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(The solid lines in the diagram depict cash flows while the broken lines indicate legal contractual relationships.)

Throughout the reinvestment period the investment manager can select and delete reference obligations, as long as compliance with eligibility criteria is maintained and no tests are breached. The investment manager is usually paid a senior management fee near the top of the priority of payments and also receives a fee at the bottom of the priority of payments. In addition the manager may participate with the equity holders in any residual cash flows. In the event that there is not enough income to cover expenses due to higher than expected losses, some structures allow the liquidation of the SPV’s collateral to pay expenses as far down as the note coupon to keep the notes current. Otherwise the notes may capitalise interest. In either case, the shortfall is recouped to the extent that the funds become available in the future (Gerity and Koo, 2003:2).

A typical test is for the sponsoring bank to MTM the reference portfolio at regular intervals. This test then compares the current value of the assets belonging to the SPV, including any excess spread trapped within the structure, net of credit losses and market value erosion of the reference assets, to the purchase price of reference portfolio, expressed as a percentage. If this percentage drops below a

SPV CLN investors JIBAR + premium Note proceeds R3 billion Premium Bank Bank Bank Bank Highly rated collateral Credit protection Reference assets Reference assets Reference assets Reference assets JIBAR R500 million Liquidity facility Equity investor (sponsor)

certain point, due either to excessive credit losses or market value decline, a test is breached52 _(Gerity and Koo, 2003:3).

Another unique structural feature not found in traditional synthetics is the existence of a liquidity facility that allows the structure to maintain the maximum amount of leverage. In all synthetics, there is a certain amount of loss that the transaction must be able to withstand to achieve a specific rating. These losses are absorbed by a combination of excess spread and subordination. In contrast, synthetically created arbitrage CDOs rely primarily on excess spread (ibid.). To help achieve this, the structure allows the manager to reinvest recoveries on defaulted and sold assets and use the liquidity facility to reinvest the amount of any losses53_.

3. CONCLUSION

Credit derivatives appeared in the early 1990s largely as a market response to increasing credit-related concerns, primarily from banks. They are financial instruments that isolate and transfer the credit risk in lending transactions. The basic structure of a credit derivative is a transaction between a credit protection buyer, which is interested in transferring credit risk, and a credit protection seller, which is willing to accept that risk. If a pre-defined credit event occurs with regard to the obligations of a reference entity to which the protection buyer has credit exposure, the protection seller covers the loss suffered by the protection buyer. For taking this risk the protection seller receives regular premium payments from the protection buyer. Typical credit events are bankruptcy of non- government borrowers, or moratorium by governments, failure to pay after a grace period, materially adverse (for the creditor) restructuring of debt, obligation acceleration i.e. the reference debt becomes due early, or repudiation, that is the refusal of public authorities to acknowledge or pay debt. If a credit event occurs the transaction can be settled in two ways. Under a cash settlement the protection seller makes a cash settlement payment to the protection seller. The amount of the cash settlement is determined as the difference between the notional principal and the reduced recovery value of the reference obligation, after the credit event. In physical settlement, the reference obligation is delivered by the protection buyer to the protection seller against payment of the obligation’s par value by the protection seller.

52 _{Assume a R3 billion aggregate reference portfolio and R500 million collateral, thus the collateral comprises 16.67% of}

the asset portfolio. If this ratio were to decrease below that threshold, then all cash flows in the priority of payments below payments to noteholders would be trapped until the test was back in compliance.

53 _{If an asset in the reference portfolio defaults the manager may decide that the best course of action is, after having paid}

the protection amount and taking delivery, to sell the asset at 75% thereby locking in a loss of 25%. The manager can then reinvest the 75% recovery on the sale of the defaulted asset and then draw on the liquidity facility, reinvesting the 25% in additional assets. While the SPV would have to pay interest on the amount drawn under the liquidity facility, it

There are several types of credit derivative instruments. A total return swap is where the protection buyer pays out to the protection seller the total return of an asset, including any interest payments and capital appreciation, in return for receiving a regular floating-rate payment linked to an interest rate index e.g. JIBAR. At maturity of the contract the seller will make good to the buyer any depreciation in the underlying asset. In a credit default swap contract the buyer pays the seller a premium to protect itself against the occurrence of a contractually-defined credit event on a specific underlying risk of a reference entity. Credit default swaps can be structured as single-name or portfolio transactions. A single-name swap transfers the credit risk of a single reference entity’s obligations from the buyer to the seller, whereas a portfolio swap covers the credit risk of a basket of reference entities or obligations. Credit default swaps have become the dominant credit derivative product. In the case of a credit spread option the buyer pays the seller a premium to protect itself against adverse spread movements on an obligation such as a bond issued by the reference entity. Credit spread options are difficult to hedge and complicated to price, and most investors can achieve their objectives with cheaper credit default swaps. Credit-linked notes are synthetic securities with embedded credit default swaps. The redemption of note principal depends on the loss, if any, suffered on the reference assets. If a credit event occurs, the note issuer’s repayment obligation decreases by an amount sufficient to offset the loss on the reference assets. The performance of the credit-linked note can be tied to a single reference asset or a basket of reference assets.

The payment structure of credit derivatives is similar to that of credit insurance contracts. Unlike credit insurance, credit derivatives are tradable and there exist an active secondary market for them. Because they are tradable, credit derivatives appeal to a larger group of investors than does credit insurance. The ability to trade credit risk separately breaks the link between lending of funds and assuming credit risk, without disturbing the relationship between the lender and the borrower.

The rapid growth of the credit derivatives market has been supported by the development of standardised credit derivative contract terms and definitions. The development of standardised documentation has been greatly facilitated by the International Swaps and Derivatives Association (ISDA) through its issuance of the 1999 credit derivative definitions and the updated version of that in 2003. In attempting to standardise documentation for credit derivatives, ISDA has faced the task of reconciling the interests of protection sellers who want the narrowest possible interpretation of credit events, and protection buyers who want the broadest definition.

The combination of credit derivatives technology with traditional cash flow securitisation techniques gave rise to unfunded or synthetic securitisation. In a synthetic securitisation the credit risk of a pool

of assets is transferred from an originator to investors, but the assets themselves are not sold and remain on the originator’s balance sheet. Synthetic transactions have become popular in jurisdictions where it is difficult to undertake a cash transaction due to legal, regulatory or cross-border restrictions. It is generally also quicker and easier to implement a synthetic securitisation since there is no requirement to sell the assets physically, as risk transfer takes place through the use of credit derivatives. Since the inception of the first synthetic transactions, the market has evolved, with continuing development of newer structures to meet differing originator and investor requirements. Originally synthetic CDOs were driven by banks seeking to gain capital relief on assets already on their balance sheet. As the market has developed and became more liquid, banks, asset managers and hedge funds are increasingly using synthetic CDOs for arbitrage rather than balance sheet purposes.