settlement; and
* Since they are based on the size and implied volatility of notional stock positions, spreads on equity-default swaps tend to be much larger than credit spreads in CDS of like tenor referencing similar entities.
Development And Growth
Equity-default swaps have enjoyed a significant amount of growth over the past two years. Building on their years of experience with CDS, several of the major derivative dealers expanded their market-making activities during this period to include equity-default swaps. JPMorgan, credited by many as the first bank to develop a market in equity-default swaps, stated in March 2004 that it quoted equity-default swap prices on 150 European, 109 U.S. and 55 Asian corporate names. Deutsche Bank was reported at the same time to quote equity-default swaps on a comparable number of entities. In Japan, Nomura Securities and Mizuho Securities each commenced preparations for trading equity-default swaps. In October 2004, Merrill Lynch announced that it, too, was considering quoting prices on equity-default swaps. Indeed, the number of banks making markets in equity-default swaps led GFI Group, the New York-based interdealer broker, to introduce a platform that permits trading of equity-default swaps alongside CDS.
Equity-default swaps have attracted particular attention in the context of structured products. In a period of less than one year beginning December 2003, the market saw three privately rated European hybrids, or CDOs in which the collateral portfolios included equity-default swaps in addition to CDS, one publicly rated European hybrid, and one privately rated Japanese CDO backed entirely by equity-default swaps.
The Debate: Innovation Or Reformulation?
To those market participants who arrange and market them, equity-default swaps are innovative financial instruments, their structural similarity to CDS notwithstanding. In their view, there is a growing emphasis on the convergence between equity and credit markets, evidenced in part by the importance currently placed by stock and bond investors alike on the relationship between share volatility and corporate bond spreads.
Some market participants, on the other hand, appear to dispute the notion that equity-default swaps are new financial instruments. Others downplay the significance of market convergence, arguing that equity and credit investments are fundamentally different. They point out that, at the very least, the term equity-default swap is a misnomer, since the term equity represents ownership rather than liability and is therefore incapable of default. These participants also note that in many companies, even where net assets are worth less than net liabilities on a current basis, the company may still be solvent because it will often have several years to pay down the outstanding debt and, in that period, the company's asset values may rise.
Major Transactions
As discussed above, the most significant use of equity-default swaps to date has been as synthetic collateral for CDOs. The first such transaction was the "Odysseus" deal, a hybrid European CDO arranged by JPMorgan in December 2003. Odysseus contained a portfolio of 100 blue-chip reference entities with a weighted average rating of "Baa2," and the mix of swaps was 90% CDS and 10% equity-default swap on a notional amount of EUR1.2 billion.
Europe's first publicly rated CDO containing equity-default swaps in the collateral portfolio was the Chrome ACEO transaction, arranged by CDC IXIS Capital Markets and rated by Moody's in September 2004. In Chrome ACEO, the SPE entered into swaps referencing 30 second-to-default baskets, each containing three CDS and one equity-default swap, with no overlap between the 120 reference entities. As in Odysseus, the equity event trigger was set at a 70% price decline in the stock of each reference entity.
Another variation can be found in the CEDO I transaction, which was arranged by Credit Suisse First Boston in April 2005. Although Moody's described CEDO I as "the first pure EDS CDO rated by Moody's in Europe," the collateral consisted of equity-default swaps with both credit- and equity-linked trigger events. That is, any of:
i) Bankruptcy;
ii) Failure to pay; and
iii) A substantial (65%) price decline in the stock of a reference entity could trigger a floating payment on the swap. Any such payment, if triggered by bankruptcy or failure to pay, would equal 100% of the swap notional amount.
CEDO I is also distinguished by the fact that it sold protection on one of its two portfolios (each containing 60 names) but purchased protection on the other. Ostensibly, the purpose of this arrangement is to effectively arbitrage any swap market inefficiencies that may exist with respect to the reference entities. The four tranches of notes issued by the SPE received provisional Moody's ratings of "Aaa," "Aa1," "A1" and "Baa2," respectively.
In contrast with CEDO I and the European hybrid deals discussed above, the "Zest Investments V" transaction, arranged by Daiwa Securities and rated by Moody's in March 2004, contained a portfolio entirely comprised of equity-default swap referencing 30 blue-chip Japanese companies. The trigger was set at the typical 70% level, but the recovery rate was defined in terms of the final stock price of each reference entity at the end of the transaction. The SPE entered into swaps with a single counterparty and issued ¥31.5 billion principal amount of notes to investors in five separate tranches, the three senior most of which carried ratings of "A3," "Baa2" and "Ba2," respectively. Given the high subordination levels, the lower ratings in this transaction (compared with Odysseus) likely reflect (i) the lower potential recovery value to be had from using a final stock price formulation as opposed to a flat 50% recovery rate and (ii) the lack of any other type of collateral besides equity-default swaps in the deal.
Conclusion
Year to date, the level of issuance of CDOs backed by equity-default swaps has not matched that of 2004. Thus, the pace and scope of growth of the equity-default swap market remains uncertain. Nevertheless, cash CDOs increasingly allow for discrete investments in equity-default swaps as a means of boosting yield. The debate surrounding their novelty notwithstanding, equity-default swaps clearly are the object of growing attention from deal arrangers, rating agencies and investors alike, and their emergence in CDOs marks a significant development in the structured finance marketplace.
This week's Learning Curve was written by Neil Weidner, partner, and Peter Williams, associate, at Cadwalader, Wickersham & Taft LLP.
