Default and total-return swaps transfer the full economic risk of an underlying credit or basket from one counterparty to another. This frees economic and regulatory capital at the same time. However, for banks that wish simply to arbitrage between the market's and the regulators' views of capital adequacy, collateralized loan obligations (CLOs) and repackaged credit-linked notes are the answer. The crisis in Japan has already prompted issuance in the straight CLO markets and many more huge deals are predicted as Japanese banks once again struggle with capital adequacy.
The first public deal securitized credit exposures incurred by SBC Warburg Dillon Read's lending, securities and derivatives businesses. To achieve the best capital treatment, the bank did not simply issue credit-linked notes. Instead it set up a Cayman Islands-based special purpose vehicle, SBC Glacier Finance, which issued $1.5 billion of notes whose proceeds are used to buy credit-linked notes issued off the medium-term-note programme of SBC's New York branch.
The credit-linked notes redeem early at less than par in the event of defaults by specified reference assets underlying them.