After completing this reading you should be able to:
- Compare different types of credit derivatives, explain how each one transfers credit risk and describe their advantages and disadvantages.
- Explain different traditional approaches or mechanisms that firms can use to help mitigate credit risk.
- Evaluate the role of credit derivatives in the 2007-2009 financial crisis and explain changes in the credit derivative market that occurred as a result of the crisis.
- Explain the process of securitization, describe a special purpose vehicle (SPV) and assess the risk of different business models that banks can use for securitized products.
Overview of Credit Risk Management
Lending is undoubtedly one of the most profitable investment avenues for banks. Traditionally, banks take short-term deposits and pool them together to provide long-term loans. However, these loans introduce credit risk – the possibility that the funds disbursed may not be recovered following an event of default by the borrower. There are several ways used by banks to deal with credit risk exposure. Banks can
- Accept the risk, where the bank simply provides loans and takes no further action
- Avoid the risk, which means the bank turns down credit applications
- Reduce the risk by taking measures that eliminate at least part of the exposure, for example by adopting a rigorous screening process at the application stage
- Transfer the risk to some other entity or person (collectively referred to as the counterparty)
In this chapter, we will extensively look at various methods used by banks to transfer credit risk exposure.
The Role of Credit Derivatives in the 2007-2009 Financial Crisis
Risk transfer among banks began in earnest towards the end of the 20th century. Indeed, onetime Federal Reserve Chairman Allan Greenspan is on record admitting that credit derivatives and securitizations represent the main reason why the United States banking system emerged from the 2001-2002 economic slowdown largely unscathed. Some of the instruments that had been in use at the time included credit default swaps, collateralized debt obligations, and collateralized loan obligations.
In the aftermath of the 2007/2009 financial crisis, however, credit derivatives took a significant share of the blame. It has since emerged that the problem was not the instruments themselves but the manner in which they were used. While some of these instruments virtually disappeared from the market in the years following the crisis, others continued to thrive. In particular, the CDS and CLO markets remained robust and are still being used widely by banks to manage and transfer credit risk. The very complex instruments such as collateralized debt obligations squared (CDOs-squared) and single-tranche CDOs are unlikely to be revived. In recent years, new credit risk transfer mechanisms have also emerged.
Types of Credit Risk Derivatives
Credit derivatives are financial instruments that transfer credit risk of an underlying portfolio of securities from one party to another party without transferring the underlying portfolio. They are usually privately held, negotiable contracts between two parties. A credit derivative allows the creditor to transfer the risk of the debtor’s default to a third party.
Credit derivatives are over-the-counter instruments, meaning that they are non-standardized and their trading is not bound by the Securities and Exchange Commission regulations.
The main types of credit derivatives include:
- Credit default swaps
- Collateralized debt obligations
- Collateralized loan obligations
- Total return swaps
- Credit spread swap options
Credit Default Swaps (CDS)
In a CDS, one party makes payments to the other and receives in return the promise of compensation if a third party defaults.
Suppose Bank A buys a bond issued by ABC Company. In order to hedge the default of ABC Company, Bank A could buy a credit default swap (CDS) from insurance company X. The bank keeps paying fixed periodic payments (premiums) to the insurance company, in exchange for the default protection.
Debt securities often have lengthy terms to maturity, sometimes as much as 30 years. It is very difficult for the creditor to come up with reliable credit risk estimates over such a long investment period. For this reason, credit default swaps have over the years become a popular risk management tool. As of June 2018, for example, a report by the office of the U.S. Comptroller of the Currency placed the size of the entire credit derivatives market at $4.2 trillion, of which credit default swaps accounted for $3.68 trillion (approx. 88%).
Like other derivatives, the payoff of a CDS is contingent upon the performance of an underlying instrument. The most common underlying instruments include corporate bonds, emerging market bonds, municipal bonds, and mortgage-backed securities.
The value of a CDS rises and falls as opinions change about the likelihood of default. In fact, an actual event of default might never occur. A default event can be difficult to define when dealing with CDSs. Although bankruptcy is widely seen as the “de facto” default, there are companies that declare bankruptcy and yet proceed to pay all of their debts. Furthermore, events that fall short of default can also cause damage to the creditor. These events include late payments or payments made in a form different from what was promised. Trying to determine the exact extent of damage to the creditor when some of these events happen can be difficult to determine. CDSs are designed to protect creditors against such credit events.
Advantages of CDSs
- CDSs can serve as shock absorbers during a corporate crisis. As happened during the 2001/2002 economic slowdown in the U.S., many creditors from firms such as Worldcom and Enron had transferred the risk and as a result, these corporate scandals did not spread into the banking sector.
- CDS contracts ultimately result in more liquidity (access to capital) since banks have an incentive to lend more at favorable terms.
- The pricing of credit default swaps serves as evidence of the prevailing financial health of the debtor. When used alongside credit ratings, CDSs offer an opportunity to further improve market information about the creditworthiness of the debtor.
Disadvantages of CDSs
- Speculators may increase trading on a CDS resulting in an increase in the CDS premium with respect to a given entity. Such an entity could face increased borrowing rates if it tries to access the financial markets for a loan. For sovereign name CDS contracts (where the borrower is a sovereign country), high premiums may force investors to stay away or switch investments to avoid losses.
- The termination event (i.e. default event) may not be clearly specified, and even if a clear definition exists, the credit protection seller may find it difficult to price some events.
- CDS contracts can be abused and manipulated, creating the illusion that the protection buyer is protected when in fact they are not.
- Example: Assume that we have 5 parties – A, B, C, D, and E. We assume that party B buys protection from party C for the loan made to party A, but C also transfers this risk to party D, and D does the same and buys protection from monoline insurer E. In this scenario, there are three individual agreements made, but economically, only the last buyer (the monoline insurer) bears the ultimate risk. Most important, the gross notional amount is inflated for three times more than the aggregate net exposure.
- Figure 1 – Credit Risk Transfer in a Credit Default Swap
- Participation of banks in the CDS market can introduce a moral hazard in the sense that the CDS (which is essentially an insurance policy against default) may result in laxity in credit monitoring. Take the case of Enron, for example: several lenders had debt exposure to Enron and to protect their investments, the banks bought a massive amount of insurance in form of CDSs. It is estimated that about 800 swaps were bought to insure $8 billion on Enron’s risk. By so doing, the banks neglected their specialty for monitoring, despite having the necessary tools and access to Enron’s financial system.
Collateralized Debt Obligations
Collateralized debt obligations (CDOs) are structured products created by banks to offload risk. The first step entails forming diversified portfolios of mortgages, corporate bonds, and various other assets. These portfolios are then sliced into different tranches which are sold to investor groups having different risk appetites.
The safest tranche is also known as the senior tranche. It offers the lowest interest rate, but it’s the first to receive cash flows from the underlying asset portfolio. The middle tranche offers a slightly higher interest rate and ranks just below the senior tranche. It takes the second spot during cash flow distribution. The most junior tranche, also called the equity tranche, offers the highest interest rate but ranks last during cash flow distribution. It’s also the first tranche to absorb any loss that may be incurred. The amount available for distribution to the equity (junior) tranche is whatever is left from the two other tranches less management fees. These fees can range from 0.5% to 1.5% annually.
Investors in these tranches can protect themselves from default by purchasing credit default swaps. The CDS guarantees a pre-specified compensation in the event that a given tranche defaults. In turn, the investors must make regular payments to the credit protection seller (writer of the CDS).
Each tranche is assigned its own credit rating, except the equity tranche. For instance, the senior tranche is constructed to receive an AAA rating. Highly rated tranches are sold to investors, but the junior ranking ones may end up being held by the issuing bank. That way, the bank has an incentive to monitor the underlying loans.
Example: Calculating Cash Flows for CDO Tranches
Let’s assume there is a $100 million collateral portfolio that is composed of debt at 6%. To pay for this collateral, the CDO is divided into three tranches:
- $85m of Class A securities, with a credit rating of AAA, senior debt paying 5.0%
- $10m of Class B securities, with a credit rating of BBB, mezzanine debt paying 6.0%
- $5m of Class C securities (equity tranche)
In this scenario, the $85m of Class A would pay out $4.25m (= $85m x 5.0%) in interest each year, Class B pays out $0.6 ($10m x 6.0%). Of the remaining $0.85m ($6m – $4.25m – $0.90m), $0.2m is used to pay for fees, leaving the equity holders with a return of 13% ($0.65m/$5m).
Advantages of CDOs
- When used responsibly, CDOs can be excellent financial tools that can increase the availability and flow of credit in the economy. By selling CDSs, banks are able to free up more funds that can be lent to other customers.
- CDOs take into account the different levels of risk tolerance among investors. An investor without much of a tolerance for risk could buy the senior tranche of a CDO, which represents the highest quality loans. On the other hand, an investor with higher risk tolerance could buy the junior tranche that’s backed by somewhat riskier loans.
- Collateralized debt obligations allow banks to transform a relatively illiquid security (a single bond or loan) into a relatively liquid security
Disadvantages of CDOs
- CDOs can result in relaxed lending standards among banks, as happened in the run-up to the 2007/2009 financial crisis. Most of the CDOs sold at the time were composed of mortgage loans made to borrowers with questionable Banks were not so keen to establish accurate and reliable borrower profiles because they would repackage and sell the mortgages to third parties, essentially taking the risk of default off their books.
- Market fears can result in a near standstill in trading, thereby creating a liquidity problem and financial loss for the investor. In the run-up to the 2007/2009 financial crisis, the CDOs market grew at an astonishing rate particularly because there was an overly positive forecast of the mortgage market. It was expected that home prices would continue going up indefinitely. So when prices stopped going up, defaults skyrocketed and panic set in. All of a sudden, banks stopped selling CDOs, and the housing market plunged. As CDOs dropped in value, billions were lost by investors including pension funds and corporations.
Collateralized Loan Obligations
A collateralized loan obligation is similar to a collateralized debt obligation, except that the underlying debt is of a different type and character—a company loan instead of a mortgage. The investor receives scheduled debt payments from the underlying loans, bearing most of the risk if borrowers default.
As with CDOs, CLOs use a waterfall structure to distribute revenue from the underlying assets. The structure dictates the priority of payments when the underlying loan payments are made. It is also indicative of the risk associated with the investment since investors who are paid last (equity holders) have a higher risk of default from the underlying loans.
CLOs have the same set of advantages and disadvantages as CDOs.
Total Return Swap
A total return swap is a credit derivative that enables two parties to exchange both the credit and market risks. In a total return swap, one party, the payer, is able to confidentially remove all the economic exposure of the asset without having to sell it. The receiver of a total return swap, on the other hand, is able to access the economic exposure of the asset without having to buy it.
For example, consider a bank that has significant (but risky) assets in form of loans in its books. Such a bank may want to reduce its economic exposure with respect to some of its loans while still retaining a direct relationship with its customer base. The bank can enter into a total return swap with a counterparty that desires to gain economic exposure to the loan market. What happens is that the bank (payer) pays the interest income and capital gains coming from its customer base to these investors. In return, the counterparty (receiver) pays a variable interest rate to the bank and also bears any losses incurred in the loan.
Figure 2 – Mechanics of a Total Return Swap
Advantages of Total Return Swaps
- The TRS allows one party (receiver) to derive the economic benefit of owning an asset without putting that asset on its balance sheet and allows the other party (payer) which does retain that asset on its balance sheet) to buy protection against loss in the asset’s value. This makes TRSs one of the most preferred forms of financing for hedge funds and special purpose vehicles.
Disadvantages of Total Return Swaps
- TRSs carry counterparty risk. To see how this manifests, consider a TRS between a bank (payer) and a hedge fund (receiver). Any decline in the value of the underlying loans will result in reduced returns, but the fund will have to continue making regular payments to the bank. If the decline in the value of assets continues over a significant period, the hedge fund could suffer financial strain, and the bank will be at risk of the fund’s default. That hedge funds almost always operate with a lot of secrecy only serves to heighten default risk.
- TRSs are exposed to interest rate risk. The payments made by the total return receiver are often equal to LIBOR plus a spread. An increase in LIBOR during the agreement increases the payment due to the payer, while a decrease in LIBOR decreases the payments to the payer.
Credit Default Swap Option
A credit default swap option (CDS option), also known as a credit default swaption, is an option on a credit default swap. It gives its holder the right, but not the obligation, to buy or sell protection on a specified reference entity for a specified future time period for a certain spread.
CDS options can either be payer swaptions or receiver swaptions.
- A payer swaption gives the holder the right to buy protection (pay premiums)
- A receiver swaption, gives the option holder the right to sell protection (receives premiums)
Traditional Approaches that Firms can Use to Help Mitigate Credit Risk
Banks use several ways to reduce their exposure to credit risk—both on an individual name and an aggregate basis. Such credit protection techniques include the following:
Credit Risk insurance is a critical risk-mitigation technique when protecting against bad debt or slow payments that are not in line with the initial agreement. In the event that the counterparty can’t pay, as a result of a host of issues such as insolvency, political risk, and interest rate fluctuations, the credit insurer will pay. By the principle of subrogation, the insurer can then pursue the counterparty for payment. When insurance is sought on an individual obligor basis, this is termed guarantee.
Netting is the practice of offsetting the value of multiple positions or payments due to be exchanged between two or more parties. Netting entails looking at the difference between the asset and liability values for each counterparty involved, after which the party that is owed is determined. For netting to work, there must be documentation that allows exposures to be offset against each other.
Netting frequently occurs when companies file for bankruptcy. The entity doing business with the defaulting company offsets any money they owe the defaulting company with money that’s owed them. The parties then decide how to settle the amount that cannot be netted through other legal mechanisms.
This refers to the settlement of gains and losses on a contract on a daily basis. It avoids the accumulation of large losses over time, something that can lead to a default by one of the parties. As with netting, an agreement has to be in place allowing counterparties to periodically revalue a position and transfer any net value change between them so that the net exposure is minimized
Termination describes a situation where parties come up with trigger clauses in a contract that gives the counterparty the right to unwind the position using some predetermined methodology. Trigger events may include:
- A ratings downgrade
- Exceedance of a borrowing/leverage limit
- Performance below a specified threshold
The Securitization Process
Historically, banks used to originate loans and then keep them on their balance until maturity. That was the originate-to-hold model. With time, however, banks gradually and increasingly began to distribute the loans. By so doing, the banks were able to limit the growth of their balance sheet by creating a somewhat autonomous investment vehicle to distribute the loans they originated. This is known as the originate-to-distribute business model.
From the perspective of the originator, the OTD model has several benefits:
- It introduces specialization in the lending process. Functions initially designated for a single firm are now split among several firms.
- It reduces banks’ reliance on the traditional sources of capital, such as deposits and rights issues.
- It introduces flexibility into banks’ financial statements and helps them diversify some risks.
To borrowers, the OTD model leads to an expanded range of credit products and reduced as well as from the borrowing costs.
The OTD model, however, has its own disadvantages:
- Allowing banks to hive off part of their liabilities can result in relaxation of lending standards and contribute to riskier lending. This implies that borrowers who previously would be turned away – possibly because of poor credit history – are now able to access credit.
- By splitting functions among multiple firms, the model can make it difficult for borrowers to renegotiate terms.
A direct result of the shift to the originate-to-distribute model is securitization, which involves the repackaging of loans and other assets into new securities that can then be sold in the securities markets. This eliminates a substantial amount of risk
(i.e., liquidity, interest rate, and credit risk) from the originating bank’s balance sheet when compared to the traditional originate-to-hold strategy. Apart from loans, various other assets such as residential mortgages and credit card debt obligations are often securitized.
To reduce the risk from holding a potentially undiversified portfolio of mortgage loans, a number of originators (financial institutions) work together to pool residential mortgage loans. The loans pooled together have similar characteristics. The pool is then sold to a separate entity, called a special purpose vehicle (SPV), in exchange for cash. An issuer will purchase those mortgage assets in the SPV and then use the SPV to issue mortgage-backed securities to investors. MBSs are backed by the mortgage loans as collateral.
The simplest MBS structure, a mortgage pass-through, involves cash (interest, principal, and prepayments) ﬂowing from borrowers to investors with some short processing delay. Usually, the issuer of MBSs may enlist the services of a mortgage servicer whose main mandate is to manage the flow of cash from borrowers to investors in exchange for a fee. MBSs may also feature mortgage guarantors who charge a fee and in return guarantee investors the payment of interest and principal against borrower default.