Limited call aims to reduce optionality

A group of 15 dealers in New York has launched new documentation for loan-only credit default swaps. Both Isda and the Loan Syndications and Trading Association have been involved in drawing up the documents.

Traders say the new confirms are substantially the same as the ones dealers have been using in North America for some time. (The European market has yet to reach agreement on market standards for loan-referenced credit derivatives.) "This is pretty much the doc that everyone has been trading with some of the glitches ironed out," says Jeremy Vogelmann, a loan credit default swaps trader at Lehman Brothers in New York.

A loan-only credit default swap allows only loans and not bonds to be delivered following a credit event. This means that the seller of protection should benefit from the usually higher recovery rates seen for loans compared to bonds. It should also mean that the pricing of the derivative mimics the loan rather than behaving like unsecured debt.

The key issue for traders trying to devise a loan-like credit default swap contract has been figuring out what happens when the reference entity repays its loans. This has been less of a problem for bond-referenced credit default swaps, since bond issuers do not have the same early payment options that loan borrowers enjoy, and because bonds are usually longer dated than loans.

North American protection sellers have resisted the idea of callable loan-only credit default swap contracts - which are generally used in Europe - since this makes it difficult to price the credit derivative. Instead, the new standard confirm allows the contract to be called only in the event that there is no longer any debt of the designated seniority trading in the market.

The dealers that have signed up to the North American loan-only confirm are Bank of America, Barclays Capital, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, JP Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley, RBS Greenwich Capital, TD Securities, UBS and Wachovia.

Michael Peterson