A Simple Loan CDS Model

Bjorn Flesaker
Quantitative Finance Research Group
Bloomberg
PRMIA NY Credit Risk Forum

February 13, 2008

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 1 OVERVIEW

1 Overview

Loan Market Background

LCDS

Modeling LCDS Termination

Aside - Why are we modeling LCDS?

A (very) Simple Model

Calibration and Extensions

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 2 LOAN MARKET BACKGROUND

2 Loan Market Background

Syndicated loans by borrowers generally below investment grade (BB/B)

Secured and protected by covenants ) higher recoveries than for bonds

A "loan" is typically a credit agreement covering multiple separate term loans

along with a revolving credit line

Loans are usually ‡oating at Libor+spread

Generally 5-7 year maturities, but prepayable without penalty

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 2 LOAN MARKET BACKGROUND

Historically held by banks, but increasingly by CLOs, hedge funds, and other
institutional investors

Secondary market liquidity improved signi…cantly until 2007

Consent required for assignment - alternative is participation agreement

Not public securities - various information issues

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 3 LCDS

3 LCDS

Market has developed over the last 3-4 years, with increased liquidity coming
from standardization of ISDA documents and introduction of indices (Markit
LevX and Markit LCDX)

LCDS refers to deliverable instrument; credit events are per reference name,
but the deliverable obligation is restricted to speci…c loans

So, up to possible di¤erences in restructuring language, the credit events for

regular CDS and LCDS coincide

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 3 LCDS

Con‡icting interests between dealers and banking regulators have resulted in

separate documentation details developed for Europe and North America

The standard restructuring language is Modi…ed Modi…ed Restructuring in Eu-

rope and No Restructuring in North America

Upon full redemption of the reference obligation LCDS contracts terminate in

Europe but they only terminate in North America if no substitute reference
obligation is found within 30 days

In either case, LCDS termination is on a walk-away basis (with a …nal payment

of accrued premium)

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 4 MODELING LCDS TERMINATION

4 Modeling LCDS Termination

Similar to the problem of valuing the underlying loans

Can be highly relevant for LCDS valuation (especially under European docs)

Research from Citigroup (2007) showed 45% of BB+ rated loans redeemed
after 5 years - much lower prepayment rates for lower rated borrowers

... but note that current market conditions are very di¤erent

Broadly speaking: loan prepayment is good news for issuer credit quality

Market value of an LCDS is given by the di¤erence between market spread and
contract spread times risky annuity value

Risky annuity value depends on interest rates, default risk, and cancellation risk
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 5 ASIDE - WHY ARE WE MODELING LCDS?

5 Aside - Why are we modeling LCDS?

The textbook answer - To …nd their value (duh!)

Some real world answers:

1. To interpolate between closely related (observable) values

2. To provide risk measures vs market inputs

3. To simplify and streamline market communication

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 5 ASIDE - WHY ARE WE MODELING LCDS?

An example of model as communication device: Black-Scholes for FX options

OTC swap market quotes are clean and simple for new trades

Quotes related to assigning/unwinding existing swaps are trickier, especially to

get exact agreement between counterparties

The Bloomberg function CDSW serves this role for the regular CDS market,
and is now being updated to include "…xing swap curves"

We plan to o¤er similar functionality for the LCDS market

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 6 A (VERY) SIMPLE LCDS MODEL

6 A (very) Simple LCDS Model

We will seek to make minimal changes to the market standard CDS model.

Fix a name and let t denote the time varying risk neutral hazard rate of
its default process of the underlying name, such that the ncumulative odefault
Rt
probability up to time t can be expressed as t = 1 exp 0 u du .

Assuming a …xed recovery rate R as a fraction of par and deterministic interest

rates given by a set of current discount factors Pt, we have the CDS balance
equation (with continuous premium payments):

Z T Rt Z T Rt
ST Pte 0 u du dt = (1 R) Pt te 0 u du dt (1)
0 0
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 6 A (VERY) SIMPLE LCDS MODEL

Denote the cumulative risk neutral probability of LCDS contract termination

to time t by qt.

Consider two extreme cases of dependence between default and termination:

1. Events of default and termination are independent

2. Events of default and termination are mutually exclusive

For case 1, treat LCDS as a regular amortizing CDS with an amortization factor
given by qt

For case 2, treat LCDS default leg as for a regular CDS, but use the sum t + qt
to reduce the expected outstanding notional to value the premium leg
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 6 A (VERY) SIMPLE LCDS MODEL

Neither case is quite satisfactory as a description of reality, so we will mix them

with a constant weight on the independent case

We have the constraint on the relationship between the default and termination
probabilities that t + (1 )qt 1.

Viewed as a constraint on the dependence parameter , we see that it is only

binding in the case where T + qT > 1, where T is …nal maturity, and the
general limit on the range of is:

max [ T + qT 1; 0]
1 (2)
qT

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 6 A (VERY) SIMPLE LCDS MODEL

For given schedules of t and qt along with the dependence parameter , the
loan recovery rate RL, we obtain the theoretical replacement LCDS spread
for maturity t as follows, making use of the continuous premium payment
approximation:

R R
(1 RL) 0t Pu u exp f 0u v dvg (1 qu) du
St = Rt Ru (3)
0 Pu exp f 0 v dvg (1 qu) du

Based on default statistics, RL may be as high as 75%-85%, but then again,

the subprime mortgage repayment history was also pretty good...

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 7 CALIBRATION AND EXTENSIONS

7 Calibration and Extensions

In the standard CDS framework, assumptions of deterministic interest rates and

…xed recovery is enough to …x the map between CDS spreads and hazard rates.

For LCDS, we also need the termination probabilities and the weight .

Possible data sources/approaches:

Both regular CDS and LCDS on the same name

Time series of loan prices

Historical loan prepayment data

Development of "market conventions" (e.g. 40% recovery)

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