Credit Markets in 2005Terry Tse, Deutsche Bank

· · page 2

Who Are We?

n The Loan Exposure Management Group (LEMG) is responsible for actively managing Deutsche Bank’s loan book – pricing, hedging and risk management

n We price loans to the cost of hedge in the credit derivatives market

n Once the loans are priced and booked, LEMG owns the loans and hedges them according to Deutsche Bank’s internal threshold policy

n LEMG hedges loan exposures in the credit derivatives markets, primarily through single name credit default swaps (CDS)

n LEMG also monitors credit risk of individual borrowers and the loan portfolio

n Deutsche Bank is one of the earliest pioneers of applying the credit portfolio management approach to the loan book, and was awarded the Credit Portfolio Manager of the Year in 2005 by Risk Magazine

· · page 3

2005 was an eventful year in financial markets…

n Corporate Defaults: Delta, Southwest, Delphi, etc.

n Ford and GM downgraded to junk

n A resurgence in M&A activities (AT&T/SBC, Federated Department Stores/May Department Stores, Toys “R” Us sold to private equity, etc.)

n Energy crisis: oil at historical highs (closed at $69.81 in New York on 8/30/2005)

n North Korean and Iranian crises

n Continuing (and worsening) war in Iraq

n Problems with the Bush administration

n Fed changes chairman, rate hikes, yield curve inversion and US double deficits

n China revalues its currency

n Economic recovery in Japan

· · page 4

Topics

We will focus on a few issues most relevant to US high grade credit markets

n Overview of the Broad Credit Market

n Crisis in US Auto Sector: Ford, GM and Delphi

n The Macro Picture– Energy: Oil and Geopolitics– Yield Curve: Bernanke, Rate Hikes, Deficits, China, Japanese Recovery

n Q&A

The idea is to illustrate the dynamics and mechanics of the credit derivatives markets via real events

· · page 5

Overview of the Broad Credit Market

· · page 6

US High Grade Credit Market Overview 2005

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April 15. GM failed to get health care concessions from union.April 19. GM announces 1.1 billion Q1 losses.

May 4. Kerkorian offers public bid for GM shares for $30.May 5. S&P downgrades Ford and GM to junk.May 17. Collins & Aikman fails chapter 11.

June 23. Autos down on Moody’s negative tone on GM.Oil approaching $60 for the first time.

October 11. Delphi filed chapter 11 over the weekend (October 8).October 17. GM announced $1.6 billion Q3 losses.

End of year, market basically acts manic depressive over rumors of GMAC sale.

· · page 7

Crisis in US Auto Sector

· · page 8

Why is the US Auto Sector so Important?

n Ford and General Motors alone constitute about one third of the bond market by notionals

n Traditionally, Ford and GM represent the investment grade bellwethers

n As Ford and GM become junk (below BBB/Baa3), many asset managers – mutual funds, pensions, insurance firms, etc. – are forced to sell as they are only allowed to invest in investment grade bonds

n Ford and GM woes:– Staggering healthcare and pension costs due to union contracts– Stiff competition from Asia, lack of innovative design– Rising gas prices– Vicious cycle with auto suppliers: Ford and GM in trouble, suppliers lose business, suppliers

threaten to disrupt supplies, Ford and GM in more trouble

n Only the auto finance units – Ford Motor Credit Co (FMCC) and General Motors Acceptance Corp (GMAC) – make money

n Market currently anticipates some sort of sale of GMAC but no one has any detail

· · page 9

What exactly does the credit market look like?§ Dealers send in quotes via messages on the Bloomberg terminal

§ Transactions are completed over the phone and then booked

§ This is a over thecounter (OTC) market

§ Cash bonds and credit default swaps (CDS)trading desks are now typically combined

· · page 10

Basics of a Single-Name Credit Default Swap Contract (1)

n A credit default swap (CDS) contract allows a buyer of credit protection to pay a spread to the credit protection seller in return for a settlement in case the reference entity incurs a credit event

n For example, a protection buyer can purchase a CDS for General Motors for $X. If GM defaults, the protection buyer gets paid by the protection seller

n The protection buyer pays the spread on IMM dates: March 20, June 20, September 20, December 20 or the next business day of the settlement city (usually London or New York) if the IMM date falls on a holiday

n A protection buyer is short default/credit risk

n A protection seller is long default/credit risk

n An investor can go long credit by either selling CDS or buying a cash bond

n An investor can go short credit by buying CDS protection

n In reality, it is difficult to short a cash bond

n Shorting credit is expensive because you have to pay the spread (you have to bleed the carry)

· · page 11

Basics of a Single-Name Credit Default Swap Contract (2)

n In case of a credit event, the CDS contract can be can be settled physically or in cash

n In physical settlement, the protection buyer delivers defaulted bonds or loans to the protection seller, who must buy the defaulted paper at par

n In cash settlement, the protection seller pays the protection buyer (1 – recovery rate) * Notional. Market assumes recovery rate to be 40%

n Settlement can also be privately negotiated

n Precise definitions of credit event, deliverable instruments and delivery mechanisms appear in the CDS documentation, which is typically governed by the International Swaps and Derivatives Association (ISDA)

n CDS documentation typically conform to the ISDA Master Agreement. The latest version is 2003, known as “03 docs”

n We will walk through Delphi bankruptcy and settlement later

· · page 12

A Single Name CDS Quote

Buyer means this dealer is more interested inbuying credit protection than selling.

Bid spread – The spread level at which the investor can sell credit protection to this dealer.

Ask spread – The spread level at which the investor can buy credit protection from this dealer.

· · page 13

Investment Grade CDS Indices (1)

n A CDS index allows investors to buy or sell protection on a basket of equally weighted names.

n The North American benchmark index is known as the CDX, which contains 125 investment grade names. An entity must attain investment grade rating from both Moody’s and S&P to belong to the CDX

n The fair spread of the index is in principle the average of all the individual spreads weighted by duration

n If an index component name experiences a credit event, the effective exposure of that name in the index is used to calculate the settlement

n Example: If a protection buyer has a $1 billion position in the CDX and one of the name defaults, he is eligible for $1 billion/125 = $8 million settlements in physical delivery or cash

n Indices are typically settled in cash, in which case the protection buyer receives $8 million * (1 – 40% recovery) = $4.8 million

· · page 14

Investment Grade CDS Indices (2)

n The most liquid/traded names in the credit market enter the index

n The components of the index change every 6 to 9 months. This change in the underlying components is called the roll. Names downgraded out of investment grade fall out the index

n CDX1 represents the first roll, then CDX2, etc. We are currently up to CDX5

n For each roll, the most volatile 30 names make up a sub-index known as HVOL

n HVOL has the same roll dates as the CDX, so we are currently at HVOL5

n CDX and HVOL are the most convenient and liquid ways for credit investors to long or short the broad credit market without expressing a correlation view

n Indices also offer an effective channel to hedge a bunch of positions

n To express a correlation view, one has to use tranched products, which we will not go into in this presentation

· · page 15

Index Market Quotes

· · page 16

Liquidity (1)

n It is most common to buy/sell protection for 5 years in investment grade single names and indices. This means the protection buyer pays for the risk of default for 5 years going forward

n In trader-speak: “The 5 year is the most liquid point on the curve”

n Other points in the term structure are also traded

n For single names: – 6m, 1 to 10y, 15y, 20y and 30y are quoted– 6m, 1y, 2y, 3y, 5y, 7y and 10y are most liquid (also depends on the name)

n For CDX:– 5y, 7y and 10y are most liquid– Other points on the curve possible, but need to call dealers

n For HVOL:– 5y and 10y are most liquid– Other points on the curve not really traded

· · page 17

Liquidity (2)

n Aside from the term structure, liquidity in the market varies by individual name based on many factors: how many bonds does the entity have outstanding, supply/demand of capital, risk appetite, market sentiments, etc.

n Bid-ask spreads indicate liquidity in the market

n Example: GMAC 5Y 405/410, the bid-ask spread is 5 bp, which is the level at “normal” market conditions

n FMCC and GMAC 5Y are probably the most liquid single name CDS quotes

n Some names (like Oracle) are just not traded

n A name can also be liquid for a while but fades out into relative illiquidity when people don’t care about it as much (e.g. Bombardier)

n Indices are far more liquid, with bid-ask spreads around half to a quarter basis point in “normal” markets

n Liquidity dries up quickly when volatility sharpens or when markets become very distressed

· · page 18

Market Technicals

n OTC markets, which are necessarily opaque due to lack of a centralized exchange, are susceptible to factors other than the fundamental economic situation of the company, which market players call credit fundamentals

n For the lack of a better name, these are known as technical factors

n Market players’ perception of risk-return and willingness to put down capital influence liquidity, which translates to bid/ask spreads, which translate to transactions that do not necessarily reflect fair value

n These technical factors become especially pronounced in distressed markets

n Traders always say that markets operate by fear and greed

n A perplexed economist asks: “Why are markets so emotional?”

n Trader says: “Of course, there’s a lot of money involved!”

· · page 19

The Ford and GM Crisis (1)

n April 15. GM failed to get health care concessions from union– FMCC 530/550, GMAC 640/660

n May 5. S&P downgrades Ford and GM to junk– Ford and General Motors have two curve each: the company itself and the financing

subsidiary. As their problems aggravate, the gap between the co and the sub widens– Major sell-off by bondholders. Structured credit market roils (although we will not

discuss this in detail)– FMCC 600/620, GMAC 700/720, FMCO 650/700 GMCO 910/950, HVOL4 ranged from

123 to 144

n September 20. Investment grade indices rolled.– Because of the downgrades, FMCC and GMAC fall out of CDX5 and HVOL5– CDX4 and HVOL4 continue to trade, because they contain FMCC and GMAC– New crossover XO5 is created to contain toxic fallen angels like FMCC and GMAC– CDX4 51/51.5 CDX5 47/47.5 HVOL4 117.5/118, HVOL5 97/98, XO5 222/224

· · page 20

The Ford and GM Crisis (2)

n October 12. Just after Delphi default– FMCC 515/530, GMAC 530/540, FMCO 750/770, GMCO 975/985– HVOL4 135/136, CDX4 56/56.5, HVOL5 107.5/108.5, CDX5 48.5/49, XO5 256/257.5

n November 16. Negative comments from UAW– GMAC 450/460, FMCC 530/540, FMCO 920/940– GMCO begins to trade with points upfront: 20/22+500 running

n Points upfront– Suppose you have to buy $10 m 5 year protection on GMCO, you pay: $10 m * 21% =

$2.1 m cash upfront to the protection seller, AND 500 bp (annualized) per year– Why? Protection sellers believe that the credit risk is so high that only upfront cash will

compensate them. Basically near default names are traded with point up front– To this day, GM still trades with points upfront

n Spreads have been volatile since then: GMAC 420, FMCC 480, GMCO 18 + 500 running, FMCO 900

· · page 21

Cure Inversion

n The credit curve, (or the curve), refers to the spectrum of term structure being quoted on the market

n For example: GMAC on April 1, 2005– 1Y: 320, 2Y: 405, 3Y: 445, 4Y: 465, 5Y: 475, 7Y: 485, 10Y: 500

n Normally, the curve is monotonically increasing with tenor since cumulative probability of default always increases with time given constant recovery rates

n But when a name becomes very distressed, the market will charge a wider spread for the shorter tenors than the longer tenors

n When this happens, we say the curve is inverted, for example:

n GMAC on November 17, 2005– 1Y: 560/610, 2Y: 510/550, 3Y: 490/530, 4Y: 470/510, 5Y: 460/470, 7Y: 445/465, 10Y: 435/455

n Curves inversion reflects supply and demand of capital, risk appetite as well as a bet on the recovery rate

n GMAC curve in January is still inverted

· · page 22

General Motors Co and GMAC Spreads 2005

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· · page 23

Ford Motor Co and FMCC Spreads 2005

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· · page 24

Ford and GM Outlook for 2006

n The fundamental issues remain: inflexible cost structure, union contracts, lack of innovative products, losing market share

n President Bush has repeatedly refused a federal government bailout

n However, GM is generally perceived to be in worse shape than Ford:– GM loses more money. In 2005Q4, they announced a $4.78 billion loss (1/26/06)– Delphi, now in Chapter 11, is GM’s biggest supplier– Investors (including Kerkorian) are losing patience with GM management

n Ever since October 17 (Q3 earnings) call, the market has been anticipating the sale of GMAC, which trades tighter than FMCC and much tighter than GMCO

n So far, GM management has given no detail on such a sale

n However, no one cannot afford to short GMAC. If GMAC sale materializes and regains investment grade rating, spreads will tighten rapidly

n GMAC and FMCC are probably concentrated in the hands of active traders like hedge funds and prop desks. More volatility expected in 2006

· · page 25

Delphi’s Downfall – Background

n Delphi is one of General Motor’s biggest suppliers

n Delphi originally belonged to General Motors, and was spun off in spring 99

n They have inherited a lot of GM’s cost structure, especially the legacy of inflexible union contracts regarding healthcare and pension costs

n A union contract prevented the union to strike as long as management does not cut wages and benefits

n If management tried to get concessions from the UAW, they would likely strike, which would seriously disrupt the firm’s production

n Delphi has also been involved in an accounting probe, which tends to terrify investors after Enron

n Visteon is Ford’s analogy to Delphi, but is in better shape since Ford makes more money than GM

· · page 26

Delphi’s Downfall – Timeline

n Mid April. Autos blew out. Delphi came under a lot of pressure and traded around 800 to 1000 bps.

n Mid May. Delphi delayed 10Q filings. Fear of Delphi credit event. Delphi traded upfront about 30 + 500 bps running

n May 19. Ford and Visteon reached an agreement where Ford will take back a lot of Visteon’s plants and workers. Pressure off Delphi. Market players expected GM will bail Delphi out with some sort of financial assistance

n July 1. Robert “Steve” Miller, a restructuring specialist, became Delphi CEO

n September. Bankruptcy fears loomed as GM showed little interest in bailing Delphi out. Delphi back to 30 + 500 bps running

n October 8. Delphi filed for Chapter 11 bankruptcy protection. All auto names widened significantly.

· · page 27

Delphi CDS Spreads 2005

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· · page 28

Why File for Bankruptcy?

n In the US, filing for chapter 11 bankruptcy does not mean the death of the company. It is more of a series of legal procedures to restructure the company

n Critics of this process have prompted Congress to draft up tougher bankruptcy requirements which took place on October 17, 2005

n Delphi filed mainly to force concessions from the UAW

n Under chapter 11, a bankruptcy court judge could nullify the UAW contracts, which would 1) give the UAW power to strike, 2) offer flexibility to Delphi to cut healthcare benefits as well as pensions and shut down factories

n Delphi’s overseas operations, which are not governed by UAW contracts, actually make money

n Most market participants have confidence that Delphi will re-emerge and banks do try to help them on the financing

· · page 29

Delphi CDS Settlement

n Given the reasons for Delphi’s filing, loan and bond recoveries would be very high: up to 80% for bonds and even higher for loans

n Under ISDA 03 docs, protection buyers can deliver the cheapest paper (loan or bond) to settle the CDS contracts

n The cheapest-to-delivery would be the Delphi 06 bonds, the shortest maturity

n BUT: there aren’t that many of those available in the market. In fact, there aren’t that many Delphi bonds

n Delphi 06 bonds were bid up to 60 cents on the dollar right before the bankruptcy. They reached 70 cents on the dollar after the filing

n Eventually dealers had to organize an auction for the bonds

n Some parties privately negotiated a cash settlement

n All indices were settled in cash

· · page 30

The Macro Picture

· · page 31

The Macroeconomic Backdrop

n In 2005, the two most important macroeconomic issues that gripped the credit markets were the yield curve and oil prices

n The yield curve has a much more direct impact on the credit markets

n Interest rates directly affect cash bond issuance and yields

n Oil is more of wildcard capable of shocking the system with price spikes

n Both interest rates and oil prices have an enormous sway on market sentiments

n The BIG question: is global economic growth slowing down?

· · page 32

The Global Liquidity Cycle

n Many market participants believe that the world is awash with liquidity due to low interest rates from the Fed

n The liquidity cycle: Asian countries peg their currencies and buy Treasuries àUS can maintain low interest rates à US consumers borrow to buy cheap made-in-China (or generally Asian) imports à Asian economies grow à Asian governments keep currency pegs à Asian countries buy more Treasuries…

n Low interest rates have made it cheap to invest in risky assets – equities, credit, real estate – and have caused markets to rally

n Low interest rates have also prompted investors to look for alternative investments: hedge funds, art, private equity

n Low interest rates also mean low funding costs for hedge funds, hence the market has a lot of fast money

n Can global economic growth sustain this cycle?

· · page 33

An End to the Liquidity Party?

n The market is split on this question

n Yes, the party is ending– The Fed has been raising interest rates since June 30, 2004, now at 4.5%– China has moved towards a more flexible currency system– Japanese recovery may end zero-rate policy– Energy-induced inflation will prompt the Fed to keep raising interest rates– Mounting twin deficits will haunt the US– China slowdown is coming

n No, the party is still on– Corporate earnings have been good– Housing market remains robust, at least not crashing– Consumers are confident and spending– Internet and other technologies have made the economy less dependent on oil– Globalization makes it possible to fund the deficits

· · page 34

The Oil Factor

n From a purely market perspective, sharp increases in oil prices instill a lot of fear since the factors affecting them – geopolitics, weather, demand shocks from India and China – are difficult to gauge, price and hedge

n Geopolitical tensions and two hurricanes gave us record oil prices in 2005

n Oil prices affect:– GDP growth– Consumer spending– Consumer confidence– Inflation, and hence interest rates

n Aside from energy companies themselves, high energy prices is a credit negative for all the large industrials, especially autos and retailers

n On the whole, oil prices had a greater impact on equities than on credit

· · page 35

Oil Prices and Dow Jones Industrial 2005

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· · page 36

Oil Prices and CDX Indices 2005

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· · page 37

More Uncertainty in 2006

n New Fed chairman: what is Bernanke going to be like?

n Inverted yield curve– Short term interest rates are higher than 10 year rates– Historically an inverted yield curve strongly hints at a recession around the corner

n More unrest from the Middle East– An escalating situation with Iran– A more aggressive Palestinian government– A worsening and expensive war in Iraq

n Can Japan sustain its recovery?

n Will China slow down?

n It is hard to say whether the world will slow down, but most market participants do expect more volatility in 2006

· · page 38

Appendix

· · page 39

CDX4 Components

· · page 40

HVOL4 Components

· · page 41

CDX5 Components

· · page 42

HVOL5 Components

· · page 43

XO5 Components