Credit Linked Notes

i. The risk and cash flow attached to a Tranche is represented by the value of a credit linked note. Credit linked notes (CLNs) are an instrument for fusing multi-named credit derivatives with structured finance. They are therefore a means for redistributing risk and cash flow throughout capital markets by process of structured synthetic finance.

A CLN is a debt note, or obligation, sold for a sum to an investor by an issuer, wherein that note represents a commitment by the issuer to make a principal payment due at maturity, or a coupon payment periodically, and whose value and yield is agreed to ahead of time –but whose value and yield is written down contingent to occurrence of a credit event [figure 2.3]. For this reason, the simplest way to begin to understand a CLN is to think of a fully funded credit derivative in which the protection seller prepays to the issuer the notional value of the swap ahead of time, and in return receives periodic (re)payments over the tenure of the swap; but if a credit event occurs, the principal owed to the protection seller by the protection buyer for providing event protection is written down.

In other words, when a synthetic financial exchange makes use of CLNs, the payment for an event which has not yet happened is paid in full at the commencement of the transaction by the CLN investor, who is the protection seller. And then a payment for that nonevent is periodically made, or rather returned to the protection seller over the tenure of the transaction by the issuer, who is the protection buyer –unless of course this nonevent eventually occurs. The terms of the exchange are backed by the issuance of a note, with a corresponding notional value: this note is a debt security, and as such, is a CLN.

by Natalie Brescia
by Natalie Brescia

ii. Let us consider an example of a CLN.

First, we pool and tranche 100 generic names of $10 million each into a synthetic portfolio of $1 billion.

 Secondly, we wish to transform this unfunded multi-name credit derivative into a fully funded asset: to do this, the protection buyer will issue, or sell, CLNs to investors, with a total notional value of $1 billion. (Note: because this is a structured synthetic exchange, the CLNs are ‘linked’ to the notional value of different Tranches, and will therefore have various levels of subordination, credit enhancement, and leverage, and thus different amounts of risk, expected yields, cash flow, and possibly even different maturities). By purchasing CLNs, the issuer prefunds the $1 billion synthetic portfolio.

 Thirdly, the CLNs yield a periodic coupon payment, whose amount is agreed to ahead of time; but they also carry a contingent payment feature. Over the tenure of the of transaction, the issuer will continue to make coupon payments to the holder of the CLN, unless or until such time of occurrence of a credit event in the reference portfolio –at which point the notional value of the reference portfolio is written down, and in turn the coupon payments made to the holders of the CLNs are also written down. As the losses to the reference portfolio continue to accrue, so too is the interest on the notes and principal owed the holder of the CLN reduced.

Lastly, at the termination of the transaction, the remaining principal is returned to the protection seller.      

Let us consider the basic material significance of a CLN.

We earlier observed that a standard, single-name credit derivative is generally an unfunded asset, insofar as there is no invariance requirement on the collinearity risk and ownership. We also observed that this means, for instance, that the protection buyer –who is virtually detaching the risk and its cash flow from the referent in order to replicate and exchange that risk and its cash flow with the protection seller– need neither own nor have any other direct exposure to the generic asset whose event risk is replicated by the synthetic exchange. To any reader otherwise uninitiated in the peculiar materiality of credit derivatives, it’s likely that this already looked rather topsy-turvy: ‘How can one sell that or a part of that which they do not own?!’ Or, ‘How can one buy event protection on an asset that they do not own?!’, our reader will have marveled. ‘Does not the concrete principal of private property stand for nothing?!’

However, we should caution this reader that with the progressive differentiation of the CLN things have yet become more peculiar still. An unfunded credit derivative may have struck one as odd, or not; but its concept was always accompanied by the reassuring notion that the protection seller was being paid for a service of labor: namely, that she may or may not become the party responsible for repaying a generic debt obligation –contingent on occurrence of a credit event– to whose risk she was originally unexposed, but was now being paid in advance to assume. Conversely, the protection buyer was purchasing a guarantee on the risk of the reference asset, and so was naturally paying the protection seller in advance for assuming such risk. It was a synthetic exchange, inasmuch as no party to the synthetic exchange was party to the original generic financial exchange, whose asset provided the referent from which the synthetic asset was derived. But it was enough like a classical exchange of labor for wages, or rather wages now for possible future labor, insofar as the protection seller may have to provide a service of labor for the protection buyer in the future, and so is paid now for assuming this risk in the present. And it was enough like a generic financial exchange of insurance, insofar as the protection buyer was guaranteeing a level of value of the reference asset, and making a premium payment in the present, as an advanced charge by the protection seller for providing the guarantee of the level of value of the asset in the future. This portion of the transaction, at least, was surely partially acceptable to our uninitiated reader, even if they fundamentally regard credit derivatives as at base perverse, and otherwise desecrating the holy unity of property ownership and valorization of capital.

However, with the CLN we are now observing a method of prefunding a synthetically replicated exposure to risk and cash flow, and so have effectively reversed the temporal order of the distribution of cash flow amongst the parties, yet without reversing the spatial order of the distribution of risk. And for this reason, any ostensible similarities between either a classical exchange (of wages in advance for assuming the risk of service of labor in the future), or a generic financial exchange (of insuring the value of an asset in the future by making payment on its value in the present) now collapse. For now the CLN investor is buying from the CLN issuer a risk in a reference asset that the issuer does not own –but is also agreeing to pay in full and in advance for this risk. Correlatively, the CLN issuer is selling to the CLN investor a risk in a reference asset that the issuer does not own –but is being paid in advance for assuming the risk that no credit event in the reference asset will occur.

iii. There are several revelatory material effects that result from this method of synthetic exchange. We will only concern ourselves here with the most notable.

A CLN investor, as a protection seller, is purchasing from the CLN issuer the risk in the generic reference entity, just like the protection seller would do in any standard credit derivative transaction. Albeit now, by prepaying the issuer for this risk, the CLN investor has also purchased a generic risk in the issuer of the CLN as well. This writes another asset into the synthetic exchange that was not there from the start. Namely, this effectively creates an additional generic debt obligation, and therefore a new generic financial asset within the synthetic asset itself. For the CLN investor is now not only ‘going long’ the synthetically replicated reference obligation of the $1 billion portfolio, but has now also created a new generic financial asset through purchasing a risk exposure in the CLN issuer –which is to say that the CLN investor is now also ‘going long’ a generic financial obligation in the CLN issuer. In short, and importantly, this means that the CLN investor is synthetically invested in the material success of the reference entity, but therefore also generically invested in the material success of the CLN issuer. And this means that in reality the CLN investor is invested in both the material success of the $1 billion reference portfolio and CLN issuer alike. Unlike the unfunded single-name CDS, then –wherein the protection seller and protection buyer are involved in a zero-sum, high-stakes game, which one of the parties will ‘win’ and the other will ‘lose’; now, by contrast, it is possible for both parties to benefit from the transaction –which means that synthetic exchange contains a non-zero sum mode of economic transaction. 

Relatedly, because the CLN is a device for converting a credit derivative as an unfunded asset into now a funded asset, we immediately become aware that there is a basic ontological difference between these two different synthetic incarnations –i.e. of an unfunded single-name credit derivative and a fully funded multi-name credit derivative.

We observed at the outset that single-name credit derivatives are unfunded replicas of funded generic financial assets, and so in this respect what defined the single-name synthetic asset –as an avatar of its generic referent– was precisely its unfunded nature. But now we see that the progressive differentiation of a CLN signals the arrival of a mode of synthetic financial exchange that is, on the one hand, an exchange of a fully funded asset that is yet still synthetic, when what had previously distinguished the synthetic asset from the generic asset was precisely this basic ontological difference; but that on the other hand, it now turns out that this type of synthetic financial exchange is even capable of creating new generic financial assets ex nihilo.

That the synthetic asset is fully funded, and yet is nonetheless ontologically and a fortiori a completely different asset from any generic asset is observable by virtue of the fact that the synthetic asset has loosened many of the invariance requirements on the collinearities (e.g. on ownership, maturities, notional amount, and so on), and therefore has both more fungibility and a higher degree of symmetry than its generic counterpart. This, perhaps, at this stage in our investigations, is unsurprising, given its consistency with the ontological trend we have observed throughout our examination of synthetic finance. But to say the least, it is rather surprising to witness a method of generic financial exchange, and therefore a method for the creation of generic financial assets embedded within a technology for synthetic financial exchange. This tells us once again that you can derive the principles of generic finance from those of synthetic finance. And this also once more tells us that synthetic finance is a larger class of exchange than generic finance, since the former already contains the latter within itself, but not vice versa.

The question is what this means, ontologically and materially? This warrants a deeper look into structured synthetic finance. This is a future task for speculative materialism.

4 thoughts on “Credit Linked Notes”

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