AN INTRODUCTION TO CREDIT DERIVATIVES
By Moorad Choudhry
Copyright © 2013 Moorad Choudhry and Elsevier Ltd.
All right reserved.
Chapter One Credit Risk
The development of the credit derivatives market, and hence the subsequent introduction of structured credit products, was a response to the rising importance attached to credit risk management. For this reason, we believe it is worthwhile beginning this book with a look at credit risk, credit risk transfer and credit ratings from first principles.
1.1 THE CONCEPT OF SYNTHETIC INVESTMENT
If one stops to consider it, banks have been 'selling protection' on their customers ever since they began formally borrowing and lending amongst their customers in the Italian city-states during the Middle Ages. We describe how.
A Bank lends 100 florins to Mr Borrower for a period of 5 years, who agrees to pay interest of C% per year each year until loan expiry, at which point he will return the original 100 florins. This is shown in Figure 1.1. We assume that Mr Borrower does not default on payment of both interest and principal during the term of this loan.
The net gain to Bank after the 5 years is the interest of C each year, which after 5 years will be 5C.
A Bank sells protection on Mr Borrower to Mr Practitioner for a period of 5 years, who agrees to pay C basis points premium per year each year until trade expiry. This is also shown in Figure 1.1. We assume that Mr Borrower does not go into bankruptcy, liquidation or administration during the 5 years of the contract between Bank and Mr Practitioner, and that Mr Practitioner keeps up the premium payments until contract expiry.
The net gain to Bank after the 5 years is the credit default swap (CDS) premium of C each year, which after 5 years will be 5C. Note that Mr Borrower is not involved in this transaction at all, as we see in Figure 1.1. The contract is between Bank and Mr Practitioner.
This illustration is a bit cheeky but it makes the point. The return for Bank of C is identical in each case. So Bank can decide between cash and synthetic investment; in theory the return will be identical. In terms of net cash flow, the end-result actually is identical if the price associated with Mr Borrower credit risk is C. The only difference is that the cash trade is funded, while the CDS trade is unfunded. Bank has to find 100 florins to lend to Mr Borrower, but it doesn't need to find any cash to invest in Mr Borrower by means of the contract with Mr Practitioner.
Of course, if there is a credit event, then under the synthetic investment Bank will have to find 100 florins. So we need to consider the event of default. Before we do, let's make the illustration more real-world.
If we convert the bond investment to an asset-swap that pays Libor 1 X basis points, the interest basis of the bond has changed from fixed coupon to floating coupon. It is now conceptually identical to the synthetic (credit default swap) premium of X basis points.
In the cash market, we assume that the investor has funding cost of Libor-flat, so that the 100 florins it borrows to buy the bond costs it Libor-flat in funding. The net return to the investor is X. For the synthetic investor, who has no funding cost (it does not borrow any cash as it is not buying a bond), the net return is X basis points.
Let us now allow for a default or 'credit event'.
At the beginning of year 3, Mr Borrower is declared bankrupt and defaults on his debt to Bank. The Bank falls in line with the other creditors, and after 3 years receives a payout from the administrators of 39 cents on the florin.
After 5 years, Bank has therefore received 2C in interest, but lost 61 florins of capital, a substantial loss.
At the beginning of year 3, Mr Borrower is declared bankrupt and immediately Bank pays 100 florins to Mr Practitioner. In return, Mr Practitioner delivers to Bank 100 florins nominal of a loan that Mr Borrower took out from A N Other Bank. This loan has some residual value to Bank, at the time it is valued at 30 cents on the florin so Bank records a capital loss of 70 florins, a substantial loss.
After 3 years the Mr Borrower loan that Bank is holding is valued at 39 cents on the florin, so Bank recovers 9 florins of the loss it booked 3 years ago. So after 5 years Bank has received 2C in interest, but lost 61 florins of capital, a substantial loss. The illustrations are shown in Figure 1.2.
The point we are making is that funded and unfunded investments are identical on a netnet basis, at least in theory, and involve taking credit risk exposure in Mr Borrower's name. The price of this risk is C%, and reflects what the market thinks of the credit quality of Mr Borrower. Of course there are some technical differences, not least the introduction of another counterparty, Mr Practitioner. But from the point of view of Bank, both trades are in essence identical, or at least have identical objectives. And the synthetic trade actually has some advantages, principally with regard to the fact that no funding is required. The counterparty risk to Mr Practitioner (principally his ability to keep up premium payments) can be viewed as a disadvantage.
1.2 BANKS AND CREDIT RISK TRANSFER
Banking institutions have always sought ways of transferring the credit (default) loss risk of their loan portfolios, for two reasons: (i) to remove the risk of expected losses from their balance sheet, due to an expected increase in incidence of loan default and (ii) to free up capital, which can then be used to support further asset growth (increased lending). The first method of reducing credit risk is selling loans outright. This simply removes the asset from the balance sheet, and is in effect a termination of the transaction. Alternatives to this approach include the following:
spreading the risk in the first place via a syndicated loan, in partnership with other banks;
securitizing the loan, thus removing the asset off the balance sheet and, depending on how the transaction is structured and sold, transferring the credit risk associated with the loan;
covering the risk of default loss with a CDS or an index credit default swap;
transferring the risk of the asset to a specialty finance company.
In principle, the ability to transfer credit risk is an advantage to the financial market as a whole, as it means risks can be held more or less evenly across the system. In practice this may not happen, and risk can end up being concentrated in particular sectors or amongst particular groups of investors. But such a result is not to detract from the inherent positive impact of credit risk transfer.
Credit risk transfer enables banks to manage bank capital more efficiently, and also to diversify their risk exposures. In theory this means they can reduce their overall credit risk exposure. (We emphasize 'in theory'. In practice, during a market downturn such as the financial crash of 20072008, diversified investment portfolios may perform no better than concentrated portfolios.)
The risk is transferred not eliminated to other banks and other market sectors such as institutional investors, hedge funds, corporations and local authorities. More efficient allocation of capital should, in theory, lead to a lower cost of credit, which is a positive development for the economy as a whole. Put against this is the negative notion that securitization and the use of CDS results in the poorest-quality assets always being retained on bank balance sheets, because such assets are illiquid and not attractive to other investors; this concentrates risk. In addition, loan risk may be transferred to investors who are less familiar with the end-obligor, and so are less able to monitor the borrower's performance and notice any deterioration in credit quality. Where banks originate debt that they then instantly transfer, they may pay less attention to borrower quality and repayment ability: this reduction in lending standards was one of the contributing factors to the US sub-prime mortgage market default.
In essence though, these are 'micro-level' arguments against, and we will proceed with the premise that credit risk transfer is on balance a beneficial activity.
Risk transfer is a logical part of bank risk management. The benefits of credit risk transfer are (i) reduction of capital costs that were associated with the full-risk-exposure loan asset and (ii) diversification of risk. Risk transfer via securitization produces other potential benefits, in the form of new investment product for bank and non-bank investors that is a liquid financial instrument, which may not have been the case for the securitized asset.
Risk transfer via CDS enables the bank to maintain the loan and thus the client relationship, while benefiting from a capital cost reduction. That the CDS can be executed with an identical maturity to the loan is one of the prime advantages of the CDS instrument.
Given that there are various drivers behind why a bank may select to transfer the credit risk of an asset on its balance sheet using a credit derivative, by extension one can see that the same advantages apply if a bank wishes to transfer entire books of risk via a basket credit derivative, which can be either a cash collateralized debt obligation (CDO) or synthetic CDO. From the other side, investor demand for the product that arises from a CDO deal is also a driver of the transaction. Synthertic CDOs are discussed in the author's book Structured Credit Products, 2nd edn (John Wiley & Sons, 2010).
1.3 CREDIT RISK AND CREDIT RATINGS
Credit derivatives are bilateral financial contracts that transfer credit default risk from one counterparty to another. They represent a natural extension of fixed income derivatives in that they isolate and separate the element of credit risk (arguably the largest part of a bank's risk profile) from other risks, such as market and operational risks. They exist in a variety of forms; perhaps the simplest is the credit default swap, which is conceptually similar to an insurance policy taken out against the default of a bond, for which the purchaser of the insurance pays a regular premium. However, credit derivatives are different from other forms of credit protection, such as guarantees and mortgage indemnity insurance, because:
the borrower is generally asked for a mortgage indemnity policy, or a guarantee;
the credit derivative is requested by the lending bank, and the borrower doesn't have to know that the transaction has taken place;
credit derivatives are tradable, while other forms of protection are generally not.
The currency and bond market volatility in Asia in 1997 and 1998 demonstrated the value of credit derivatives. For example, in 1998 the International Finance Corporation of Thailand bought back $500 m of bonds several years before maturity because of a graduated put provision that was exercisable if the bank's credit rating fell below investment grade; the bond would have paid out an additional 50 basis points of yield if the bond fell two levels in creditworthiness and 25 basis points per additional level until the put threshold below investment grade was reached. This in fact occurred when Moody's re-rated Thailand to Bal grade. In volatile markets, investors are generally happy to give up yield in return for lower credit risk. Thus financial institutions have started focusing on credit as a separate asset class rather than treating counter-party credit risk as one of the risks associated with an asset.
1.3.1 Credit Risk
There are two main types of credit risk that a portfolio of assets, or a position in a single asset, is exposed to. These are credit default risk and credit spread risk.
Credit Default Risk
This is the risk that an issuer of debt (obligor) is unable to meet its financial obligations. This is known as default. There is also the case of technical default, which is used to describe a company that has not honoured its interest payments on a loan for (typically) 3 months or more, but has not reached a stage of bankruptcy or administration. Where an obligor defaults, a lender generally incurs a loss equal to the amount owed by the obligor less any recovery amount which the firm recovers as a result of foreclosure, liquidation or restructuring of the defaulted obligor. This recovery amount is usually expressed as a percentage of the total amount, and is known as the recovery rate. All portfolios with credit exposure exhibit credit default risk.
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