New swap hedge seen emerging in CDOs

With correlation being the risk of the moment in credit derivative markets, UBS Warburg CDO researcher Douglas Lucas takes the argument one step further and theorizes that the result of the heightened correlation risk will be an increase in a relatively unknown derivative product. 

In the most recent CDO Insight Lucas asks: "Does a 10% probability of default mean that one out of 10 credits is going to default, or that 10% of the time all credits are going to default?" Given the deterioration in CDO collateral over the past two years, it may be better to prepare for the latter. 

Pointing out that defaults tend to hit in waves (1933, 1970, 1991 and of course 2001 for example) CDOs use of single-credit default swaps may be flawed. What may be a better bet for the CDO market to employ is called a Nth (1st, 2nd, 3rd credit) to default swap, which is a more efficient play on default correlation. The bonds in which said default is structurally embedded is dubbed, not surprisingly, the Nth to default swap note.  

Rather than buying protection on underlying credits in a portfolio, for the purposes of a CDO structure, it is only necessary to purchase protection against that credit defaulting at the margin of where bondholder cashflows would erode. "Nth to default swaps and notes allow investors to take on increased credit risk," Lucas pens.

Using the examples of oil-company defaults in the mid-1980s and savings & loan defaults in the 1989 to 1990 period, Lucas states that defaults, to varying degrees, have positive default correlation across industries. Using historic data, Lucas finds that defaults correlate to a greater degree as one migrates down the ratings spectrum. As can be expected, highly rated issuers rarely default over an intermediate period of time, and when they do, "these problems are by definition isolated to individual credits and do not produce default correlation."

This, as well as the fact that Nth to default swaps are a particularly attractive product in low spread environments, should lead to favorable pricing for the Nth to default swap, Lucas adds. In turn, he "expects to see greater use of Nth to default swaps to take on credit risk."