Creditflux CDPC Booklet May 08

Creditflux inside guide
Credit Derivative
Product Companies
5/6 D
8/6 D
Designs for a new type of credit investor
The CBM
Group, Inc.
Creditflux inside guide
Credit Derivative
Product Companies
Written by Andre Cappon, Lisa Cooper, Richard Gonseth, Claudia Green, Neil Ham-
ilton, Guy Manuel, Stephan Mignot, Brian Naini, Michael Peterson, Mark Redinger,
Algis Remeza and Chris Wu. Designed by Katrina ffiske.
This guide is published in collaboration with the CBM Group, Clifford Chance and
Ernst & Young
Creditflux would also like to thank the many individuals and organisations who sup-
ported this publication editorially and/or financially, notably Channel Capital, as well
as Bank of New York Mellon, Fitch Ratings, KBC Financial Products, LBBW, Moody’s
Investors Service, Natixis, Primus Financial, Principia Partners, Société Générale and
Standard & Poor’s
Published by Creditflux Limited, London, June 2008

About the sponsors
Ernst & Young LLP is the leading assurance, tax,

transaction and advisory services provider to credit
derivative product companies (CDPCs), having served
all 11 of the currently rated CDPCs, and also assisting
several CDPCs in the process of getting rated. The
firm’s services include assistance in developing CDPC
capital models and operating guidelines, independ-
ent validation of CDPC capital models, verification of
compliance with key operating guidelines, and annual
financial statement audits of the operating company
and the holding company.
International law firm Clifford Chance combines the

highest global standards with local expertise. Lead-
ing lawyers from different backgrounds and nation-
alities come together as one firm, offering unrivalled
depth of legal resources across the key markets of
the Americas, Asia, Europe and the Middle East. The
firm focuses on the core areas of commercial activ-
ity: capital markets; corporate and M&A; finance and
banking; real estate; tax, pensions and employment,
and litigation and dispute resolution.
The CBM Group Inc is a New York-based management

The CBM
consulting firm, founded in 1992. The firm advises
Group, Inc. leading global financial institutions on strategy and
risk management in capital markets businesses.
CBM is active in credit risk management and works ex-

tensively in the financial guaranty, structured finance
and credit derivatives areas. In particular, CBM has
been a consultant to the first CDPC, Primus.
2 guide to credit derivative product companies

Contents
Chapter 1 Assessing the value of CDPCs page 5
Chapter 2 CDPCs: understanding the role of operating guidelines page 11
Chapter 3 CDPCs: handling the legal issues page 17
Chapter 4 CDPCs: running the capital models page 25
Chapter 5 Understanding the rating agency viewpoint on CDPCs page 33
Chapter 6 CDPCs: tackling the operational issues page 36
Chapter 7 CDPCs: hearing the sponsors’ viewpoint page 38
Chapter 8 CDPCs: looking to the future page 41
Glossary page 45
guide to credit derivative product companies 3

Foreword
There are few more pressing topics in the perspective as highly experienced manage-
credit derivatives market than the role of ment consultants who have been asked to
credit derivative product companies look objectively at the value and potential of
(CDPCs). In this, the first comprehensive CDPCs.
guide to CDCPs, we analyse the potential for
these companies to absorb much of the high In chapters two and four (pages 11 and 25),
grade credit risk that banks and other institu- Randy Gonseth and Chris Wu of Ernst &
tions are increasingly unwilling to hold. Young give an expert run-down of the typical
workings of CDPC operating guidelines and
On the one hand, the recent crisis in the capital models respectively.
financial markets and the switch to the Basel
II bank capital standard create enormous op- In chapter three, Neil Hamilton and Mark
portunities for CDPCs. On the other hand, the Redinger of Clifford Chance address the legal
troubles experienced by other dedicated tak- aspects of CDPCs, and consider the various
ers of high grade credit risk – namely SIVs, structural and documentation issues that
monolines and certain hedge funds – have CDPCs face. They write from an English law
created uncertainty in the minds of many and European perspective. However, CDCP
market participants over the true structure managers and sponsors in other countries
and workings of CDPCs. will face a parallel set of issues.
This guide brings together a number of In the remaining chapters, Creditflux journal-
unique perspectives on CDPCs in an effort ists, with the help of a wide range of industry
to provide a much clearer understanding of participants, assess other key elements of
these companies in an accessible format. the function and structure of CDPCs – the
rating agencies, the importance of opera-
In chapter one, opposite, Andre Cappon, tional issues, and the perspective of CDPC
Guy Manuel and Stephan Mignot of the CBM sponsors and investors – and assess the
Group give a introduction to CDPCs from their future prospects of this growing industry.
Chapter 1
Introduction:
Assessing the value of CDPCs
by Andre Cappon, Guy Manuel and Stephan Mignot
The CBM Group
Credit derivative product companies (CDPCs)

are narrow-focus financial operating compa- CDPCs should become
nies who play the role of specialty “reinsur- increasingly important
ers” of credit risk.
and useful players in the
In the current credit crisis, they are per- financial system in the
forming well, honouring their obligations future – Andre Cappon
to counterparties and proving themselves.
CDPCs should become increasingly important
and useful players in the financial system in
the future.
Definition of a CDPC
One definition of a CDPC is provided by by selling protection against credit events
Moody’s: “CDPC’s are highly rated, stand- – single name defaults or “super-senior”
alone structured financial operating compa- tranches “tail risk” – primarily in the cor-
nies with tightly defined risk management porate investment grade world.
and operating parameters that offer credit • They are going-concern, perpetual operat-
protection to counterparties through credit ing companies, not temporary vehicles.
default swap (CDS) contracts on single name They are capitalised with equity and debt
corporates or tranches of synthetic CDO’s provided by long-term investors.
(mostly of corporates)” • CDPCs are designed to withstand extreme
credit conditions and perform their obliga-
The key features of CDPCs may be summa- tions to counterparties, as symbolised by
rised as follows: triple A counterparty ratings.
• They support real risk transfer for banks

CDPCs: Introduction
CdCP overview
trustee
rating agencies
independent accounting firms

(monitoring)
regulators
proceeds Debt
investors
principal &
investment cdpc interest
portfolio (protection seller)

proceeds
equity
dividends investors
payments
in case of
credit event
premiums
credit
protection
buyers
(counterparties)
reference credits
They can achieve those aims thanks to their • No need for liquidity lines / no liquidity risk
structure…
CDPC leverage is consistent with their nar-
• Operating guidelines that rigorously row focus on credit risk (and the absence of
specify their permitted activities market and liquidity risk)
• Adequate economic capital, calculated by
rigorous capital models
• Regular monitoring by independent third CDPCs’ value proposition
parties CDPCs sell protection to counterparties that
• Clear procedures in the event of distress are major players in the credit derivative mar-
• Transparency of portfolio risks to share- ket, usually large global banks. They operate
holders within credit limits determined by the coun-
terparties’ credit officers. They interact, on a
…and to a business model that is focused daily basis, with the credit derivatives trading
narrowly on synthetic credit risk: desks and the correlation trading desks of
these counterparties. They help these clients
• No collateral posting achieve better management of credit risk and
• No mark-to-market triggers related risks such as correlation risk.

CDPCs: Introduction
Most basically, CDPCs support effective risk A counterparty ratings and should these
transfer. By trading with triple A CDPCs, coun- ratings be at risk, the CDPCs are forced to
terparties can achieve capital relief relative limit their activities until they improve their
to their internal economic capital models and risk profile (in contrast to monolines, where
to the regulators. In addition, credit derivative repeated rating downgrade surprises have
traders are exposed to Gaap mark-to-market damaged credibility). Their focus is strictly
volatility arising from their credit derivative on credit risk and all other risks are carefully
positions. In a large, complex, opaque finan- eliminated or minimised.
cial institution, a sudden negative mark-to-
market can translate into a big impact on the CDPCs are unique (in contrast to other ve-
stock price. hicles, funds, CDOs, monolines) in that they
have true counterparty ratings. Counterparty
As buy-and-hold, narrow-focus, privately held ratings focus on the promise a CDPC makes
entities, CDPCs are in a better position to through all of the derivative contracts it writes
explain the mark-to-market volatility to their (CDS and other) and measure expected
investors. loss to all counterparties. True counterparty
ratings make sure that counterparties are
The one CDPC that is public, Primus, has protected ahead of other creditors. (See
been relatively successful in educating its chapter 5.)
investors that Gaap mark-to-market volatil-
ity, does not affect long-term solvency or CDPCs are limited purpose companies
economic results. Though unpleasant, it is subject to operating guidelines approved by
acceptable in view of the business model. the rating agencies. The operating guidelines
explicitly list all the permitted activities for
Overall, CDPCs act as buy-and-hold accumu- a CDPC such as selling protection, investing
lators or, in effect, reinsurers of credit risk. its cash and paying interest and dividends to
During the current credit crisis, which has investors. The CDPC is meant to stay within
seen the demise of some monolines, SIVs clear risk parameters such as exposure limits
and other accumulators of credit risk, CDPCs to single names, to sectors, asset classes
have proven themselves as one of the most and to ratings categories in order to maintain
reliable types of trading partners for banks. its rating. (See chapter 2.)
Their reliability results from their robust con-
tinuation structure, modes of operation with These operating guidelines are strictly en-
circuit breakers to reduce new risk taking if forced: they are incorporated in the company
ratings are jeopardised, and regular transpar- by-laws and management agreements. Cor-
ent reporting to stakeholders. porate governance is designed to ensure they
are followed. In addition, CDPCs’ compliance
with the operating guidelines is monitored by
third parties, appointed to perform specific
CDPC structure and operation roles under the overall supervision of rating
CDPCs are structured to protect counterpar- agencies.
ties and investors in their rated debt obliga-
tions. This is done by constraining them to CDPCs are subject to capital adequacy
specific, predefined limited activities and to models which quantify their expected credit
risk controls. They must maintain their triple loss. (See chapter 4.) These are Monte Carlo

CDPCs: Introduction
simulation-based models which are con- CDPCs usually offer a stronger form of protec-
stantly run under a range of assumptions for tion than monolines, which promise “timely
the probability of default of the assets in the payment of interest and principal”, that is,
portfolio, the correlation of these defaults, strictly “pay as you go”. Form approved Isda
the probability of default of counterparties master agreements signed by CPDCs assure
and multiple stress scenarios. The expected all counterparties are strictly pari-passu and
loss must remain consistent with the triple A enjoy cross-default provisions, unlike the fi-
ratings on the rating agencies’ global scales. nancial guaranty provisions used by monoline
insurers.
If the expected loss remains below the triple
A standard, the CDPC is free to proceed with CDPCs execute “form approved” Isda master
trades and other permitted actions. If the agreements which allow counterparties few
expected loss exceeds the triple A standard, if any “termination events”. In other words,
the CDPC must either refrain from taking once it has written a trade, the CDPC is
the action or else, it enters into suspension clearly entitled to a series of fixed payments
operating mode. for the duration of the swap. Early termina-
tion, including mark-to-market payments
Suspension means that the CDPC must go from a counterparty default, is mitigated by
static: it cannot write new business and must legal agreement.
simply hold its portfolio. It can go back to
normal operating mode by waiting until some Thanks to their triple A counterparty credit
exposures run off or by hedging some risks. ratings, CDPCs do not have to post collateral
Should the calculated expected loss worsen, when they write protection. Therefore, they
due, say, to credit rating migrations in the do not need access to liquidity, which makes
portfolio or a credit event, the CDPC may hit them immune to mark-to-market volatility and
another trigger and go into wind-down mode, liquidity crunches.
that is, a mode of operation similar to the
run-off of an insurance company. In other They are never subject to any type of mark-
words, it can do no new business of any kind, to-market triggers, such as those that led to
must make significant reduction of costs and the demise of SIVs. This has served CDPCs
must limit its activities to paying CDS liabili- well in the recent crisis which has created
ties and other claims. unusual price volatility in the credit derivative
market.
In addition to the structural features de-
scribed above, CDPCs’ mode of operation
limits their focus narrowly to synthetic credit CDPCs’ prospects
risk and practically eliminates liquidity and CDPCs are an effective solution to today’s
market risks. credit risk challenges.
Their credit guarantee is exclusively in the The Basel II framework, even if it continues to
form of credit default swaps written under be debated and revised, has driven banks to
an Isda master agreement. These swap originate and transfer credit risk rather than
contracts promise protection buyers com- hold it.
pensation for any economic loss incurred as
a result of a credit event. Note, this means

CDPCs: Introduction
Even if regulators react to the current crisis Clearly, rating agencies have made major
by prodding banks to return, to some degree, mistakes in recent years and at the time of
to the old “balance sheet” model (for exam- writing (April 2008), many investors have seri-
ple, by forcing banks to retain a meaningful ous doubts regarding the validity of ratings.
“skin-in the game” portion of the deals they
distribute) the mechanisms of structured The entire system of structured finance and
finance and credit derivatives are valuable credit risk transfer is intimately tied to credit
and are here to stay. ratings. If ratings are not credible, the system
is shaky.
There will be a lasting need for institutions
able to support the credit risk transfer proc- However, credit ratings are a necessary “lan-
ess by taking on credit risk. Clearly such guage of risk” and cannot be jettisoned. Un-
institutions must be very creditworthy, that is, doubtedly, rating agencies will do their best
highly rated. to restore their reputation and credibility.
In view of the declining number of highly In the meantime, ratings are regarded with
rated counterparties, triple A financial operat- suspicion and this affects the credibility of
ing companies will be essential. financial guarantors, in particular monolines.
Monolines and SIVs have been badly hurt in CDPCs are in a much better position to
the 2007/2008 credit crisis. Monolines have weather the crisis thanks to their superior
been hurt by their relative opacity and “rat- business model which is highly structured,
ings surprises”. SIVs have been hurt by their more transparent and narrowly focused.
need for liquidity and market value triggers.
Some CDPCs have embraced transparency to
The CDPC business model is better and more the point that they they provide outputs from
robust: it has more structure, more transpar- their capital models including stress testing
ency, no need for liquidity, and narrow focus to the credit officers of counterparties and let
on credit risk. them see all of the exposures and estimate
expected loss.
CDPCs are in a strong position to occupy the
space lost by other accumulators of credit Since not all counterparties may have the
risk. They will, however, have to overcome patience to run complex CDPC models, we
some challenges and prove themselves. recommend that CDPC define a number
of standardised “distress scenarios” (such
as default of the largest single exposures,
Challenges faced by CDPCs stressed default rates for certain sectors,
As a relatively new type of financial risk taker, stressed default correlation coefficients, etc.)
CDPCs need to convince counterparties to and publish the results of such scenarios.
give them credit lines and trade with them. This should be of great help in communi-
They are facing three key challenges: cating the strengths of the CDPC business
model.
The first and foremost challenge CDPCs face
is to ensure credibility to their counterparties The second challenge CDPCs face is related
and educate stakeholders. to their leverage, which is significantly higher

CDPCs: Introduction
than that of banks. Accustomed with bank- sume buy-and-hold) alongside their financial
like leverage of the order of 25:1, credit offic- Gaap or IFRS results (as Primus, the one
ers are understandably wary of high leverage, CDPC that is publicly traded, does).
especially in the context of the current crisis.
As a result, some counterparties are cautious
with counterparty credit limits for CDPCs. It is CDPCs’ track record
understood that recent trading lines granted CDPCs are a young industry. The first CDPC,
to more active CPDCs such as Channel Primus, launched in 2002, the second,
Capital have been for shorter maturities and Athilon, in 2005. The other nine CDPCs now
smaller notional sizes than pre-credit crisis, in existence launched in 2007. CDPCs have
with most recent transaction activity now so far written a total of some $110 billion of
limited to five or seven-year tenors and ticket notional credit derivative exposure. There has
size less than $1 billion for super senior been no downgrade of CDPC counterparty or
tranches. debt ratings by any rating agency.
According to rating agencies, the maximum Although short, the CDPC experience is
allowable leverage for CDPCs depends on encouraging. CDPCs will undoubtedly be fur-
their type of credit exposure. For single name ther tested in the years to come, yet we are
portfolios, maximum allowable leverage is up confident they should perform well.
to 50:1, for tranche portfolios it is 80:1. In
fact, many CDPCs today operate well below
their allowable leverage. CDPC leverage is
logically justified. The fact is that CDPCs are Opportunities arising from-
highly structured limited-purpose companies current credit crisis
that focus on credit risk, while practically Like all credit investment businesses, CDPCs
eliminating market risk and liquidity risk. have the best opportunities when the market
They take less risk than a bank, they are looks riskiest.
simpler institutions – much more transparent
and closely monitored. The current credit crisis is exacerbating the
“fear factor” in credit spreads, as illustrated
The third challenge faced by CDPCs is mark- by the CDX index for investment grade, which
to-market accounting. Since the business reached around 160 basis points in early
model is to buy and hold credit risk, rather 2008.
than trade it actively, the mark-to-market
should be irrelevant. This suggests it is a great time for CDPCs who
can charge a high premium for their protec-
Nevertheless, the accounting profession has tion. Not surprisingly, there are many newly
enshrined fair value mark-to-market account- established CDPCs and a long pipeline of
ing for derivatives, and CDPCs cannot avoid CDPCs waiting to be rated by the agencies.
it. As Primus chief executive Tom Jasper has
observed: “We are a good business model
trapped in a bad accounting framework.” Andre Cappon is president and founding
partner, Guy Manuel is managing director
The only solution is for CDPCs to systemati- and founding partner, and Stephan Mignot is
cally report “economic results” (which as- a managing director of the CBM Group, Inc.

Chapter 2
CDPCS: Understanding the role of

operating guidelines
by Randy Gonseth, Ernst & Young
Operating modes
At the heart of a triple A CDPC are its operat-
ing guidelines, which detail the fundamental The operating guidelines dictate three differ-
operating policies and procedures of the ent operating “modes” that function as built-
CDPC and are critical in the rating agency’s in circuit breakers requiring the CDPC to build
rating of a CDPC. While operating guidelines up or retain capital and reduce risk if rating
differ among CDPCs due to their differences quality is at risk. The three operating modes
in business strategies, this article describes are as follows:
the typical policies and procedures contained
in a CDPC’s operating guidelines, which are Normal operating mode – The normal
critical in maintaining sound risk manage- operating mode is generally characterised
ment in a CDPC’s narrowly focused business. by having adequate capital to support the
CDPC’s obligations to its counterparties at
the risk level indicated by the initial credit
Role of operating guidelines rating. During this mode the CDPC is in
The CDPC agrees to engage only in those compliance with its operating guidelines and
narrowly focused activities provided for in the is free to undertake all permitted activities
operating guidelines. The operating guidelines in accordance with its operating guidelines.
detail the capital structure, the types of permit- CDPCs commence operations in the normal
ted business activities, the forms of credit de- operating mode and will remain there as
fault swaps the CDPC may execute, permitted long as they maintain compliance with their
counterparties, and the conditions necessary to operating guidelines, including the capital
issue additional debt. If a CDPC violates certain tests.
aspects of the operating guidelines, the level
of operating flexibility will be reduced until such Suspension operating mode – If certain
limit violation is cured. Certain violations could operating guideline criteria that could imperil
lead to the CDPC’s ceasing to enter into new the counterparty credit rating are violated,
CDS. The policies in the operating guidelines then the CDPC enters into a suspension op-
are monitored either daily or weekly. erating mode, which typically results in the
CDPC notifying the rating agencies and the

board of directors, and the CDPC not being Permitted activities
allowed to enter into new CDS except on a The operating guidelines specify activities
“maintain or improve” basis. (See below for that the CDPC may conduct. Activities that
typical suspension events.) Upon suspension, are not described are not permitted. Typical
the CDPC will generally not be allowed to pay permitted activities include:
dividends to the equity holders, and there is • Issuance of equity and debt securities
limited ability to call debt. If a CDPC cures the • Redemption, call or retirement of equity
violation, it can exit the suspension operat- and debt securities
ing mode and return to the normal operating • Entry into and liquidation of eligible CDS
mode. Raising additional capital and novat- with permitted counterparties
ing CDS that are causing violations are two • Entry into and liquidation of eligible invest-
methods of curing violations. ments
• Receipt, purchase and liquidation of
Wind-down mode – A CDPC enters into wind- deliverable obligations assuming the CDPC
down mode if certain suspension events are is permitted to use physical settlement of
not cured within a grace period. This mode CDSs.
is permanent (unlike the suspension mode, • Entry into any other activities that have
which can be exited if a CDPC cures the viola- received rating agency consent and board
tion). During wind-down mode, the CDPC does of director approval
not enter into any new business; it just runs off • Entry into any incidental activities permit-
the existing CDS portfolio and manages risks. ted under the operating guidelines that
All cash proceeds are used to pay off liabilities allow it to perform the activities described
until the CDS portfolio is completely matured. above
Suspension events Eligible CDS

The following are examples of suspension events The operating guidelines list specific, objec-
contained in a CDPC’s operating guidelines that could tive boundaries on the types of CDS that
result in temporary suspension of new business: the CDPC may transact, such as the types
• Insufficient capital to support the initial counter- of reference entities (that is, corporates,
party rating sovereigns), the legal jurisdictions of such
• Failure to pay the amount owed under a CDS, or reference entities and minimum reference
senior obligations such as non-deferrable notes or credit ratings for reference entities and
any other financial contract bespoke tranches. Critical components of the
• Voluntary or involuntary bankruptcy operating guidelines are the forms of confir-
• Downgrade of a CDPC’s counterparty rating below a mation and Isda master agreement under
certain rating (typically, A/A2) which the CDPC will transact under, which
• A violation of portfolio limits are contained in the appendix. Such forms
• Failure to perform capital adequacy tests with suf- will dictate the types of obligation categories,
ficient frequency settlement methods (cash versus physical)
• The occurrence of five or more ineligible transac- and credit events (bankruptcy, failure to pay,
tions or portfolio limit violations over a year or restructuring) under which the CDPC may
transact, and are key drivers in the risks that
must be captured in the capital model. The

CDPC must obtain prior rating agency consent Eligible investments

if it wishes to transact under terms outside of
the prescribed confirmation or master agree- The CDPC invests the proceeds of the equity
ment. and debt issued in liquid, short-duration,
high-quality financial instruments so that the
Hedges: While a CDPC sells credit protec- CDPC can withstand a degree of immediate
tion in a “buy-and-hold” strategy, a CDPC may liquidation of its eligible investments to pay
choose to hedge, novate or terminate early counterparties due to credit events on the
a CDS to manage credit risk. The operating CDS. (However, note that not all CDPCs permit
guidelines allow for the purchasing of an physical settlement of CDS transactions.)
offsetting CDS to cover some or all of the risk
of the existing CDS under which the CDPC The operating guidelines detail the param-
has sold protection. The operating guidelines eters of eligible investments, such as tenor,
describe the required elements of a hedge, issuer, minimum credit rating and currency.
such as matching credit events, settlement Typically, CDPCs invest in triple A corporate
methods and reference entity, and maximum commercial paper and US government and
notional and tenor. In order to gain the agency bonds with tenors of less than three
benefit of the hedge in the capital model, a
minimum credit rating is also required for the
counterparty that is selling the credit protec- Typical CDPC eligible investments
tion. • US dollars and time deposits
• Money market funds rated Aaa/AAA
Novations and early terminations: Another • Euro-dollar deposits of less than 360 days with a bank
method to manage credit risk is for the CDPC rated P-1/A-1+
to voluntarily early-terminate a CDS with the • 180-day bankers acceptances
original counterparty, or assign a CDS to • US treasury securities with maturities of three years or
another counterparty. To early terminate or less
novate a CDS, the CDPC may have to make a • Commercial paper maturing within 270 days rated
cash payment; it can only do so if the result- P-1/A-1+
ing termination payment would not cause • Repurchase agreements on treasury securities with a
a suspension event, such as a failure of a maturity of 365 days or less
capital adequacy test.
Permitted counterparties years. See above for an example of a list of

The operating guidelines typically specify eligible investments.
that counterparties have at least an invest-
ment grade credit rating and be domiciled in The operating guidelines require that eligible
certain jurisdictions that have a degree of cer- investments be held by a custodian with a
tainty of the confirmation and master agree- minimum credit rating and that the eligible
ment. In general, permitted counterparties investments be marked-to-market on at least
are business corporations, regulated lending a weekly basis.
institutions such as commercial banks or
dedicated investment companies. If a CDS provides for physical settlement with
standard currencies (as defined in the Isda

what is a material breach?

Claudia Green, senior analyst, Moody’s
“Material breaches” are actions by a CDPC that and distributed in compliance with the operating
significantly depart from those permitted in its gov- guidelines.
erning documents and that could adversely affect
its rating. Examples of events that may constitute a material
breach include an unauthorised dividend to share-
Because compliance with the governing documents holders or other outflow of capital, an unauthorised
is a basic assumption in Moody’s ratings analysis, it grant of security interest over the CDPC collateral,
is important that there be built-in remedies should failure to abide by trading limitations when in
material breaches occur. In one typical approach, suspension mode and unauthorised changes to the
a CDPC that commits a material breach of its operating guidelines or capital model.
operating guidelines automatically loses control of
its accounts to the independent third party trustee A number of other breaches of the operating guide-
or custodian. From that time forward, the trustee lines can take a CDPC to suspension mode and even
or custodian would typically manage the CDPC in wind-down mode, but this would generally occur
a run-off mode rather than in an actively-managed while the CDPC management and board remains in
mode and would ensure that the cashflows are used control of the vehicle and its accounts.
master agreement) as a deliverable obligation ous system in place for timely monitoring of
characteristic, the CDPC could receive a “non- compliance within such limits.
base-currency” physical obligation upon a credit
event. The operating guidelines must therefore Transaction limits
describe the policy on managing such foreign Tenor limits on CDS are driven partially by the
exchange risk of the physical obligation once maturity profile of the funding of the CDPC.
the CDPC has taken custody of it. Such risk The CDPC seeks to avoid the risk of having to
could be mitigated through purchasing a foreign liquidate eligible investments to pay the ma-
currency forward or cap for the intended hold- turing debt capital before the CDS matures.
ing period. Alternatively, the CDPC could have The funding maturities therefore typically
a policy of not hedging and bear the foreign occur after the CDS maturity dates or after
currency risk. Either way, the approach must be prepayment and extension-stressed scenarios
incorporated into the capital model. establish an envelope of maturity outcomes.
Limits Notional limits are imposed so that a single

The operating guidelines will state specific name CDS does not overly jeopardise the
limits of each transaction at the time of ex- capitalisation of a CDPC. A single-name port-
ecution and also for the portfolio as a whole. folio requires a notional limit on an individual
The CDPC will be required to maintain a vigor- reference obligor.

Minimum credit ratings are required at the the capital model, the methodology employed
time of execution of a CDS. For single-name by the capital model and the resulting metrics
portfolios such limit is a minimum credit calculated to assess the risk of the CDS
rating of a reference obligation. For bespoke portfolio and the CDPC’s credit ratings. The
tranche portfolios such limit is the rating of operating guidelines contain strict policies that
the tranche (attachment point/detachment require all changes to the production version
point) for which protection is provided. of the capital model to receive rating agency
consent. (See also chapter 4, page 25.)
Portfolio limits
A key to managing the credit risk of the CDPC
is to promote diversification through portfolio Management and
limits. Portfolio limits are a function of the service providers
CDPC’s business plan and operating strategy The operating guidelines list the roles and
and vary among CDPCs. Portfolio limits are responsibilities of all the service providers to
monitored at least weekly. Types of limits the CDPC, such as:
include: • Portfolio manager
• Concentration limits – geographic, indus- • Administrative agent
try, single-name and credit-rating group • Employees – typically provided through the
• Maximum leverage limit – measured as asset manager or other service provider
the total notional of the CDS portfolio to • Custodian
capital. Such limits serve as an additional • Auditor
constraint to the CDS portfolio in addition • Periodic agreed-upon procedures provider
to the capital model and are approximately • Capital model agreed-upon procedures
50 times for a single-name portfolio and provider
80 times for bespoke tranche portfolios.
The operating guidelines also describe the
roles and responsibilities of the CDPC board
Capital model of directors. The board is responsible for
Each CDPC develops a proprietary capital the oversight of management and the CDPC.
model to calculate the implied counterparty The operating guidelines dictate the mini-
and debt ratings based upon the CDS portfo- mum number of directors and the minimum
lio, eligible investments, the capital structure number of meetings per year. The operating
and other assumptions. The operating guide- guidelines require a minimum number of
lines describe the frequency (at least weekly independent directors (often at least two),
but often daily) which the capital model should specify the criteria to be considered inde-
be run (also known as the “capital adequacy pendent and also dictate which material ac-
tests”) to assess debt and counterparty rat- tions of the board require approval by all the
ings. The operating guidelines also state the independent directors.
immediate actions (such as, entering into sus-
pension operating mode) and notifications (to
the board and rating agencies) required if the Operations and controls
tests indicate that the current ratings of the The operating guidelines typically describe the
CDPC are in jeopardy. A key appendix to the key transaction processes and controls. These
operating guidelines is the capital model tech- processes and controls include the trade
nical document, which details the inputs into approval process, roles and responsibilities

agency consent. Management must prove to

the rating agencies that it has the appropriate
Weekly reporting
expertise and infrastructure in place and that
to the rating agencies
the new activities would not negatively affect
the risk profile of the CDPC. It is not unusual
● For each single name trade:
for a CDPC to seek periodic modifications to
• Reference entity name, credit rating, industry and
the operating guidelines, for example, to add
jurisdiction
new types of CDS.
• Notional amount
• Maturity date
• Counterparty name, rating and jurisdiction
• Applicable credit events
Monitoring compliance with
the operating guidelines
A strong oversight function is key to ensure
● For each tranche trade:
the timely monitoring of the requirements
• All the information above for single-name trades
and limits of the operating guidelines. The
• Attachment and detachment points
CDPC also engages an auditor to conduct
● The portfolio limits report showing each of the
monthly agreed-upon procedures to test the
CDPC’s exposures versus its limits (such as industry
CDPC’s compliance with certain of its operat-
concentrations and rating concentrations)
ing guidelines. CDPC management uses the
● Outputs from the capital model displaying risk
results of the agreed-upon procedures in its
measurements, leverage and rating agency metrics
evaluation of the operational effectiveness
● The description and market value of the eligible
of the controls over compliance with the
investments
operating guidelines. The rating agencies
also provide certain surveillance procedures,
such as receiving weekly reports from the
CDPC on granular information about the
for monitoring operating guidelines compli- CDPC’s portfolio, counterparties and eligible
ance (including performing capital adequacy investments. See above for types of reports.
tests and monitoring exposures concentration Rating agencies also perform an initial and
limits), credit surveillance, approvals of trade sometimes periodic review of the business
documentation, monitoring of outstanding plan and operational platform, including man-
confirmations and meeting third-party report- ager due diligence.
ing requirements. Other key controls include
keeping the capital model in a secure environ-
ment, and that all changes to the capital Conclusion
model and related technical document are Detailed operating guidelines are one of the
documented, approved and tested. defining characteristics of a CDPC. They are a
key element in the CDPC conducting a narrow
business line in a well controlled and well
Modifications to capitalised manner, by contrast to entities
operating guidelines that have a more flexible operating structure.
Any changes to the operating guidelines
require a strict approval process. Typically, Randy Gonseth (212-773-8162 / richard.gon-
such approvals include prior written approval seth@ey.com) is a partner in Ernst & Young
by the board of directors and written rating LLP’s Financial Services Office in New York.

Chapter 3
CDPCs: handling the legal issues

by Neil Hamilton and Mark Redinger, Clifford Chance
A number of legal issues may arise in various

jurisdictions in connection with the establish- Care needs to be taken
ment and operation of a CDPC. The following
are selected English and UK law issues that
to ensure that the CDPC
may arise where the bulk of the CDPC’s legal is off balance sheet for
documentation is governed by English law any bank sponsor – Neil
and/or where the CDPC has a presence in
the UK, for example through an investment
Hamilton
manager or adviser based in the UK.
Structural issues
Jurisdiction of incorporation
As with other special purpose vehicles in tax treaty network. Accordingly, CDPCs have
the structured finance markets, the choice been established in a number of different
of jurisdiction of incorporation of a CDPC jurisdictions, including Bermuda and Ireland.
is largely determined by tax and regulatory
considerations. Tax
In cases where the CDPC is established
Since the payment flows to the CDPC consist outside the UK, it is important that the CDPC
principally of premium income from credit is structured so that it is neither tax resident
default swap counterparties and distributions in the UK nor treated as carrying on a trade in
on eligible investments in which the CDPC’s the UK through a permanent establishment. In
capital is invested, there is generally no need order for the CDPC to remain resident outside
to avoid the imposition of withholding tax on the UK, central management and control of
the CDPC’s cash inflows by siting the CDPC the CDPC must rest exclusively with directors
in a jurisdiction which benefits from a double whose specialist knowledge enables them to

legal issues
oversee the business of the CDPC and who needs to be taken that the relevant regula-
actually exercise this control outside the UK. tory and accounting regimes are complied
with. This is most likely to impact on issues
Even if the CDPC is not resident in the UK such as the circumstances in which the
for UK tax purposes, it might be subject to investment manager’s appointment can be
UK corporation tax if it is carrying on a trade terminated by the CDPC, the extent to which
through a permanent establishment in the the investment manager can exercise voting
UK. If the CDPC were to be viewed as carrying rights in relation to the CDPC, and aspects of
on a trade (which is a question of fact) an the structure under which the sponsor is pro-
investment manager which has authority to viding implicit or explicit credit support to the
conduct business on behalf of the CDPC in CDPC. In the wake of the support that spon-
the UK (rather than as adviser to a non-UK sors of structured investment vehicles (SIVs)
manager of the CDPC) could constitute a have recently provided to SIVs structured to
permanent establishment of the CDPC in the be off balance sheet to the structuring bank,
UK through which a trade is carried on. the possibility exists that the accounting and
regulatory tests for off-balance-sheet treat-
If the CDPC is incorporated in a jurisdiction ment will be re-assessed.
such as Bermuda, the Cayman Islands or
Jersey, it is unlikely that any double tax treaty Consent rights
will alleviate this potential tax exposure and In structuring a CDPC, consideration should
reliance will therefore have to be placed be given to whether stakeholders of the
on the UK investment manager exemption. CDPC should have approval or voting rights
This exemption provides protection from an with respect to changes to the CDPC’s busi-
assessment for UK corporation tax if the ness, such as (i) the ability of the CDPC to
investment manager is an “agent of inde- write credit protection on new asset classes
pendent status” acting in the ordinary course (ii) substantive changes to the operating
of its business. Certain conditions need to be guidelines and (iii) termination and replace-
satisfied for this exemption to apply, including ment of the investment manager.
that the transactions carried out pursuant to
the investment management agreement are Debt issuance
investment transactions, that the fees pay- CDPCs have funded their capital requirement
able to the investment manager are not less in various ways: most commonly by issuing
than the customary market rate, and that the term subordinated debt (ranking junior to the
“20% rule” is satisfied (under which, broadly claims of credit derivative counterparties)
speaking, the investment manager and its and/or by issuing auction rate notes on a
affliates may not own more than 20% of the continuous issuance basis. The legal issues
CDPC’s “relevant excluded income” (broadly which arise in relation to the establishment
speaking, capital or equity-like instruments in of the CDPC’s funding structure are generally
the CDPCs capital structure)). the same issues as arise in relation to debt
issues for other types of structured vehicle.
Regulatory and accounting issues These include disclosure requirements and
Where a bank is the sponsor of a CDPC, it will marketing and selling restrictions. Given the
usually be looking to ensure that the CDPC current emphasis on transparency in the
is off balance sheet for both accounting and structured products market post the “credit
bank regulatory capital purposes, and care crunch”, it is more important than ever to

legal issues
ensure that the disclosure documents for the of a CDPC are not unlike those required for
relevant debt issuance have clear disclosure the establishment of other managed vehicles
of matters such as the triggers for changes in and are typically an investment management
operating states, and a general outline of the agreement, a custody agreement and an
operation of the capital model, so as to avoid administration agreement. Some CDPCs have
any potential mis-selling claim. also included a security trust deed.
Where the CDPC funds itself through Investment management agreement

auction-rate securities or other continuous CDPCs, like SIVs, are intended to be “indefi-
issuance debt programmes, rather than by nite life vehicles”, or “going concerns” mean-
issuing capital or term debt, dealers on the ing that the vehicle has the ability to continu-
programme may request an indemnity from ously fund itself. The investment manager
the investment manager, as well as from the has the responsibility to manage the asset
CDPC itself, in relation to losses suffered as side of the CDPC structure and provide the
a consequence of misstatements or omis- overall management responsibility for the
sions in the disclosure documents for the vehicle. It is difficult to over-emphasise the
programme. The extent to which any such importance of the investment manager to the
indemnity covers misstatements or omis- overall rating of the CDPC.
sions in reports prepared by the investment
manager, such as portfolio reports produced From a structural perspective, the investment
by the investment manager, is often a point manager is appointed by the board of the
negotiated between the parties. CDPC to manage its assets and obligations,
and the board has ultimate oversight of the
performance of the investment manager. In
Documentation certain extreme circumstances the board
Once the structural issues have been settled may direct the investment manager to take or
with some certainty, attention can turn to refrain from taking certain actions, or other-
documenting the vehicle and closing the wise terminate for failure to perform.
transaction. Subject to any taxation or regu-
latory requirements the legal documentation In practice the investment manager under-
can be as creative or “off the shelf” as the takes its responsibility in strict adherence
various parties have the appetite for and can with the operating guidelines that have been
be tailored to suit any particular structure. highly negotiated with various rating agencies
and are designed to ensure that, if complied
In commencing the documentation process with, the vehicle will maintain its ratings.
for the CDPC it is critical for counsel to under-
stand the risk profile of each of the parties Some additional responsibilities may include
involved in respect of their discreet roles in the requirement to monitor the operation of
the transaction. Too often parties enter into the CDPC to ensure that the CDPC is operat-
the documentation process prematurely with- ing within its required criteria, including com-
out a frank understanding of a counterparty’s plying with various threshold tests required
interests which causes unnecessary delay in by each of the rating agencies. A capital
completing the paperwork. model will be employed by the investment
manager and run on a frequency discussed
The “core documents” for the establishment and agreed with the rating agencies to test

legal issues
the performance of the CDPC against these provisions are typically highly negotiated
various criteria. and in the absence of “wilful misconduct,
fraud, bad faith, gross negligence or reckless
The investment manager may also be disregard” the investment manager will typi-
required to formally enter into reporting cally have no liability to the CDPC for actions
obligations apart from its obligations to the undertaken on behalf of the CDPC pursuant
CDPC and provide such reports directly to the to the investment management agreement.
rating agencies, or other counterparties of The investment manager typically obtains a
the CDPC. Where the investment manager is blanket indemnity from the CDPC for actions
also responsible for running and administer- taken on its behalf in compliance with its obli-
ing the capital model, an on-going obligation gations under the investment management
to report to the rating agencies the outcome agreement. Unsurprisingly, these clauses
of the capital model will likely be present. tend to be highly negotiated between the
parties.
The investment manager will be entitled to
fees in the performance of its services to the The introduction of the Markets in Financial
CDPC. Where a CDPC has a pre and post Instruments Directive (MiFID) on 1 November
payment priority waterfall, generally those 2007 to replace the Investment Services
portion of fees that are in the nature of a Directive requires investment managers to
“reimbursement expenses” for example, legal evaluate whether their actions under the
costs, travel expenses, and in some cases investment management agreement are
a base set management fee may be taken impacted by the directive. Additional drafting
out quite senior in the waterfall whereas the will be required to ensure that investment
performance related fees, which are payable management agreements comply with MiFID
based on the overall performance of the
vehicle annually, will typically be subordinate
to all other payments but ahead of any final Security trust deed
amounts payable to the vehicle as excess. A security trustee may be appointed to act
on behalf of the secured creditors pursuant
Throughout the term of the investment to a security trust deed. The nuances of
management agreement, the investment English law require that the security granted
manager will need to covenant with the by the CDPC to the security trustee will cover
CDPC to maintain certain financial criteria both those assets (including rights, obliga-
as well as other criteria related to its status tions) owned by the CDPC at the time of
and operation. Due care needs to be taken execution (fixed charge) but also those assets
to ensure that covenants are not drafted too that may become the property of the CDPC at
restrictively so as to inadvertently cause the a later date (floating charge).
investment manager to be in breach.
Broadly, the class of secured creditors is
The investment management agreement will intended to include any party to which the
typically clarify that the investment manager CDPC owes any obligations. Since the CDPC
will make no warranty about the performance is prevented from granting security to any
of the CDPC in the compliance with its obliga- party other than the security trustee, all the
tions. The standard of care and indemnity parties to whom the CDPC owes any obliga-

legal issues
Are operating guidelines enforceable?

Claudia Green, senior analyst, Moody’s
A critical component of the counterparty ratings and operating guidelines, often the CDPC itself oversees
debt ratings that Moody’s assigns to CDPCs is the any transition from one operating mode to another.
enforceability of the company’s operating guide- In contrast, if a material breach has occurred, an
lines. The operating guidelines define the CDPC’s independent trustee or custodian takes control of
permitted scope of activity and limit permitted the CDPC’s accounts and ensures that cashflows
trades to those whose risk can be captured by the are used and distributed in compliance with the
CDPC’s capital model. The operating guidelines operating guidelines.
also set out other governing provisions including
the triggers for converting normal operating mode It is important from a ratings perspective that such
to a suspension or wind-down mode, and limita- an independent third party be responsible for super-
tions on payments of dividends and other activity. vising the CDPC’s accounts once the CDPC’s ability
The operating guidelines, despite their name, are or willingness to conform to the operating guidelines
enforceable against the CDPC and not an optional or becomes doubtful. To merit a high rating, Moody’s
discretionary guide. Compliance with the operating expects significant assurance that the CDPC will
guidelines is typically verified by an independent au- adhere to the parameters and limitations built into
ditor who performs regular agreed-upon procedures. the operating guidelines, especially since most
CDPCs are newly formed companies with limited
Unless the CDPC commits a “material breach” of its operating histories.
tions have an interest in ensuring that they operating mode and after the CDPC has
are able to obtain the benefit of the security entered into suspension operating mode
trust deed. or wind-down mode. Payments to the
security trustee come ahead of all other
Where it is used, the security trust deed will monies due and owing to any other party;
typically provide for:
• the list of discretionary and mandatory
• the secured creditors to expressly agree to powers of the security trustee, notably
limited recourse and non-petition provi- the ability/requirement to appoint a
sion, which limit their ability to take any receiver once the CDPC has become
independent action against the CDPC for insolvent; and
payment of debts owed to them;
indemnity for the security trustee in under-
• the order of payment of obligations by the taking any activity under the security trust
CDPC both when the CDPC is in normal deed.

legal issues
Following the deterioration of the credit mar- eral accounting records;

kets in 2007, greater attention has been paid
to the role intended to be exercised by the • providing administrative assistance to
security trustee in structured debt transac- the CDPC and the investment manager in
tions. acquiring and disposing assets; and
Certain CDPCs, including Channel Capital, • acting as the verification agent in the
have employed the use of a security trust event of it entering wind-down mode,
deed given preferences of CDS swap counter- meaning that it must approve any instruc-
parties. tion to make a payment before that pay-
ment can be made.
Administration agreement The administration agreement should ex-

The CDPC itself does not have any employ- pressly distinguish the role of the administra-
ees, as a result it outsources all administrator from that of the investment manager by
tive functions to an administrator that the stating that the former will not be responsible
CDPC’s directors cannot do (or are unwilling for the obligations of the latter. This ensures
to do) themselves. that the administrator does not stray outside
of its expertise and acceptable risk bounda-
The CDPC administration agreement gener- ries.
ally grants the administrator full authority to
act as the CDPC’s agent in fulfilling the follow-
ing roles: Custody agreement
The CDPC will enter into a custody agreement
• conveying all information, notices and with a custodian bank. The custodian will
other documents to the CDPC, the security be a financial institution, which under the
trustee, any of the CDPC’s debt-holders, custody agreement assumes responsibility
the investment manager, the custodian for safeguarding and managing the CDPC’s
and the rating agencies; assets. These will largely consist of the highly
liquid low risk assets owned by the CDPC in
• ensuring the calculation of the daily mark- order to meet its potential liabilities under
to-market values of the CDPC’s assets the credit default swaps it enters into. In ad-
and informing the investment manager of dition to providing what is held by whom, the
these; custody agreement will also state where the
assets are held.
• operating and monitoring an account to be
used by the custodian, and instructing the The custody agreement will also lay down
custodian to make appropriate payments the mechanics of the custody, determining
from it to meet the expenses of the CDPC; when and how the assets will be transferred
and what events might lead to the assets no
• providing any other organisational services longer being held for the CDPC. It is typical for
to the CDPC that are deemed necessary the CDPC to assign the benefit of the custody
and requested by the CDPC; agreement to the security trustee and for the
custodian to acknowledge that it will hold the
• maintaining the CDPC’s books and gen- assets on trust in the custody agreement.

legal issues
This will be necessary to ensure that the Credit derivative

CDPC does nothing to breach its obligations documentation
under the security trust deed, where it grants Templates for the forms of Isda master
a charge over all of its assets. agreement to be put in place with credit
default swap counterparties, and the forms
In fulfilling its duties the custodian might, of confirmation for different types of credit
amongst other things, be expected to: derivative transactions, will typically be
reviewed and “form-approved” in advance of
• safekeep securities such as notes and trading by the rating agencies. Since CDPCs
shares; do not post collateral with their credit default
swap counterparties, there is no requirement
• organise settlement of sales and purchas- to put in place credit support agreements.
es of the CDPC’s assets where sufficient Because CDPCs are continuation vehicles,
funds are advanced to it by the CDPC; the circumstances in which credit default
swap counterparties have the right to termi-
• collect any income from the CDPC’s nate outstanding transactions will differ from
securities; those found in vehicles which have termina-
tion structures. In the case of CDPCs which
• receive and provide information on the create security over their assets in favour of a
assets and their issuers; and security trustee, amendments will need to be
made to the standard Isda events of default
• regularly report on its activities to the to ensure that the appointment of the secu-
CDPC. rity trustee, or actions by the security trustee
under the terms of the security trust deed, do
However, the custodian will make sure that not of themselves permit the counterparty to
in no event it is responsible for the selection, terminate the swap.
disposal and acquisition of the assets as this
discretion would bring potential risk to a very
risk averse body. It will also want to hold the Documentation process
discretion to decline to hold assets where CDPCs are fairly novel transactions in the Eu-
this would be reasonable and to ensure that ropean context, despite persistent rumours of
where additional unforeseen costs arise the new market entrants, the most recent CDPC
CDPC will reimburse it fully. being Channel Capital, launched in 2007.
The custodian will seek to limit its liability As a result of their relative novelty, the time-
to the CDPC to losses caused through the line for execution and negotiation of docu-
custodian’s negligence, fraud or wilful default mentation is a bit longer than some other
under the custody agreement. It shall also transactions. A typical timeline is shown
require an indemnity from the CDPC for all overleaf.
reasonable losses it suffers in performing the
terms of the custody agreement, subject to As in any transaction, our experience has
those arising from its own negligence, fraud demonstrated that the key to smooth
or wilful default. Once again, this reflects the execution is dependent on keeping all par-
unwillingness of the custodian to assume a ties moving towards targets and engaging
risk out of proportion with its modest fees. third-parties, namely, the security trustee,

Legal issues
timeline
month 1 Month 2 month 3 month 4 month 5
Listing process
ratings
structuring
Launch
- tax
- regulatory
document
negotiations
(internal) document negotiations
(external)
- rating agencies
- trustee
- custodian/
administrator
engagement of rating agencies
swap negotiations
the administrator and custodian, and their product however, part of the challenge is in
counsel, as well as rating agencies and their educating counterparties about its novelty
respective counsel, early in the process in while pointing out the similarities with prior
order to avoid any last minute surprises. structures. Having competent counsel is only
one element in ensuring the smooth launch
Given the nature of the transactions under- of your vehicle.
taken by CDPCs, the documentation process
naturally continues after launch as new busi-
ness is written with various counterparties.
Neil Hamilton is a partner in capital markets

Conclusion and Mark Redinger is a senior associate in
While CDPCs are relatively new in the Euro- capital markets at Clifford Chance LLP. The
pean context they benefit from a wealth of authors would like to give special thanks to
prior experience that has been obtained in Jan Hobbs for assistance in preparing this
the structured debt market. As with any new piece.

Chapter 4
CDPCs: running the capital models

by Randy Gonseth and Chris Wu, Ernst & Young
Each triple A credit derivative product

company (CDPC) develops a proprietary,
simulation-based cashflow capital model to The capital model is a
determine whether the size of the current circuit breaker to prevent
capital supports the CDPC’s counterparty and the CDPC from jeopard-
debt ratings. The capital model simulates the
CDPC’s future cash flows for a large number ising its credit ratings –
of simulation paths to the longest obligation Randy Gonseth
(credit default swaps and debt) of the CDPC.
For each path, it is determined if there is ad-
equate capital to pay the CDPC’s obligations.
The capital model is typically run on at least a
weekly basis.
Objective and methodology sistent with the rating agency’s CDO models.
The capital model measures the credit risk Therefore, as each rating agency has its own
in the portfolio versus the available capital to CDO model, CDPCs will have a separate capi-
determine the CDPC’s ability to pay counter- tal model for each of the rating agencies that
parties and debt holders with certainties com- rates it. As depicted in the diagram on page
mensurate with the respective credit ratings. 27, the starting point of the capital model
Generally, the greater the notional exposure process is inputting the data and assump-
and portfolio risk, the greater is the capital tions about the CDPC’s asset and liabilities
required to achieve a particular credit rating. into the model, which is followed by three
The capital model assumes that the CDPC is in sequential processes:
wind-down mode. Therefore the capital model
assumes there is no new business activity - no • A Monte Carlo simulation of correlated
new credit default swaps transactions or ad- defaults and recovery rates for refer-
ditional debt issuances by the CDPC. ence entities or assets of the CDS, and
also simulation of interest rates, foreign
The engine of the simulation model and its currency rates and potentially credit
functions and inputs should be generally con- spreads;

capital models
what is the purpose of the capital model?

Algis Remeza, senior credit officer, Moody’s
Most CDPCs choose to have their ratings managed- CDPCs build and operate their own capital models,
with-model. The premise of managed-with-model which are reviewed for consistency with Moody’s
ratings is that if a CDPC were to suspend all trading measurements of risk. There are many similari-
permanently, it would become a static portfolio of ties among the different CDPCs, especially for the
CDS, whose risk could be modeled accurately and modeling of core risks which follow Moody’s CDO
simply. In order to apply the managed-with-model analyses. Beyond this level, modeling similarities
methodology, a CDPC commits to (a) becoming often end as CDPCs typically have different forms
static if its credit risk estimates exceed the criteria of contracts and structures, which require different
for any of its ratings and (b) not taking action, modeling treatment. Moody’s analysts review capital
including trading and allowing outflows of capital, model technical descriptions to ensure that modeling
if it would cause the CDPC to exceed the credit risk is consistent with documentation and Moody’s analy-
associated with its rating. Therefore, the capital ses. Before launching, the CDPC performs a battery
model serves the critical purpose of measuring of model runs used to verify the model output. Finally,
credit risk and, in turn, the trades that are within the an independent auditor reviews the capital model and
permitted risk profile. delivers an agreed-upon procedures letter.
• Projection of future cashflows of the market prices of eligible investments as such

CDPC based on the simulated default eligible investments would have to be sold
times, recovery rates, interest rates, for- by the CDPC to pay counterparties under a
eign currency rates and credit spreads; credit event under a CDS. The applicable
and haircuts are documented in the operating
• Calculation of the rating agency and guidelines and are based on their maturity
other metrics to gauge the CDS portfolio and type of asset. Second, the CDPC must
risk. set aside “operational risk capital” to offset
nonquantifiable risks, such as the potential
for operational errors (that is, systems errors,
Inputs to the capital model coding errors in the capital model and docu-
Inputs to the capital model include the mentation errors), unexpected legal costs
CDPC’s assets and liabilities, and rating associated with events, as well as economic
agency assumptions on default probabilities, risks that have not been modeled adequately.
correlations and recovery rates. The entire The amount of operational risk capital for a
CDS portfolio is entered into the capital CDPC is also a function of the rating agency’s
model in granular detail (see opposite). The assessment of the CDPC’s manager and the
current market values of the CDPC’s eligible soundness of its operations. Operational
investments are entered into the capital risk capital is usually a fixed amount that
model with two reductions. First, the market increases over time or as the CDS portfolio
value of eligible investments are reduced grows, and is documented in the operating
by haircuts to account for risk of fluctuating guidelines.

capital models
CdPC CaPital model overview

inputs (source) simulations Quarterly cash flow calculations risk measurements
inflows:
- cds portfolio - interest income on
(trade capture eligible investments
system) - cds premiums on
- Debt terms sold protection
(indenture) - correlated reference - receipts of credit
- eligible investments obligations default times events (hedges)
(custodian statement) - correlated counterparty outflows:
- expense projections default times - payments on credit - rating agency metrics
(cdpc management) - recovery rates events for counterparty and
- Default tables - interest rates - administrative and debt credit ratings
(rating agency) - Foreign currency rates operational expenses - other management
- recovery tables - cds premiums on reporting metrics
(rating agency) purchased protection
- correlation (hedges)
assumptions - interest and
(rating agency) principal on debt
- interest rate and - dividends to
FX parameters equity owners
(derived by cdpc)
Three parts of a capital model
tracked to determine whether the attachment
1. Simulations point has been breached.
Default and recovery
For each Monte Carlo path, default times for Recovery rates of corporate assets are also
all underlying reference entities are simulat- simulated based upon the methodologies
ed using the rating agency default frequency the rating agencies use in their CDO models.
assumptions. The default simulation model The recovery rates are assumed to follow
is generally based on the normal Gaussian
distribution whereby normally distributed
correlated variables (simulated default times) CDS portfolio details entered
are generated for each underlying refer- into the capital model
ence entity and compared with the default • Reference entity name
probability thresholds. The correlations of • Industry
the normal variables are consistent with the • Jurisdiction
asset-specific correlation approach in the • Credit rating
rating agencies’ CDO models. If the simulated • Counterparty name and credit rating
default time for a reference entity is less than • CDS effective date and maturity date
the remaining tenor of the CDS transaction, • CDS settlement method (cash/physical)
the entity is considered to have defaulted. • CDS credit events
If the simulated default time is greater than • CDO tranche name, attachment and detachment
the remaining tenor, then the entity is not points (if referenced by CDS)
considered to have defaulted. For bespoke • CDS notional amount and currency
tranched CDS the defaults of the underly- • CDS premium rate, payment frequency
ing reference entities are simulated using a • Interest and foreign currency hedge transactions,
drill-down approach, in which the impact of if any
the underlying reference entity defaults is

capital models
Counterparty default in the capital model
If a counterparty defaults, not only do cash inflows however, the limited case law in some jurisdictions
of CDS premiums in the capital model terminate, but may lead the rating agencies to require the CDPC to
such counterparty default also creates the risk of model this risk. A CDPC may not need to model such
a declaration of a termination event, and the value termination payment risk if it can provide adequate
of the mark-to-market of the transactions between legal and structural comfort to the rating agency
the two parties less any unpaid amounts may be that the CDPC will not be exposed to it. From a legal
due and payable (a cash outflow from the CDPC to perspective, this requires altering standard Isda lan-
the defaulting counterparty). CDPCs typically write guage and transactions with counterparties subject
their CDS contracts in a way as to avoid the risk of to insolvency regimes that will honour such altered
an early termination payment to a counterparty; language.
beta distributions with or without correla- Foreign currency

tions among the assets. The parameters of A CDPC may face foreign exchange risk
beta distributions are derived from historical if counterparties pay CDS premiums in a
means and standard deviations of corporate non-base currency or, if a CDS provides for
recovery rates from the rating agencies. physical settlement with standard currencies
(as defined in the Isda master agreement)
Interest rates as a deliverable obligation characteristic,
A CDPC could face interest rate mismatches the CDPC could receive a non-base-currency
between the debt issued by the CDPC and physical obligation upon a credit event.
the eligible investments. Therefore the CDPC Although a CDPC can structurally mitigate
would need to simulate the interest rate re- such risks by not allowing counterparties to
turn for the eligible investments and the inter- pay non-base currency premiums or to deliver
est rate for the debt liabilities in the capital non-base currency obligations, such actions
model. Interest income on eligible invest- may limit the CDPC’s business opportunities.
ments is typically modeled at a spread below A CDPC exposed to such foreign currency
the simulated Libor, and debt liabilities are risk must therefore capture it in the capital
modelled to be consistent with any floating model. Cash inflows on non-base currency
rate and step-up features and the maximum CDS premiums should be modelled using a
rates for auction-rate securities. Any interest market standard methodology that converts
rate swap used by the CDPC to manage the all future cash flows into the base currency.
interest risk between the eligible investments The foreign currency risk on a delivered ob-
and the debt liabilities would likely have to be ligation could be mitigated through purchas-
incorporated into the capital model, including ing a foreign currency forward or cap for the
the risk of default by the interest rate swap intended holding period. Alternatively, the
counterparty. CDPC could adopt a policy of not hedging and
bear the foreign currency risk.

capital models
Foreign currency derivatives used to hedge has completed all time intervals, it moves on
premiums or delivered obligations, including to the next simulation path. The number of
the risk of counterparty default, would need simulation paths must be great enough to ob-
to be incorporated into the capital model. Al- tain stable and “converged” results from the
ternatively, if no such foreign currency hedges capital model. It is not uncommon for a CPDC
were utilised, the risk of foreign currency to run one million or more simulation paths.
movements on non-base-currency cash depos-
its and delivered obligations held by the CDPC 3. Risk measurement calculation
would need to be incorporated into the capital Rating agency metrics are produced based on
model. Because interest rates and foreign cur- the results of each of the simulation paths.
rency exchange rates often move in tandem, Basically, the outcome of each path is that
simulations of interest and foreign exchange the CDPC was either able to pay all of its
rates generally must be correlated, with the obligations in a timely manner or not able to
parameters derived from historical data. pay them in a timely manner. As each rating
agency has different metrics for its respec-
2. Cashflow projections tive credit rating assignments, such metrics
Each of the simulation paths runs to the must be produced for each of the applicable
maturity of the longest CDS and is divided ratings agencies. The required metrics and the
into smaller time intervals (typically quarter method from which to derive such metrics are
year increments). For each time interval, the generally publicly available from rating agency
defaults and recoveries upon default are CDPC and CDO criteria, but generally the
obtained for all reference entities and coun- default probabilities generated by the capital
terparties, and the following cash inflows and model must be less than a AAA default prob-
outflows are summed: ability at a certain time horizon for S&P and
Fitch, or the losses calculated by the capital
• Inflows: CDS premiums, interest income model must be less than a Aaa expected loss
on eligible investments, payments ratios at a certain time horizon for Moody’s.
received due to default on purchased
credit protection. CDPC management can also use the capital
• Outflows: expenses (fixed and variable), model to produce additional risk measures
debt interest and principal, payments to assist in managing the business, such as
due to default on credit protection sold, sensitivity measures, averages or scenario
premiums on purchased credit protec- analysis. For example, management could
tion and dividends. Cash outflows are in run scenario analysis assuming all reference
order of legal seniority. entities within a certain industry sector were
downgraded one notch or a specific reference
If the CDPC has sufficient eligible invest- entity had defaulted.
ments and cash inflows to pay all claims and
expenses, such payments are made and the
model simulation moves onto the next time Capital model technical
interval. If the cash outflows exceed the eligi- document
ble investments and cash inflows, the CDPC The “technical document” written by the
will not have the ability to pay all of its obliga- CDPC details the required inputs to the
tions to its debt holders and/or counterpar- capital model, the methodology employed
ties in that simulation path. After the model and the resulting risk measurement calcula-

capital models
tions. Such documents can range from 30 typically performed prior to the CDPC starting
to 80 pages, including exhibits, and typically business:
detail the formulas for all key computations
performed by the capital model. The capital Benchmarking to rating agency models
model technical document is a key compo- The CDPC will determine whether the capital
nent of the rating agency review process and model complies with the rating agency meth-
is reviewed thoroughly. This document is typi- odologies employed in the rating agencies’
cally an appendix to the operating guidelines. CDO models. This reconciliation is done by
running a number of portfolios that com-
ply within the limitations of the operating
Capital tests guidelines through the simulation portion of
The operating guidelines describe the fre- the capital model and also the rating agency
quency with which the capital model should CDO model. The metric output of each of the
be run (also known as the ‘capital tests”) to two models is checked for equality within a
assess debt and counterparty ratings. Typi- margin of statistical error.
cally, capital tests are run at least weekly, but
often daily. If capital tests indicate that the Stress tests
current ratings of the CDPC are in jeopardy The CDPC generates a series of extreme
(for example, if the minimum required capital portfolios permissible under the operating
per the capital model exceeds 95% of avail- guidelines, such as a portfolio maximising the
able capital), the operating guidelines typi- exposures versus limits on certain industries,
cally dictate certain immediate actions (such having reference entities with the lowest pos-
as a suspension event) and notifications (for sible permissible credit ratings, and including
example, to the board and rating agencies). CDS with the longest possible permissible
Results of the capital tests are provided by tenors. Such extreme portfolios are run
the CDPC to the rating agencies weekly. through the capital model along with the
proposed initial capital levels. The proposed
The operating guidelines also specify the fre- capital level of the CDPC must be sufficient
quency with which inputs to the capital model to satisfy the threshold requirements for the
must be updated. CDS portfolio detail inputs target counterparty and debt ratings. Some
(that is, new trades and reference obligation CDPCs conduct further scenario analysis
credit ratings) are updated every time the on the portfolio, including rating stresses
capital model is run (weekly or daily). There- to obligors and counterparties and other
fore, deterioration in the credit quality, or in- distressed scenarios for their counterparties
crease in the size, of the CDS portfolio should and investors
result in an increase in the required capital
on a relatively timely basis. Other inputs such Capital model agreed-upon procedures
as the volatility and correlation assumptions CDPCs engage an independent accountant to
on interest rate and foreign currency rates perform agreed-upon procedures to test the
are typically updated less frequently. consistency of key computations performed
by the capital model with the methodologies
described in the technical document. The
Controls over the capital independent accountant performs calcula-
model tions described in the technical document
The following tests of the capital model are on a sample portfolio with an independ-

capital models
CDPC capital model: scenario analysis and stress testing

Brian Naini, chief risk officer, Channel Capital
Stress testing and scenario analysis are intended to in assessing capital adequacy under adverse portfo-
forewarn of situations where the capital adequacy lio migration and/or default scenarios. Defaults can
limits may be breached. The general approach for be modelled by changing the ratings to the CC/Ca
stress testing is to change the model inputs adverse- bucket. Industry and country codes can be used to
ly and assess the impact on various risk measures. downgrade or default specific slices of the portfolio.
Given the number of inputs to the model and typical
capital model run times, it would be impractical to It is also useful to assess the impact of a downgrade
consider very granular permutations of inputs. or default of some or all of the counterparties. For
capital models that incorporate termination pay-
A good starting point is to change some of the key ments, downgrading counterparties highlights the
inputs one at a time. Capital model inputs can be exposure to termination payments. Counterparty
split into five groups: downgrades can also indicate the extent of reliance
on cashflows from a single or group of counterparties.
1. Capital structure and levergeable capital: details
of CDPC issued debt and the leverageable capital Capital models require calibrated parameters to
2. Agency rating model data: default probabilities, simulate FX, interest rate and credit processes.
transition matrices, recovery rate and correlation It is typically required that these parameters be
tables calibrated periodically in order to incorporate the
3. Reference entity details: rating, country/region, most recent market data. If the most recent market
industry behaviour is different from the historical norms,
4. FX, interest rate and credit process parameters the newly calibrated parameters may be materially
5. Portfolio data: details of transactions different form those currently in use, especially if
the data history is relatively short. To get a preview
Capital structure data is not expected to change of the potential impact on capital adequacy, it would
frequently if at all during the life of a CDPC. How- be a good idea to shock the process parameters.
ever, leverageable capital could change due to, for
example, making default protection payments or To establish whether existing capital can support
default of eligible investments. planned business growth, the current portfolio with
various hypothetical portfolios can be run. For both
Reducing the leverageable capital in the model, the current and hypothetical portfolios, it is advis-
keeping all other parameters constant, gives an in- able to run the scenarios through time. Time affects
dication of the excess capital in the CDPC. This cor- the average life of the portfolio, hence the risk
responds to the unexpected cash outflows the CDPC measures and limits. Furthermore, maturing deals
can tolerate without breaching any of its limits. can affect the portfolio’s diversity and cashflows
creating capital bottlenecks which may not be ap-
Stress testing reference entity ratings is very useful parent in daily production runs.

capital models
ent model. The independent accountant’s Changes to the capital model

results are then compared with the results As the CDPC expands its business platform
calculated by the CDPC using the capital (for example, by adding additional types of
model and the same sample portfolio. Such permitted CDS or by changing its capital
agreed-upon procedures are done at the structure), the CPDC makes corresponding
initial rating of the CDPC, and thereafter any changes to the capital model. The operating
time substantial changes are proposed to the guidelines contain strict policies that require
capital model. For certain CDPCs, agreed- keeping the model in a secure environment,
upon procedures are repeated periodically and that all changes to the capital model and
regardless of changes. related technical document are documented,
approved and tested. This includes providing
Controls over the capital model after the rating agency with a marked-up version
launch of the capital model technical document
Capital model inputs showing proposed edits or additions to the
The CDPC also engages an independent methodology, and obtaining rating agency
accountant to conduct monthly agreed-upon consent prior to utilising the revised version
procedures to test the CDPC’s compliance of the capital model to perform the capital
with certain of its operating guidelines. Man- adequacy tests. Depending on the sig-
agement of the CDPC uses the results of the nificance of the modifications to the capital
agreed-upon procedures in the CDPC’s evalu- model, the CDPC may re-perform some, or
ation of the operational effectiveness of its all, of the above-mentioned tests (such as
controls over compliance with the operating tie-out to rating agency models, stress tests
guidelines. Included in such monthly agreed- and capital model agreed-upon procedures)
upon procedures are tests comparing certain prior to implementing such changes into the
inputs to the capital model with the respec- production version of the capital model.
tive sources as specified in the technical
document. Such procedures may include:
Conclusion
• Comparing the total value of eligible The capital model acts as one of several
investments, less haircuts per the “circuit breakers” in a CDPC to prevent it from
operating guidelines, from the custodian conducting additional business that could
statement with the capital model jeopardise its credit ratings.
• Comparing the operational risk capital
amount from the operating guidelines In this way, the capital model provides
with the capital model counterparties and other stakeholders with
• Comparing the total portfolio notional reassurance about the CDPC’s creditworthi-
from the capital model with the trade ness over the long term.
capture system
• Comparing a sample of key CDS terms
(such as reference entity, credit rating, Randy Gonseth (212-773-8162 / richard.
notional, maturity date) from the capital gonseth@ey.com) is a partner and Chris Wu
model with the trade capture system (212-773-1989 / chris.wu@ey.com) is a sen-
and the confirmation ior manager in Ernst & Young LLP’s Financial
Services Office in New York.

Chapter 5
Understanding the rating agency

viewpoint on CDPCs
by Lisa Cooper
For a credit derivative product company there than rules-based – they describe the issues
are few relationships as important as that we are trying to address,” says Khakee.
with the rating agencies that provide the
company’s crucial triple A ratings. A CDPC Once the capital model and operating guide-
must get the rating agencies on side from the lines are fleshed out, the rating agencies can
start, get them comfortable with the CDPC’s begin to review the quantitative and qualita-
business plan and set-up, and keep them on tive sides of the company’s operations. “We
board over time. This relationship is one of talk to the management frequently in the
the first a new CDPC thinks about. process of rating the company and conduct
at least one on-site review,” says Yvonne
“It all starts with a phone call,” says Nik Fu, New York-based managing director in
Khakee, a managing director in the struc- Moody’s structured finance group. “We look
tured finance group at Standard & Poor’s in at their systems and procedures so that we
New York, as the prospective company makes have a comfort level that they can perform
contact to find out more about the rating their day-to-day operations and that they have
agencies’ criteria. From the agency’s point of the necessary skills to run the company, in
view, the first issues it wants to ascertain are addition to the quantitative assessment.”.
the company’s business objectives; its five-
year plan; how it will be structured (parent “The quantitative and qualitative parts of
company, strategic partners, large majority our review are equally important,” says Alan
investors); the sectors it plans to target; and Dunetz, a managing director in the structured
the potential management team. credit group at Derivative Fitch in New York.
The quantitative review focuses on the capi-
For the company, a clear understanding of tal model, which is used to measure capital
the rating agency criteria enables it to de- adequacy, with particular emphasis on any
velop its capital model and operating guide- potential correlated portfolio losses, while the
lines – the two key points of focus for the documentary review revolves largely around
agencies. “Our criteria are more prescriptive the operating guidelines.

rating agency viewpoint
What is a CDPC “counterparty rating”?

Algis Remeza, senior credit officer, Moody’s
A Moody’s counterparty rating is an opinion of the

• There may be exceptions to the counterparty’s
financial capacity of a CDPC to honor its obliga-
priority of payment, such as when the counter-
tions under its financial contracts. The rating
party is the defaulting party.
addresses the risk to each counterparty individually
as well as in the aggregate. Risk is measured in
• Rated debt may mature or be redeemed before
terms of expected loss, based on the contractual
a CDPC’s obligations to its counterparties end,
promise. Expected loss is benchmarked against
resulting in increased credit risk to the counter-
Moody’s Global Scale for corporate ratings,
parties as capital flows out of the CDPC.
meaning that expected loss in the CDPC context is
consistent with the expected loss of a comparably
A counterparty rating addresses some such risks.
rated corporate entity.
However, as with all Moody’s ratings, a counter-
Because CDPCs do not necessarily issue rated
party rating does not explicitly indicate specific
debt, a counterparty rating may be the only publicly
levels of rating stability or recoveries upon a CDPC
available opinion of its credit quality. Even if a
default. Moody’s urges counterparties to review
CDPC has issued rated debt, the credit risk to a
the new issue and pre-sale reports, which address
counterparty may differ from the risk of the rated
these and other CDPC risk characteristics not
notes. For example, if a counterparty is senior in
reflected in the Moody’s rating. Similarly, ratings
payment priority to rated debt, it may be incorrect
of debt and obligations of CDPCs do not reflect
to conclude that the expected loss under trading
their market value or potential volatility. Also,
contracts is less than that of the rated debt. In
a counterparty rating does not imply a standard
fact, the expected loss to the counterparty under
CDPC structure or contract. Moody’s ratings are
trading contracts with a CDPC without a counter-
its opinion about credit risk, and are not meant to
party rating may be greater than that of the CDPC’s
substitute for a counterparty’s own due diligence.
debt for numerous reasons, including:
“The guidelines are like a credit and in- “We express our concerns about any aspect
vestment policy, linked in with a policy on that looks like it could create additional
liabilities,” says Khakee. They outline how the risk, whether it’s in the model, the operat-
company will use the proceeds of the capital ing guidelines or in other documents,” says
it raises, how it funds itself, and any contin- Dunetz.
gent obligations it will take on – how much
and what type of debt it will raise, for exam- Another vital issue outlined in the operating
ple. It also outlines the exposure the vehicle guidelines is what happens should the com-
will take to different sectors, rating levels and pany fail one or more of its tests.
the types of investment.

rating agency viewpoint
It is imperative, therefore, that the documen- significantly longer, as no two vehicles are
tation discusses the consequences of test or completely alike.
guidelines failure, including events that could
force the vehicle from normal operations into “They could be investing in a different asset
restricted or wind-down mode. “When the class or have a different mix of funding, and
company starts to see its financial position each difference flows through to the rest of
being eroded, we need to know what the the rating process, so even if two companies
remedies are that can cure it,” says Khakee. appear to do the same thing, it’s like a matrix
“And if those remedies are not effective, what – there are lots of different combinations,”
more stringent tactics will the company take says Khakee.
to shore up its finances? And what measures
will it take if ultimately that is unsuccessful.” Once the company is up and running, its
relationship with the rating agencies may be-
In addition to reviewing the capital model come less intense than in the start-up phase,
and operating guidelines, a third aspect of but it remains critical. An annual site visit is a
a rating agency’s assessment is a review of bare minimum, but the two parties remain in
the managers. “It’s very important
to have a good understanding of the
qualifications of the management
team,” says Dunetz. “We need to be “When the company starts to see its
sure that they are fully dedicated to
the operation of the vehicle and have financial position being eroded, we
a strong background in credit deriva- need to know what the remedies are
tives and structured credit.” that can cure it”
For the rating agencies, assessing a
CDPC is very different from rating a
fixed-life vehicle such as a CDO. “A
CDPC is a living, breathing company,
with lots of flexibility in terms of how it
might evolve down the road,” says Fu
at Moody’s. “So this makes the initial rating contact at least once or twice a month. “They
process much more elaborate than for rat- are perpetual vehicles and we monitor them
ing a synthetic CDO. With a CDO you have a actively,” says Dunetz at Fitch. “We receive
much simpler structure and one that is better weekly capital adequacy reports and have an
defined and has a finite life. Plus you’re rating ongoing dialogue. If they want to make any
debt which has a set maturity.” changes, they would normally discuss them
with us to see how they would impact our
It’s hardly surprisingly, then, that the initial analysis.”
rating process can be time-consuming.
According to Khakee, when the first CDPC Dunetz adds that Fitch has not rated any
– Primus – was established in 2002, it CDPCs since beginning its review of its CDO
took over two years to complete the rating criteria back in November, but has kept com-
process. Today the timeframe could be as panies informed of its review process and
short as three months, but it could still be continued to discuss it with them.

Chapter 6
Tackling the operational issues

by Lisa Cooper
For many companies, operations may be Managers of a CDPC that tries to generate
something of an after-thought. But for credit these reports manually are soon likely to be
derivative product companies, which need overwhelmed by the workload. “We as a com-
to win the confidence of a wide range of pany generate a large number of reports for
constituents and keep those parties informed multiple interested external parties such as
over time, operational issues are absolutely the rating agencies, counterparties and our
essential. investors,” says Allcock. “It is essential that
these reports are both timely and accurate.
According to David Allcock, head of systems Robust IT systems enable us to do this.”
at CDPC manager Channel Capital Advisors,
there are three factors that make operational A CDPC that puts on just a handful of trades
efficiency critical for CDPCs: risk manage- may be able to exist with a rudimentary tech-
ment, reporting and scalability. “IT systems nological infrastructure. But CDPC strategies
are an integral part of the CDPC,” he says. typically call for significant volumes, and this
Effective systems reduce the scope for hu- means that the company needs to be able to
man error. This is particularly important when expand without losing track of what it has on
there are many details in a transaction that its books.
need to be checked – each one of which
has the potential to cause problems for the “As more business is carried out by the CDPC
investor. For example, a CDPC that invests in it would become increasingly difficult, if not
synthetic portfolio tranches need to check impossible, to generate the required reports
that each of the names in each transaction is in any fashion other than through IT sys-
the one the firm thinks it has traded with the tems,” points out Allcock.
correct reference obligation.
Most companies meet their operational
“A human being may think they recognise needs through a mix of off-the-shelf and
each of the reference entities,” says Allcock. customised software. Commercially available
“But it is all too easy to make a mistake un- products may meet some of the needs of a
less you have a system cross-checking every CDPC.
detail.“
For example, Principia Partners’s SPF soft-
CDPCs have onerous reporting requirements. ware is used by many structured credit vehi-

operations
The role of the administrator
With small teams of highly specialised and administrator is then responsible for capturing
business-focused staff, running a full back-of- cashflows from settlement through to maturity,
fice function tends to be a step too far for most and for daily reconciliation of all current and
CDPCs. Therefore, most choose to outsource future cashflows. Any discrepancies between
their downstream operations. expected and actual received cashflows are
captured in the reconciliation process and the
Cash management and operational infrastruc- administrator takes responsibility if investiga-
ture are typically passed over either to the com- tion or resolution with counterparties needs to
pany’s bank sponsor or to a third party service. be undertaken.
“We’re the books and records for the struc-
ture,” says John Spedding, a managing director According to Spedding, the prime advantage of
at QSR Management, a subsidiary of Bank of using a third-party administrator is its transpar-
New York Mellon, which acts as administrator to ent, non-biased approach. “We have no eco-
CDPCs and other structured finance vehicles. nomic risk to the transaction as we receive fixed
QSR has developed its own software platform, fees to provide the service,” he says. For QSR,
EnSIS, for middle- and back-office functions. its relationship with a major financial institution
is essential. “Any administrator must have very
In QSR’s case, information on all trading activity good relations with the custodian, the paying
is fed into EnSIS from the client’s system. The agent and the security trustee,” says Spedding.
cles including CDPCs. The platform provides IT requirements by buying off the shelf. Typi-
functionality from front office right through cally, there is a long period of tailoring. Long
to accounting. “Clients use us for different at Principia says CDPC customers typically
pieces of that,” says Douglas Long, execu- require around six months to install and tailor
tive vice-president for business strategy at their software systems.
Principia Partners,.
“Our systems are heavily customised to
Effective capture and storage of data in reflect our operating guidelines and our
such a way that it can be used to ensure internal processes,” says Allcock at Chan-
compliance with trading limits and opera- nel. “Although many companies may use the
tional guidelines is at the heart of a CDPC’s same base system, a lot of work needs to be
operational requirements. Typically, compa- carried out to tailor that system to the specif-
nies would look to a software provider such ics of the company.
as Principia to build that function, although
some would be able to to piggyback on “We went through this process at Channel
systems used by sponsoring banks, such as and have customised the systems to provide
Calypso or Summit. us with the metrics and reports that we need,
and to ensure all trades are booked accord-
However, CDPCs cannot simply meet their ing to agreed procedures.”

Chapter 7
Hearing the Sponsors’ viewpoint

Thomas Keller, head of structured investments at LBBW, tells Michael
Peterson of Creditflux about LBBW’s reasons for investing in a CDPC
We are buying into the parties especially in the super senior area.
business case of an
In almost every case, the way each existing
operating company with CDPC is set up reflects the specific motivation
independent manage- of the sponsor or the group of sponsors. And
that motivation of the sponsor is essential in
ment and active corpo-
determining the way the CDPC is perceived by
rate governance – market participants, especially counterpar-
Thomas Keller ties.
MP: What was LBBW’s own motivation in

sponsoring a CDPC?
TK: Given the operating company nature of a

Michael Peterson: Why does an institution CDPC, our sponsorship of such a company is
choose to sponsor a credit derivative product not the classical sponsorship you see in the
company? structured credit world, where an institu-
tion sets up an arms-length special purpose
Thomas Keller: The CDPC industry is frag- entity.
mented with many different types of compa-
nies and that is why there is no single reason Our sponsorship of a CDPC is a real (seed)
for sponsoring a CDPC. Except that, clearly, a equity investment – economically and
sponsor’s motives are not altruistic: sponsor- legally – buying into the business case of
ship of a CDPC is an investment. an operating company with independent
management and active corporate govern-
The motivations for making such an invest- ance. That is why I think “investor” is more
ment are manifold, including: realising accurate than “sponsor” in describing our
book value multiples through a (fast) IPO, role. The business case we like to invest in
shareholding, generating a steady long-term is one promising us an attractive, long-term,
income stream, creating a prudent risk taker steady income stream with low probability of
for credit derivatives exposure, and achieving default. In addition, Channel provides us with
diversification of credit derivatives counter- experience of a technology that will definitely

About LBBW’s investment
LBBW is one of three European banks that of European banks. The company is rated Aaa
sponsored Channel Capital, a CDPC that went by Moody’s and AAA by Standard & Poor’s and
live in 2007. Keller serves as a board member focuses on super senior tranches of global cor-
of Channel Capital’s holding company. The oth- porate risk in static and managed, index and
er two members of the consortium are Calyon bespoke formats in multiple curencies. The
and KBC Financial Products, making Channel CDPC manager is Channel Capital Advisors, an
the only CDPC to be backed by a consortium FSA-regulated UK-based manager.
have wider applications in the near future.

Setting up a triple A company is completely TK: The super senior part of the capital struc-
different to purely structuring a triple A risk. A ture is very attractive because the spread
triple A company needs triple A operation and you earn is pure risk premium bearing no
management in addition to capital adequacy. expected loss. As those kind of risks are un-
attractive for many investors like hedge funds
MP: Attractive returns with low default risk or banks as an on balance sheet investment
sound like an impossible combination… and the fact that a major industry absorbing
those risks has been falling apart, this area
TK: A CDPC like ours is different from most of the capital structure offers good opportuni-
other credit vehicles or structures because of ties.
its continuation nature. When we designed
our CDPC beginning in mid-2005, we were MP: Could you not achieve all those objec-
clear that we wanted to avoid liquidity gaps, tives through direct investment in term-fund-
market value triggers and imminent default ed CSOs on super senior risk in bond format?
risk. As a result we seeded a CDPC not a
SIV because of its pure synthetic nature; we TK: A portfolio of CSOs does not give the
chose a continuation structure eliminating same efficiency of investment compared to
all market value triggers; and we focused an investment in a CDPC. It also requires
exclusively on selling protection on corporate a lot more funding, which is expensive in
super senior single tranches. distressed markets.
That business case gives us excellent MP: What kind of returns do you expect on
access to managed diversified corporate your investment?
risk protected against defaults via the high
subordination of the tranches. In addition, TK: We expect returns reflecting the financial
the structure of the vehicle protects us from and entrepreneurial risks we are taking plus
negative impact on our investment caused by the resources we are contributing into the
market disruption and liquidity problems or structure. As we have seeded the structure
huge market-to-market swings. we clearly expect reliable and steady returns
over time but not the quick returns seen in
MP: Why do you like super senior? areas like private equity. We expect steady and

Sponsors’ viewpoint
reliable dividends. However our return expec- team and board of directors. The operating
tations are not purely expressed in monetary professionals are all first-rate at running
terms as we clearly have already and will con- the day-to-day investment operations of the
tinue to exploit new structuring technologies, company from front-middle-back while the
knowledge transfer and relationships which board sessions provide an excellent opportu-
can be put to use in other applications. nity to set strategy along with credit market
aware colleagues. This setup gives Channel
MP: What were LBBW’s investment param- the ability to have aligned of interests with all
eters? And how did they shape the structure parties involved.
of the company?
MP: It sounds as if you have done much
TK: When designing the structure we were more than the minimum necessary to get the
aware that the success of a CDPC is mostly company up and running. Is that extra work
dependent on its credibility among a wide paying off?
range of market participants: other seed in-
vestors, debt investors, management, board TK: It is definitely paying off. As you remem-
members, rating agencies and counterpar- ber, Channel has been operative since June
ties. We saw the need for a well balanced, 2007 shortly after getting its triple A ratings
transparent and sound structure to make it and shortly before the crisis started. Chan-
successful. nel has issued term debt and has resisted
the temptation to launch auction rate notes
Achieving triple A counterparty ratings is a (which introduce liquidity risk). Channel has
necessary but not sufficient condition for grown to nearly $11 billion of super senior
the success of a CDPC. To attract demand risk and succeeded in continuously attracting
from various market participants we needed new counterparties in these difficult market
to add substantial features to the company: environments.
commitment to a sound, well designed and
focused investment strategy, robust corpo- MP: What does the future hold for CDPCs?
rate governance principles and processes,
independent, experienced management TK: The crisis has changed the credit market
professionals, strong infrastructure with dramatically. Especially in the super senior
backup facilities, global counterparty and area, a lot of very large market participants
debt investor relationships – we have added have fallen away. It is not attractive for
everything market participants can expect regulated financial institutions to keep this
from a professional managed, independent kind of risk on their books, so a new industry
triple A company. is needed to absorb the supply. The CDPC
industry is dedicated to taking that role.
That is why a main focus of the structuring
work has been set on corporate govern- The main concern here is setting proper
ance, alignment of interests and quality of industry standards for CDPCs. As I have just
the management. We have put much effort described, there are huge differences in the
in creating a triple A or first class company way that different companies that share the
regarding operational setup. Channel has name CDPC are set up. That is why we are
outstanding operating professionals and an working on setting proper standards beyond
experienced non-executive management the triple A rating criteria.

Chapter 8
CDPCs: looking to the future

by Michael Peterson
The concept of a CDPC, if not its exact work-

ings, has become widely known in the credit
“CDPCs have demon-
market in recent years. So much so that it
is easy to forget just how recent a creation strated their operating
these companies are. resiliency and ratings
stability when compared
Until around 2006, the term itself was
rarely used. (The first use of credit derivative to collateral-posting vehi-
product company to describe these vehicles cles” – Walter Gontarek,
in Creditflux was in December 2005.) Before
Channel Capital
then, these companies were termed loosely
as credit derivative operating companies or
dedicated credit protection sellers.
In the period following Primus’s launch in vehicles. “In the challenging credit markets
2002 and before the appearance of Athilon we have seen since last year, CDPCs have
in 2005, this was a club with only one mem- clearly demonstrated their operating resil-
ber. Indeed, it was only in 2007 with the ap- iency and ratings stability when compared
pearance of a flurry of new entrants – mostly with collateral posting vehicles or operating
targeting tranched risk – that CDPCs began companies with market value triggers,” says
to take shape as a coherent sector, with a Walter Gontarek, chief executive of Channel
growing (but far from complete) standardisa- Capital. “They are facilitating the restructur-
tion of terminology and concepts. ing of credit portfolios and the execution
of new transactions in this risk adverse
That burst of new business formation coin- environment where arrangers have little ap-
cided with a seismic shock in the financial petite for retaining correlation or super senior
market which has, paradoxically, helped to corporate credit risk on their books. Increas-
create a much clearer sense of CDPCs as a ingly, the industry is now aware of the subtle
distinct class of entities. but critical differences between CDPCs and
monoline insurers,” he added.
As discussed earlier in this guide, CDPCs
have been able to demonstrate the funda- The central premise of a CDPC is that it is a
mental difference between their business better constructed holder of many types of
model and those of other structured credit credit risk than other institutions. In particu-

Looking to the future
lar, CDPCs claim to be more efficient holders ing up by taking on unfunded credit can also
of very high quality corporate risk (either in be problematic. It is not yet clear that the
portfolios of single names or tranches) than monoline model will survive the reputational
banks, whose regulators force them to set damage stemming from the downgrade of
aside higher levels of capital against these firms such as FGIC, XLCA and CIFG and the
assets. continued uncertainty over the ratings of
Ambac and MBIA.
That impetus by banks to offload certain
types of credit risk is only likely to intensify CDPCs claim to have certain advantages over
as banks learn how to operate within a new monolines. These include the presence of
global capital framework, Basel II. “As an operating modes to serve as “circuit break-
active credit portfolio management desk, we ers” to stop new business if the rating is in
are always interested in new vehicles and jeopardy, the lack of market value triggers
counterparties that are well rated entities to leading to early termination, predominately
buy and hold term credit risk,” Says Allan Yar- corporate asset classes, lower leverage than
ish, head of credit portfolio management at monolines and more transparent capital and
Société Générale in Paris “Critical for us is a risk reporting.
real capacity to absorb risk. Basel II requires
us to achieve ‘significant risk transfer’ and The big challenge for CDPCs is to win the
therefore we need counterparties that can trust and understanding of their various
actively participate in the risk of our portfolio stakeholders – notably counterparties, debt
in exchange for a true market-based yield.” investors and equity investors.
But the emergence of CDPCs begs two For existing CDPCs, getting counterparties
fundamental questions. First, are CDPCs truly comfortable to trade with them is the most
an appropriate vehicle for holding credit risk? immediate challenge. And, after a period
Second, how will they evolve in future? when new business for CDPCs slowed, there
are signs that a growing number of banks are
CDPCs have clearly answered part of the first interested in putting on trades with CDPCs
question. The use of market value triggers or in the second quarter of 2008. For example,
rolling funding to provide high degrees of lev- as reported in Creditflux, at least one CDPC
erage has been discredited since the demise - Channel Capital - has added new transac-
of SIVs and highly leveraged funds such as tions in the second quarter of 2008.
those managed by Bear Stearns.
Typically, banks need to perform a large
If investors cannot get the leverage to invest degree of due dilligence on each individual
in high grade credit through market value CDPC counterparty. “We welcome the addi-
mechanisms or playing the curve, then an tion to the credit markets of well rated and
obvious alternative is to use credit deriva- performing counterparties including operat-
tives to provide leverage. That is exactly what ing companies and CDPCs which promotes
CDPCs do. trading liquidity,” says Robert Shi, head of
structured credit trading at Commerzbank.
But the problem is that this looks very similar “When evaluating counterparty opportunities
what monolines do. And the problems facing we are pretty clear that sponsorship, a clear
monolines show that a strategy of leverag- risk strategy, transparency and high under-

looking to the future
writing standards go a long way in the front

office.” “The key to the account-
Those sentiments are echoed by officials at
ing issue for us was to
other banks. “We also support the develop- establish a non-Gaap
ment of a roster of well rated and high quality measure. We did that
CDPCs as commercial banks are simply not
the best holder of super senior corporate risk
long before we were a
for example in any meaningful size today,” public company.”
says Richard Jacquet, head of alternative – Thomas Jasper, Primus
credit and structured assets at Natixis. “We
are cautious with those entities we transact
with. Good sponsors, quality managers,
transparency and stable ratings are critical
features for us.” While the most immediate challenge facing
the CDPC industry may be to regain the con-
One important motivation for banks to buy fidence of counterparties, a longer term chal-
protection on super senior risk with CDPCs lenge is to explain their business model to eq-
is the growing nervousness of many banks uity investors. A big concern for many is that
about holding onto this part of the capital their earnings can be highly volatile when
structure. Many banks that arranged syn- measured on a mark-to-market basis, as they
thetic CDOs in the past would routinely retain must be if they become publicly listed.
this exposure to help get the deal done. The
large losses sustained by banks recently on For a CDPC that is sponsored by a bank or
the super senior tranches of ABS CDOs has group of banks and has no intention of tap-
served as a reminder of the value of hedg- ping the public equity market, this may not be
ing risk that is theoretically remote in the a concern. But most new companies would
extreme. like at least the possibility of being able to
raise capital from a public listing.
KBC Financial Products is one bank that has
long steered clear of launching synthetic The one CDPC that is public, Primus, has
CDOs if it is unable to hedge the senior addressed this issue by consistently giving its
risk. “KBC Financial Products has issued investors a buy-and-hold view of its accounts
a number of synthetic CDOs since 2002,” as well as a mark-to-market one. “The key
explains Noah Millman managing director at to the accounting issue for Primus was to
KBC Financial Products. “Our primary busi- establish a non-Gaap measure, which we
ness and risk focus is to risk-manage obligor did long before we were a public company,”
credit risk at the portfolio level. We decided says chief executive Thomas Jasper. “It was
a long time ago that taking views on the cor- absolutely essential to convince the invest-
relation pricing and trading dynamics was not ment community that Gaap was not going to
our priority in the transactions. This realisa- be helpful – especially in a short timeframe
tion underscored the need to be prepared to like a quarter.”
place the full capital structure at transaction
inception.” The migration of CDPCs to the public equity
market is one possible future for an enlarged

Looking to the future
and thriving CDPC industry. Another fre- better understood there will less focus on the
quently made prediction is that there will be accounting and reporting structure of CDPCs
consolidation within the industry. On the one and more on their core business.
hand, greater size might give CDPCs more
credibility as counterparties. On the other The CDPC industry has grown up in response
hand, consolidation would make it harder for to a need created by the needs of banks
banks to spread their counterparty risk. to shed risk and their capital and reporting
requirements. So it is not surprising that so
Another long awaited development is the much of the industry’s intellectual efforts
broadening of the CDPC asset class. There have been centred on issues of accounting,
has been something of a false start in this reporting, ratings and structure.
direction, given the rather painful experience
of the two CDPCs (Primus and Athilon) that But as the industry matures, expect the role
have experimented with diversifying into ABS of the accountants, legal structurers and
as an alternative to investment grade corpo- modellers to take second place to that of the
rate credit. credit analysts that are already employed by
CDPCs in large numbers.
However, there are already early signs of
diversification in other directions. Many in CDPCs are a new type of credit risk-bearing
the industry see high yield loans as a natural entity. But once their structure is known,
add-on to CDPCs’ existing corporate risk tested and understood, the world will inevita-
management expertise – especially given the bly start to focus more on the load they bear
emergence of synthetic loan tranches. than the structure supporting that load.
Says Walter Gontarek, chief executive of

Channel Capital, “We have excluded single-
name risk from our existing super senior ve-
hicle as we believe
that investors and Existing CDPCs
counterparties
no longer tolerate CDPC founded
co-mingled risk Primus Financial Products LLC April 2002
profiles. However Athilon Asset Acceptance Corp January 2005
we might consider NewLands Financial Limited March 2007
that asset class in Cournot Financial Products LLC March 2007
a separate operat- Invicta Credit LLC May 2007
ing company in the Koch Financial Products LLC July 2007
future”. Channel Capital July 2007
Quadrant Structured Credit Products October 2007
A longer term Aladdin Financial Products November 2007
prediction is that
as the CDPC model Source: CBM Group
becomes more
established and

Glossary
Auditor loss of the normal operating mode status,
The nationally recognised auditing firm and a reduction of risk taking activities by the
appointed by the CDPC for the purpose of CDPC.
auditing financial statements and corporate
accounts. As CDPCs are operating compa- Continuation vehicles
nies, they typically prepare accounts under Entities that become static, closed-end
IFRS or FASB standards. vehicles upon the occurrence of a wind-down
event. Each claim is satisfied over time in
Agreed-upon procedures (AUP) order of their priority in the waterfall with
The review completed by a nationally recog- counterparty claims satisfied first and equity
nised accounting or audit firm with respect capital repayment/any profits paid at the end
to a particular aspect of the CDPC and its of the vehicle’s life. Continuation vehicles
operations including the monthly operations, may retain their triple-A ratings in suspen-
documentation, compliance to the operating sion or wind-down but their activities will be
guidelines, cash accounts and also the capi- significantly restricted as described in the
tal model validation (capital model AUP). operating guidelines. Continuation vehicles
therefore do not post collateral under a col-
Capital model lateral support annex. All CDPCs rated to date
The model used by the manager which as- are continuation vehicles.
sesses CDPC capital adequacy and size, the
appropriateness of the capital resources to CDPC
meet its longest liability obligation in a man- Credit derivative product company - a type of
ner consistent with its counterparty rating. financial operating company which trans-
The results of the capital model are reviewed acts in the CDS markets, has no market
by the rating agencies before the they issue a value triggers that can lead to an unwind of
counterparty rating and are further validated the CDS book and exists as a continuation
by the capital model AUP validation exercise. vehicle.
CDPC capital models typically take into ac- CDPC board of directors
count the quality and composition of the CDS The board of directors of the CDPC which
portfolio, eligible investments, and counter- must approve any CDPC dividends and any
parties. Key parts of the capital model typi- changes to the operating guidelines or core
cally include the default engine, CDS termina- documents.
tion risks, and cashflows of the company.
CDS (credit default swap)
Capital tests (or capital adequacy An over-the-counter derivative contract to
tests) transfer the credit risk of a reference entity or
The capital related tests as defined in the group of reference entities. A protection buyer
capital model technical document and oper- transfers the credit risk to a protection seller.
ating guidelines. Failure of the capital tests The protection buyer pays a premium to the
will result in the change of operating states, protection seller and the protection seller

glossary
makes a payment in the event of a default by described in the operating guidelines which
the reference entity. are permitted to be executed by the CDPC
including long, short and hedging CDS trans-
Collateral posting actions. Transactions outside this scope are
A common method of dealing with coun- not permitted and would be identified by the
terparty risk in a derivative transaction, in periodic agreed-upon procedures process.
which one counterparty deposits collateral
in the form of cash or securities in a margin Form approved documentation
account. The collateral can be seized if the Those template transaction confirmations
counterparty is unable to fulfil its obligations as approved by the rating agencies intended
under the transaction. CDPCs do not post for use on every transaction. By limiting
collateral. transactions to form approved documenta-
tion, CDPCs reduce their operational risk
Counterparty ratings considerably. As such, form approved Isdas
The issuer credit rating which speaks to the preserve CDPC strategy and ensure expected
capacity of the company to honour its con- losses will only occur from obligor or counter-
tractual obligations to all counterparties. CD- party defaults and not from early termination
PCs have counterparty ratings and thus treat events. Form approved documentation also
all counterparties equally. Issuers without provides equal treatment of counterparty
counterparty ratings (such as CDOs, hedge claims.
funds and monolines) carry a different set of
counterparty risks. These risks may include Global custody agreement
subordination upon default and declining See custodian
subordination as debt matures over time.
Isda master agreement
Custodian A standardised contract created by the In-
The party that provides collateral services ternational Swaps & Derivatives Association
to the CDPC and maintains the eligible (Isda) which describes the general terms of
investments as documented under a global over-the-counter derivative transactions that
custody agreement. may take place between two counterparties.
Eligible investments (or authorised Leverageable capital

capital investments) The capital base of the CDPC which is avail-
The cash investments made by CDPCs with able for leverage and is reduced by opera-
the proceeds of their equity and capital issu- tional capital requirements and the approval
ance. Most CDPCs do not seek to maximise of any dividends.
the investment return with these funds and
invest in shorter dated cash and cash equiva- Management agreement (or invest-
lent instruments such as time deposits, com- ment management agreement)
mercial paper and bank debt of the highest An agreement entered into between the
short term ratings. CDPC and the manager which lays out the
terms, conditions and constraints under
Eligible CDS (or authorised CDS trans- which the manager manages the CDPC’s
actions) portfolio.
Those credit derivative transactions as

glossary
Mark to market of leverageable capital.

An accounting convention in which a value is
assigned to an asset or liability based on its Operations review
market price. The upfront and periodic review conducted
by the ratings agencies (unlike the monthly
Mark-to-market triggers agreed-upon proceedures conducted by
Provisions which can force an investment the AUP provider) to confirm that policies, pro-
vehicle to be partially or fully unwound if the cedures, systems/IT, corporate governance
value of its portfolio declines below a certain structures, and other practices are adequate
point. CDPCs do not face mark-to-market to ensure compliance to the operating
triggers. guidelines, portfolio limits and capital model
requirements.
Monoline (or financial guaranty) insurer
An insurance company that invests in Permitted activities
credit risk by writing guarantees and, in some Those activities permitted by the CDPC
cases, credit default swaps. Monolines have operating guidelines, including the execution
a similar business model to CDPCs but are or liquidation of eligible CDS transactions,
significantly different in many respects, most the issuance of debt or equity capital, the
notably their broader scope of business, the redemption or retirement of securities and
different nature of their capital models and the making of eligible investments.
reporting rules, and the absence of pre-
scribed operating modes. Security trust deed
A document which lays out the security ar-
Normal operating mode rangement in respect of secured creditors.
The standard operating mode of a CDPC Certain CDPCs use the security trust deed
which has not been subject to any suspen- to enhance the claim of their respective
sion events. Only in normal operating mode counterparties.
may a CDPC undertake all permitted activi-
ties that would not cause a suspension or Single tranche CDO (or synthetic CDO
wind-down event. or CSO)
A CDS referencing a portfolio of underly-
Operating guidelines ing obligors which has an attachment point
The document agreed with the rating agen- (where losses up to that point do not require
cies which describes the limited operations a payment to or from the counterparty) and a
and activities of the CDPC, and conse- detachment point (where losses above that
quences of not following these limitations. point cease to require a payment to or from
The operating guidelines are typically legally the counterparty). Many CDPCs are permitted
enforced procedures and the failure to follow to execute single tranche CDO confirmations
them has significant consequences for the based on Isda standards.
CDPC and its manager.
Suspension event
Operational risk capital An event described in the operating guide-
The notional amount of capital in dollars lines which results in the CDPC entering
determined by the rating agency allocated suspension operating mode.
risks which is excluded from the calculation

glossary
Suspension operating mode ties and terminate all derivatives exposures.

The operating mode of a CDPC which has Such early termination may lead to large
experienced a suspension event but which claims being immediately due by the entity
has not experienced a wind-down event. associated with mark-to-market exposures of
In suspension operating mode a CDPC’s the derivatives contracts which may or may
trading activities are limited to only those not exceed the capital of the vehicle.
which maintain or improve the CDPC’s capital
adequacy. In this mode, CPDCs are not per- Wind-down agent
mitted to declare or issue dividends on equity A party that may be designated by the trustee
and have restricted ability to call CDPC debt. within 45 business days following a wind-
down event to serve as a replacement for the
Suspension event CDPC manager.
An event which results in a restriction of the
CDPC trading activities. These events typically Wind-down event
include a capital shortfall for counterparty An event described in the operating guide-
or debt ratings, the execution of transac- lines which results in the CDPC entering
tions which are not permitted transactions, a wind-down mode and freezes all trading by
violation of a portfolio limit as defined in the the CDPC. Wind-down events typically include
operating guidelines, a default of debt, invol- a major counterparty rating downgrade of the
untary insolvency, or other violation of the CDPC, an event of default with counterpar-
capital model operation agreement. Suspen- ties, bankruptcy, completion of an ineligible
sion events, like wind-down events, are auto- transaction while in suspension, and a failure
matic and do not require any management or to report agreed-upon procedures or portfolio
board ratification or process for implementa- results in a timely fashion for an extended
tion. The occurrence of a suspension event period of time.
suggests a counterparty or debt rating is
imperilled or at risk of downgrade. Wind-down mode
The operating mode of a CDPC which has
Termination vehicles experienced a wind-down event. A CDPC in
Entities that are obligated to liquidate assets wind-down mode is not permitted to carry
and portfolio exposures upon wind-down out any trading activities and its manager is
within a short time period, pay off all liabili- replaced.
Creditflux is the leading information service worldwide for the

fast-growing credit derivatives and structured credit markets,
publishing a monthly newsletter, online daily news and a
is published by
Creditflux Ltd comprehensive database of CDOs.
2 - 6 Northburgh Street, London EC1V 0AY, UK
www.creditflux.com With exclusive news and analysis for investors, dealers and
admin@creditflux.com service providers Creditflux provides subscribers with the
© Creditflux Ltd 2008 All rights reserved 
Available by subscription only. information needed to succeed in a fast-paced market.
Creditflux is for information purposes only and does not constitute investment advice. This publication is available exclusively to financial market
professionals and should not be circulated to the general public. All content is the copyright of Creditflux Ltd and unauthorised copying is strictly
prohibited.

Creditflux CDPC Booklet May 08

Uploaded by

Document Information

Original Description:

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Creditflux CDPC Booklet May 08

Uploaded by

Copyright:

Available Formats

Creditflux inside guide

Designs for a new type of credit investor

Published by Creditflux Limited, London, June 2008

Ernst & Young LLP is the leading assurance, tax,

International law firm Clifford Chance combines the

The CBM Group Inc is a New York-based management

CBM is active in credit risk management and works ex-

2 guide to credit derivative product companies

Chapter 1 Assessing the value of CDPCs page 5

Chapter 2 CDPCs: understanding the role of operating guidelines page 11

Chapter 3 CDPCs: handling the legal issues page 17

Chapter 4 CDPCs: running the capital models page 25

Chapter 5 Understanding the rating agency viewpoint on CDPCs page 33

Chapter 6 CDPCs: tackling the operational issues page 36

Chapter 7 CDPCs: hearing the sponsors’ viewpoint page 38

Chapter 8 CDPCs: looking to the future page 41

guide to credit derivative product companies 3

Credit derivative product companies (CDPCs)

• They support real risk transfer for banks

guide to credit derivative product companies 5

independent accounting firms

portfolio (protection seller)

6 guide to credit derivative product companies

guide to credit derivative product companies 7

8 guide to credit derivative product companies

guide to credit derivative product companies 9

10 guide to credit derivative product companies

CDPCS: Understanding the role of

CDPC notifying the rating agencies and the

Suspension events Eligible CDS

12 guide to credit derivative product companies

CDPC must obtain prior rating agency consent Eligible investments

Permitted counterparties years. See above for an example of a list of

guide to credit derivative product companies 13

what is a material breach?

Limits Notional limits are imposed so that a single

14 guide to credit derivative product companies

guide to credit derivative product companies 15

agency consent. Management must prove to

16 guide to credit derivative product companies

CDPCs: handling the legal issues

A number of legal issues may arise in various

guide to credit derivative product companies 17

18 guide to credit derivative product companies

Where the CDPC funds itself through Investment management agreement

guide to credit derivative product companies 19

20 guide to credit derivative product companies

Are operating guidelines enforceable?

guide to credit derivative product companies 21

Following the deterioration of the credit mar- eral accounting records;

Administration agreement The administration agreement should ex-

22 guide to credit derivative product companies

This will be necessary to ensure that the Credit derivative

guide to credit derivative product companies 23

month 1 Month 2 month 3 month 4 month 5

engagement of rating agencies

Neil Hamilton is a partner in capital markets

24 guide to credit derivative product companies

CDPCs: running the capital models

Each triple A credit derivative product

guide to credit derivative product companies 25

what is the purpose of the capital model?