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ISDA PRESS REPORT - NOVEMBER 7, 2001 CREDIT DERIVATIVES * Credit Derivatives - FOW DOCUMENTATION * ISDA publishes amendments to master agreements - IFR EMERGING MARKETS * Emerging market issuers press ahead - Financial Times RISK MANAGEMENT * Dumping "W" - FOW * Basel Committee, IOSCO, IAIS Publish Cross-Sector Reports - Dow Jones Credit Derivatives FOW - November 7, 2001 By Jane Douglas-Jones In the weeks following the terrorist attacks in the US, credit derivative traders reported record levels of activity. "In the immediate aftermath of the events of 11 September trade ticket size went down," says one broker. "A lot of people were prepared to make markets in $5m or euros where previously the average ticket size was $10-15m. The nominal size of the trade went down as a result of the level of uncertainty and volatility in the markets." Traders report that credit default swap trade volume soared to three times the normal level. "If nominal ticket value went down by half and trade volume went up three-fold, overall volumes were up by 5 00/0 in terms of the actual business being written," explains the broker. After the initial shock of the devastating attacks, the market recovered its poise and analysts and traders soon realised the credits that would be most affected. "Clearly, airline stocks took a pummelling," says one trader. "Prior to the event, British Airways was trading around 100 basis points for five year default swaps. After the attacks, BA widened dramatically to 350/SOObp. Spreads on this credit did come in from this level, but they have since gone back out again and are currently trading around 380/450bp. Meanwhile, we saw a credit event on Swiss Air, and German airline Lufthansa also went out, with all the European airlines following suit." Insurance sector As was expected, the credit derivatives market also saw heightened activity in the insurance and reinsurance sector. "There has been a lot of activity around companies such as Zurich Re," says the trader. "Zurich spreads moved out from around 20/40bp to 50/100bp. The credit did trade towards the offered side once or twice. Zurich spreads have stayed in this range despite the fact that the company has downsized its profits and upsized its predicted loss (effectively doubling the amount of provision) as a result of the terrorist attacks." Similarly, names such as AXA, Agon, and Aliance have all been actively quoted in the aftermath of 11 September and spreads have widened considerably on these names. For example, as FOW went to press Aliance spreads went out to 7Obp before tracking back in to 35/55bp. In addition, sectors that have not been considered directly affected by the attacks, such as the auto sector, also moved out as a result of the potential slowdown in the US. "We have seen principle investors in the credit derivatives market trading either with a view or going by what the spot markets are doing," says one dealer. "We have also seen quite a few investors gaining synthetic exposure to bonds by selling default swaps. Recent weeks have proved a significant test of the liquidity in the default swaps market. In some areas, the bond market was extremely thin and it was difficult to trade. However, with default swaps there was always a price in no more than five minutes. The market was both traded and tradable." Europe The European credit derivatives market has also had to contend with the demise of the UK's train operator, Railtrack. "Railtrack is going to be a credit event on bankruptcy rather than restructuring," says one structurer. "There was a thought initially that it would go via restructuring and that would have been an interesting test of the modified ISDA restructuring supplement. This is still very much an issue in the market. While the US has adopted the new version, by far the majority of business being done in Europe and Asia uses the original ISDA 1999 definition of restructuring. The new restructuring Z supplement has simply not been accepted and I do not think it ever will be accepted. I expect that we will soon move back along the lines of the original ISDA wording with perhaps one or two tweaks. Overall, traders say that the market has survived the seismic shock of the events of 11 September extremely well. "There was no mad panic," says one broker. "The credit derivatives market made a fair and measured response in the face of tragedy." ISDA publishes amendments to master agreements IFR - November 3, 2001 As part of its effort to improve counter-party risk management practices, the International Swaps and Derivatives Association last week released nine amendments that can be added as attachments to ISDA master agreements. Many of the changes included in the document were inspired by the market turbulence in 1998, ISDA said. Ultimately, the amendments will form the basis of an initial draft of a new master agreement. Using one amendment, a failure to pay becomes a default one local delivery day after notice of such failure is given to the relevant party. "Many market participants found three local business days after notice to be too long a period during times of market stress in 1998" ISDA noted in a commentary on the amendments. A local delivery day is a day on which settlement systems are generally open for business. Under a second amendment, market participants can use a replacement value method of valuing transactions after early termination of a master agreement. The replacement method combines elements of the market quotation and loss methods into one valuation provision, 1SDA said, noting that the quotation or loss methods are still valid. Because the inability to communicate notices via email or fax proved unduly restrictive in 1998, an amendment was added allowing market participants to use these channels to give notices. An amendment stating that the occurrence of termination events should be treated in a manner similar to an event of default also featured on ISDA's new list of amendments that may be tacked on to master agreements. According to ISDA, this option was added because a number of members hold the view that most termination events are credit-related. ISDA initiated a review of its master agreements' provisions in 1999. The process took into account recommendations by the counter-party risk management policy group's 1999 report "Improving Counter-Party Risk Management". Emerging market issuers press ahead Financial Times - November 7, 2001 By Arkady Ostrovsky Emerging market borrowers are pressing ahead with planned international bond issues, despite a deepening debt crisis in Argentina. Fitch, the credit rating agency, yesterday said Argentina's planned debt swap would amount to a default. Fitch cut Argentina's credit rating from CC to C, indicating an imminent default, and left it on rating watch negative. "Although the proposed debt exchange has been described as voluntary, public statements by Argentine officials imply that in the absence of such an exchange, public debt held by domestic investors is unlikely to be serviced," Fitch said. Fitch also said the terms of the new instruments would be inferior to those of existing debt, including lower coupons and longer maturities. However, despite all this, emerging markets remained surprisingly calm with no visible signs of contagion developing. Emerging markets bond spreads had hardly moved since last Friday's announcement and the yield spread of some countries, including Brazil, had even tightened. This is because there is little leverage in the system, compared with the 1998 Russian crisis, and because most market participants were prepared for an Argentine default. Several emerging market issuers said they were pressing ahead with bonds despite Argentina's troubles. Bulgaria is likely to launch its debut euro-denominated international bond next week. Its finance minister said yesterday the country would not launch the bond if it had to pay a coupon above 8.5 per cent. But bankers close to the deal were confident Bulgaria could borrow at between 7 and 8 per cent, or between 380 and 420 basis points over the eurozone benchmark, depending on the maturity. Bulgaria is considering a three-year or five-year issue of up to Euros 255m. Emerging market analysts said Bulgaria's economy was in good shape, despite eurozone economic slowdown and falling export revenues. The country, rated B2 by Moody's and B+ by Standard & Poor's, has attracted healthy levels of foreign direct investment by selling its banks to foreign banks, has pegged its currency to the euro and has met several Maastricht criteria. "Bulgaria is the final country to offer extra value as an EU convergence play. It is unrecognisable as the state engulfed by crisis five years ago," said Charles Robertson, emerging markets analyst at ING Barings. Latvia, which is on a roadshow in London today, is also pushing ahead with a bond issue. Sibneft, Russia's oil company, said it would also go ahead with a three-year Dollars 250m bond issue this month, although other oil companies have chosen to postpone their issues until next year. If successful, Sibneft could become the first Russian corporate to issue international bonds since the 1998 crisis. Moody's yesterday assigned Sibneft a rating of B1, a notch above Russia's sovereign credit rating. Dumping "W" FOW - November 2001 By Jane Douglas-Jones Basel Committee for Banking Supervision has been busy in recent weeks. The Committee has issued guidance to banks on customer due diligence processes, reviewed its Internal Ratings Based Approach (EBB) to specialised lending exposures, and published crucial papers on operational risk and market discipline. In addition, the credit derivatives market breathed a sign of relief at the Committee's decision to dump 'w'. In the first of a series of updates on the proposed new Basel Capital Accord, the Basel Committee's Capital Group has decided to incorporate the 'w' factor (a residual risk charge for credit derivatives) into pillar two of the Accord's framework, which deals with the supervisory review process. This move was welcomed by the banking industry and the International Swaps & Derivatives Association (ISDA), neither of which has been backward in expressing disapproval of 'w'. The news that the charge is to be assimilated elsewhere in the Accord came as no surprise given the uproar since w's birth in the January 2001 Basel consultative paper. As FOW reported (see May issue, It's the end of as we know it, page 21), the charge was derided, at ISDA's AGM, by the very regulators one would expect to defend it and the future of the 'w' factor has looked bleak since then. However, some market participants were worried that the Committee would stand by the charge both because of the immaturity of the credit derivatives market and also because of the worry that credit risk management instruments could be used for regulatory arbitrage. "Any sign of traders using a derivative to 'get around' a capital charge or regulation has been, in the past, punished by conservative and complex rules," says one source. "Recent evidence of this can be found in the securitisation market." The demise of 'w' has not meant the end of regulator concern about credit derivatives. The Capital Group states: "One of the Basel Committee's objectives in considering the treatment of credit derivatives in the trading book is to minimise the possibility of regulatory arbitrage... the Capital Group is planning to specify a rule that is already implemented by many supervisors. This rule provides that when a bank conducts an internal hedge of a banking book exposure using a credit derivative in its own trading book, in order to receive any regulatory capital benefit it must transfer the credit risk to an outside third party (ie an eligible credit protection provider)." Meanwhile, the Accord's add-on matrix for potential future exposure calculations does not explicitly cover credit derivatives and rules differ across countries. 'The Capital Group is working ~to provide proposals that will harmonise this treatment. Op risk The Risk Management Group (RMG) of the Basel Committee has also been hard at work. The Group has made a number of significant changes to the January proposals including: * Refinement of the definition of operational risk * Proposed reduction in the overall level of the operational risk capital charge from 200/0 to 120/0 * Introduction of a new regulatory capital approach that is based on banks' internal risk estimates (the "Advanced Measurement Approaches" [AMA]) * Consideration of the role of insurance as a risk mitigant in the regulatory capital calculations. The Group now defines op risk as "the risk of loss resulting from inadequate or failed internal processes, people and systems or from external events". Due diligence In the aftermath of the terrorist attacks on the US in September, the Basel Committee has issued guidance and minimum standards to banks on customer due diligence processes. "Systemic customer due diligence is an essential element of banks' risk management,' says William McDonough, chairman of the Basel Committee. "It is critical 'to safeguarding confidence and the integrity of the banking system. The importance of a rigorous approach has been underscored by the recent terrorist attacks in the US." Basel Committee, IOSCO, IAIS Publish Cross-Sector Reports Dow Jones Newswires - November 7, 2001 LONDON -- Two cross-sector reports aimed at supervisors in the banking,

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ISDA PRESS REPORT - NOVEMBER 7, 2001