Credit risk transfer mechanisms let a bank keep a loan on its books while passing the risk that the borrower defaults to someone else, or sell the loan’s risk and cash flows outright to investors. The traditional tools, such as netting, collateral and guarantees, limit exposure contract by contract. Credit derivatives such as the credit default swap and securitization through a special purpose vehicle go further: they isolate credit risk, slice it into pieces and distribute it across the market.
This fourth chapter of FRM Part 1 covers the traditional techniques and their limits, how credit derivatives work and what each type is good for, how CDS prices reveal default risk, how securitization and its tranches are built, the shift from buy-and-hold to originate-to-distribute banking, what went wrong in the 2007 to 2009 crisis, and how the market and its regulation changed afterward, including risk retention.
Key Takeaways
- Credit risk transfer mechanisms separate the credit risk of a loan or bond from the asset itself, through traditional techniques, credit derivatives or securitization.
- Traditional techniques, namely guarantees, netting, margining, collateral, termination triggers and reassignment, need contract-by-contract agreements and cannot isolate or slice credit risk; collateral can also suffer wrong-way risk.
- In a credit default swap the protection buyer pays a periodic spread and the seller pays notional times one minus recovery on a credit event, transferring credit risk without funding, a sale of the asset or the borrower’s involvement.
- Securitization sells a loan pool to a special purpose vehicle that issues senior, mezzanine and equity tranches, with losses absorbed from the equity upward.
- The originate-to-distribute model frees capital and removes credit, price and liquidity risk from the originator, but creates moral hazard in underwriting and monitoring.
- The 2007 to 2009 crisis discredited complex, opaque products and concentrated counterparty risk rather than credit risk transfer itself; reforms added 5 percent risk retention, standardized CDS contracts and central clearing of index CDS.
Why Credit Risk Transfer Matters
Credit risk is a bank’s core exposure. The traditional bank takes short-term, liquid deposits and makes long-term, illiquid loans, and for most of banking history it had only limited ways to manage the credit risk that built up as a result: it could refuse a loan, demand collateral, or hold the loan and hope. By the end of the twentieth century that had changed. Credit derivatives and securitization let a bank separate the credit risk of a loan from the loan itself and pass it to investors who wanted it.
In October 2002 the then Federal Reserve Chairman, Alan Greenspan, described this as a “new paradigm of active credit management”. He argued that US banks had come through the 2001 to 2002 slowdown in good shape partly because they had transferred and dispersed their credit exposures through credit default swaps, collateralized debt obligations and collateralized loan obligations. Five years later the same instruments sat at the center of the 2007 to 2009 crisis.
The chapter’s argument is that the blame belongs mainly to how the instruments were used, and to the failings of the pre-crisis securitization process, rather than to the principle of credit risk transfer. The evidence is in what survived. Credit default swaps, simple asset-backed securities on auto loans, credit cards, equipment leases and student loans, and collateralized loan obligations all worked through the crisis or came back afterward; the products that disappeared were the deliberately complex ones whose risks investors could not see. The crisis may come to look more like a hard test of the credit transfer market than its undoing.
The Instruments: a Working Vocabulary
Credit risk transfer has its own vocabulary, and most exam questions turn on knowing exactly what each instrument is. Exhibit 1 defines the main ones.
| Instrument | What it is |
|---|---|
| Credit derivative | Any contract that transfers credit risk from one party to another without transferring the underlying asset; credit default swaps and credit-linked notes are examples |
| Credit default swap (CDS) | The most widely used credit derivative: the protection buyer pays a regular fee, and the protection seller pays out if a reference entity suffers a defined credit event. One reference entity makes it single-name; several make it a basket or index CDS |
| Asset-backed security (ABS) | A security backed by a pool of loans or receivables through securitization, such as auto loans, credit card balances or student loans |
| Mortgage-backed security (MBS) | A security backed by residential mortgages, either guaranteed by a government agency or issued privately, including subprime MBS; commercial mortgage-backed securities (CMBS) are backed by commercial property loans |
| Collateralized debt obligation (CDO) | A structured product backed by a pool of debt instruments, such as bonds or ABS, sliced into tranches; a CDO-squared is backed by tranches of other CDOs |
| Collateralized loan obligation (CLO) | A structured product backed by a pool of commercial bank loans, usually leveraged loans to companies |
| Asset-backed commercial paper (ABCP) | Short-term paper issued by a special purpose vehicle to finance a pool of longer-term receivables |
| Structured investment vehicle (SIV) | A vehicle that funds itself short term and invests in longer-term structured products such as ABS and MBS, aiming to earn the spread between the two |
Two ideas run through all of these. One is isolation: the credit risk is separated from the funding and from the client relationship. The other is tranching: a pool of credit risk is cut into slices that absorb losses in a set order, so that investors can choose how much of the risk they want.
Traditional Ways to Mitigate Credit Risk
Long before credit derivatives, banks had tools to limit credit exposure, both to individual borrowers and in aggregate. Exhibit 2 summarizes them.
| Technique | How it works | Limitation |
|---|---|---|
| Third-party insurance (financial guarantee) | A guarantor insures the obligation of an individual borrower; monoline insurers did this for US municipal bonds and ABS | Only as good as the guarantor: monolines needed a AAA rating to add value, and their downgrades and failures in the crisis sharply reduced guaranteed issuance |
| Netting | Documentation allows the bank to offset what a counterparty owes it against what it owes that counterparty | Works only with a legally enforceable agreement in place before the default |
| Marking to market and margining | Positions are revalued periodically and the net change in value is paid across, keeping net exposure small | Needs sophisticated systems; historically common mainly in exchange-traded derivatives |
| Collateral | The borrower pledges assets that the lender can sell on default | The collateral may lose value at the very moment the borrower defaults, which is wrong-way risk |
| Termination or put option | Agreed trigger events, such as a downgrade or a breach of a balance sheet ratio, force the position to be unwound at a pre-set value, often mid-market; a put lets the lender demand early repayment at a set price | Triggers must be negotiated contract by contract |
| Reassignment | The exposure passes to another party if a trigger, such as a downgrade, occurs | Depends on finding and agreeing a willing party in advance |
Netting is the easiest of these to see in numbers. Without it, a bankrupt counterparty’s obligations to the bank shrink to whatever the bankruptcy pays, while the bank’s obligations to the counterparty stay due in full.
Northgate Bank has many derivative contracts with Delmar Trading. Contracts in Northgate’s favor are worth USD 45 million; contracts in Delmar’s favor are worth USD 30 million. Delmar goes bankrupt, and unsecured creditors recover 40 cents on the dollar. Compare Northgate’s loss with and without an enforceable netting agreement.
Step 1. Without netting: Northgate claims the gross amount owed to it and must still pay Delmar in full.
Step 2. With netting: only the net amount is at risk.
Answer: netting cuts the loss from USD 27 million to USD 9 million, a saving of USD 18 million. The exposure that matters is the net amount, and only a legally enforceable agreement makes it the net amount. This is why banks treat netting documentation as risk management rather than paperwork.
Collateral and wrong-way risk
Collateral offsets losses on default, but sometimes the event that causes the default also destroys the value of the collateral. This is wrong-way risk: exposure, or loss given default, rises exactly when the counterparty is most likely to fail. A producer that pledges its own output is the classic case, because a fall in the price of what it sells both weakens it and shrinks the collateral.
Harrow Bank lends USD 100 million to Corrib Copper, secured on 12,500 tonnes of the miner’s copper inventory. At USD 9,600 a tonne the bank judges Corrib’s one-year default probability at 1 percent; if copper falls to USD 7,200, it rises to 8 percent. Find the collateral value and the shortfall on default at each price, and the expected loss.
Step 1. Collateral value at each price.
Step 2. Shortfall on default and expected loss, ignoring sale costs.
Answer: at today’s price the loan looks fully covered, with 20 percent of excess collateral. A 25 percent fall in copper raises the default probability eightfold and turns the cushion into a USD 10 million shortfall at the same time, so the expected loss goes from zero to USD 0.8 million. The same loan secured on USD 120 million of Treasury bills would not have this problem, because the value of the bills does not depend on the price of copper.
Syndication and the secondary loan market
For very large loans, banks syndicate: a lead bank originates the loan, arranges for a wider group of lenders to take parts of it, earns a fee, and keeps a minority share for its own book. Under a firm commitment, the lead bank guarantees the borrower the full amount and must take onto its own books whatever other lenders do not buy. Under best efforts, the amount raised depends on investor demand and the full amount is not guaranteed. Banks can also sell loans they originated, or own, in the secondary market. Syndicated loans form the backbone of that market, because the lead bank must make sure the loan can be traded after it is first distributed, and as the secondary market and the market for credit derivatives have grown, loan pricing has become more transparent and loans more liquid.
All these techniques work, but they share two limits. Each needs a specific agreement between the parties, which may not suit them. More importantly, none of them isolates credit risk from the underlying position so that it can be passed on to a wide class of investors, and none can slice that risk finely enough to tune a position or portfolio. Credit derivatives were built to do exactly that.
A bank’s contracts with a hedge fund are worth USD 80 million to the bank and USD 65 million to the fund. The fund defaults and creditors recover 25 percent. What is the bank’s loss with and without enforceable netting?
Show answer
Netting cuts the loss by USD 48.75 million, because only the net claim of USD 15 million is exposed to the default.
Credit Derivatives: Isolating and Transferring Credit Risk
Credit derivatives are off-balance-sheet contracts that move the credit risk of a reference asset, such as a loan or a bond, from one party to another without anyone selling the asset. In the chapter’s terms, the beneficiary sells the risk and the guarantor takes it on. The beneficiary keeps the loan, the funding and the client; only the credit risk changes hands. Credit derivatives do for credit risk what interest rate and currency derivatives did for market risk: they separate it from funding and liquidity concerns so that it can be managed on its own.
How a credit default swap works
In a CDS the protection buyer pays a periodic fee, quoted as a spread in basis points a year on the notional amount, to the protection seller. If the reference entity suffers a credit event defined in the contract, such as bankruptcy or failure to pay, the seller compensates the buyer for the loss, usually the notional amount times one minus the recovery rate. The reference entity is not a party to the contract and need not even know it exists.
Lakeshore Bank holds USD 50 million of bonds issued by Verdant Retail. It buys five-year CDS protection on Verdant with a notional of USD 50 million at a spread of 180 basis points a year, paid quarterly. After ten quarterly payments Verdant files for bankruptcy, and the settlement process fixes the recovery value of its bonds at 35 percent of face. Find the quarterly premium, the premiums paid, the payout, and Lakeshore’s position after the default.
Step 1. Quarterly premium and total premiums paid.
Step 2. Payout from the protection seller.
Step 3. Lakeshore’s position after default.
Answer: the CDS cost USD 225,000 a quarter, USD 2.25 million in all, and paid USD 32.5 million on default. Together with the bonds’ recovery value, Lakeshore is back to USD 50 million: it has given up the premiums in exchange for removing the default loss. It kept the bonds and the relationship with Verdant throughout, which is what distinguishes the CDS from simply selling the bonds. It now depends, however, on the protection seller being able to pay.
The main types and what each is good for
Exhibit 3 compares the credit derivatives most often used to transfer risk.
| Instrument | How the risk moves | Main advantage | Main drawback |
|---|---|---|---|
| Single-name CDS | Seller compensates the buyer for a credit event on one reference entity | Precise, liquid hedge of one name; no funding needed | Counterparty risk on the seller; basis to the actual loan or bond held |
| Basket and index CDS | Protection on several names, or on a standard index of names, in one contract | Cheap, liquid hedge of broad credit exposure; index contracts are standardized | Hedges a portfolio only roughly unless the names match |
| Credit-linked note (CLN) | An investor buys a note whose repayment is cut if a reference entity defaults; the issuer holds the cash | Funded: the protection buyer has no exposure to the investor’s ability to pay | The investor bears both the reference credit risk and the issuer’s risk |
| Total return swap (TRS) | One side pays the full return on an asset, income plus price change, and receives a funding rate plus a spread | Transfers the whole economic exposure without selling the asset | Moves market risk as well as credit risk |
| Synthetic CDO or CLO tranche | A tranche of losses on a portfolio of CDS or loans, absorbed in a set order | Lets investors choose a precise slice of portfolio credit risk | Complex and sensitive to default correlation; the most complex versions did not survive the crisis |
Advantages and challenges
The advantages follow from isolation. A bank can cut its exposure to a borrower without selling the loan, without needing the borrower’s consent and without damaging the relationship. CDS need no funding, so a bank can reduce or add credit risk without changing its balance sheet. Concentrations can be reduced name by name, and a whole portfolio’s risk can be reshaped.
The challenges are mostly about understanding. Each party has to know exactly how much risk is transferred and what kind; how the trigger events are defined; what periodic payments are due; what each side owes and is owed in each trigger scenario; and when the contract is enforceable and when, if ever, it is not. There is also systemic concentration risk. Even before the crisis, regulators worried that a small number of dealers provided most of the liquidity in credit derivatives, so that distress at one or more of them, alone or together, could disrupt the whole market. The exposure a CDS removes from the buyer’s credit book reappears as counterparty credit risk on the seller. Yet single-name and index CDS markets operated relatively smoothly at the height of the crisis, under the leadership of the International Swaps and Derivatives Association (ISDA).
A fund sells five-year CDS protection on USD 20 million notional at 250 basis points a year, paid quarterly. What does it receive each quarter, and what does it pay if the reference entity defaults with 30 percent recovery?
Show answer
The seller earns a small, steady premium and is exposed to a large, contingent loss, so a seller of protection is economically long the reference entity’s credit, like a bondholder without the funding.
Price Discovery and the Market Risk of Credit Risk
In a liquid, transparent market, credit derivatives contribute to price discovery: they reveal the market value of a given type of credit risk. CDS spreads put a price on the default risk of many large companies and, unlike credit ratings, which are reviewed periodically, they move every trading day, so they can be used to monitor default risk in real time.
Corporate bonds have long done this job, but less cleanly. A bond yield blends interest rate risk, credit risk and sometimes liquidity risk, and only companies that issue liquid bonds, usually the largest, can be priced that way. Credit derivatives can, in principle, help price the credit risk in privately held high-yield loans and loan portfolios that never trade as bonds.
Once credit risk has a market price, it has a second dimension. In a mature credit market, credit risk includes not only the risk of default but credit spread risk, the risk that the spread over a Treasury bond of the same maturity widens. A wider spread lowers the value of every instrument exposed to that credit, whether or not anyone defaults. For liquid assets, traditional credit risk therefore becomes the market risk of credit risk, measured and managed like any other market price.
where the spread is in decimal form a year and the recovery rate is the expected fraction of face value recovered on default. This rule of thumb, often called the credit triangle, turns a quoted spread into the market’s implied probability of default per year, which is how CDS prices are read as a real-time gauge of default risk.
Applied to Worked Example 3, a spread of 180 basis points with an assumed 40 percent recovery implies a default intensity of about 0.0180 ÷ 0.60 = 3.0 percent a year. If the spread widened to 360 basis points, the implied intensity would double to 6.0 percent, and the value of Verdant’s bonds would fall immediately, before any rating agency acted.
Two issuers have five-year CDS spreads of 120 and 480 basis points, and the market assumes 40 percent recovery for both. What annual default intensities do the spreads imply, and why might the market price move before the rating agencies act?
Show answer
The market implies a default intensity four times higher for the second issuer. CDS spreads trade daily and react to news at once, while ratings are reviewed periodically, so spreads often move first.
The Mechanics of Securitization
Securitization repackages loans and other assets into new securities that can be sold in the capital markets. The pool of assets is the collateral for the new securities, and the securities perform only as well as the pool. Securitization is a funding source, because banks worldwide do not have enough capital on their own to meet the borrowing needs of businesses, consumers and governments, and it is a risk management tool for banks and non-financial firms alike. Banks have used it to move mortgages, corporate loans, credit card receivables and auto loans off their balance sheets, creating MBS, CLOs and credit card and auto ABS respectively.
The central element is the special purpose vehicle (SPV), a separate legal entity set up by the originating firm, called the sponsor. The SPV buys the pool of loans from the sponsor and owns it; it pays for the pool by selling the new securities to investors; and those investors receive interest and principal according to fixed rules for distributing cash and allocating defaults. Because the SPV, not the sponsor, issues the securities and owns the collateral, investors are exposed to the pool rather than to the sponsor.
An SPV typically issues three kinds of class, or tranche. The senior class has the most protection against credit losses and usually a AAA rating. One or more junior, or mezzanine, classes carry ratings below AAA. The equity, or residual, class is paid only after all the debt classes and so bears the most credit risk; it is usually a small part of the structure, often well under 10 percent of total funding. Losses on the pool are absorbed from the bottom up.
The SPV in Figure 4 holds a USD 500 million loan pool funded by a USD 400 million senior tranche, a USD 70 million mezzanine tranche and USD 30 million of equity. Allocate pool losses of USD 20 million, USD 60 million and USD 120 million, and state each tranche’s loss as a share of its size.
Step 1. Loss of USD 20 million: within the equity.
Step 2. Loss of USD 60 million: equity wiped out, then the mezzanine.
Step 3. Loss of USD 120 million: losses reach the senior tranche.
Answer: the equity absorbs the first USD 30 million, the mezzanine the next USD 70 million, and only losses above USD 100 million, a fifth of the pool, touch the senior tranche. That 20 percent of subordination is what supports the senior tranche’s AAA rating. It is also why the rating is only as good as the estimate of pool losses: if the loans are far worse than assumed, or default together, losses can climb through the structure faster than the rating implied.
Who securitizes, and since when
Securitization is not only a bank tool. Car manufacturers’ captive finance companies securitize the auto loans and leases they make to customers, consumer lenders securitize student and personal loans, and telecom companies have securitized their receivables, using it both to raise funds and to manage risk. The modern market began in 1968 with the creation of the Government National Mortgage Association (Ginnie Mae) in the United States. Consumer ABS in the United States and residential MBS in the United Kingdom emerged in the 1980s, US commercial MBS in the 1990s, and between 2000 and 2007 issuance of very complex, risky and opaque CDOs surged in the US private-label market.
A USD 1 billion pool funds a senior tranche of USD 850 million, a mezzanine tranche of USD 100 million and equity of USD 50 million. How large must pool losses be before the senior tranche loses anything, and what share of the mezzanine is lost if pool losses are USD 90 million?
Show answer
The senior tranche is untouched until losses exceed USD 150 million, 15 percent of the pool. At USD 90 million of losses, the equity is wiped out and the mezzanine loses 40 percent.
From Buy-and-Hold to Originate-to-Distribute
Before securitization, a lender held the loans it made as an investment, the buy-and-hold or originate-and-hold model, and bore the credit, price and liquidity risk of each loan for its whole life. From the 1980s, part of banking shifted to the originate-to-distribute (OTD) model: banks originated loans, pooled them and sold the risk and the cash flows to investors through ABS and similar products. Exhibit 4 contrasts the two.
| Feature | Buy-and-hold | Originate-to-distribute |
|---|---|---|
| Credit risk | Kept by the lender | Passed to investors; the originator no longer owns the collateral |
| Price risk | Kept by the lender | None for the originator once the assets are sold |
| Liquidity risk | The lender holds illiquid loans | The illiquid loans are turned into cash |
| Capital and funding | Each loan consumes capital for its life | Capital is freed for new lending; new funding sources open up |
| Revenue | Interest margin over the life of the loan | Upfront origination and securitization fees |
| Incentive to underwrite and monitor | Strong, because the lender bears the losses | Weaker, because someone else bears them: moral hazard |
Basel capital rules drove much of the enthusiasm, since banks could use capital more efficiently by moving capital-hungry loans off their books, and accounting and regulatory standards encouraged a focus on the upfront fees that securitization generated. The model seemed to benefit everyone. Originators gained capital efficiency, new funding and, at least in the short term, lower earnings volatility, because credit and interest rate risk appeared to be spread across many market participants. Investors gained a wider choice of investments with which to diversify and match risk and return to their goals. Borrowers gained more credit, more products and lower borrowing costs.
Those benefits eroded as risks built up before the crisis. There is wide disagreement about how much the OTD model contributed to the crisis, but there is consensus on two points: it created moral hazard by weakening lenders’ incentives to keep underwriting standards high and to monitor borrowers, and too few safeguards existed to offset that moral hazard.
Why does the originate-to-distribute model weaken a lender’s incentive to screen borrowers, and how does a risk retention requirement respond to that?
Show answer
A lender that sells its loans soon after making them earns its fees upfront and does not bear the losses if borrowers later default, so careful screening and monitoring pay it less than they would under buy-and-hold. That is moral hazard. Requiring the securitizer to keep part of the credit risk, without hedging it, means poor underwriting costs the originator money again.
What Went Wrong in 2007 to 2009
In practice, in the run-up to the crisis many banks did not follow the OTD model at all. Instead of acting only as intermediaries, passing mortgage risk to capital market investors, they became investors themselves. In the mortgage market relatively little credit risk was actually transferred out of the banking system; many banks kept, or even bought, large amounts of securitized mortgage risk.
Risks that should have been spread widely were instead concentrated in highly leveraged off-balance-sheet vehicles, ABCP conduits and SIVs, set up mainly to avoid capital requirements. Banks misjudged the risks in their commitments to these vehicles, including the reputational pressure to support them, and wrongly assumed that funding would always be available and that markets for the assets would stay liquid enough to keep securitizing. Firms selling credit exposure found themselves holding a growing pipeline of loans awaiting securitization, without measuring what would happen if those loans could not be sold. Some SIVs had large liquidity and maturity mismatches, funding long-term assets with short-term paper, which left them open to a classic run. The weaknesses that made matters worse were leverage, poor underwriting, and many firms’ choice to retain, rather than fully transfer, the credit risk in the securities they originated.
Four problems along the securitization chain needed fixing:
- Misaligned incentives. Originators, arrangers, managers and distributors were paid for short-term volume. Pay for loan origination was tied to volume and commissions rather than to how loans later performed, and securitization generated high fees for complex products. Investor oversight weakened amid complacency, and the products’ complexity acted as a barrier to market discipline.
- Lack of transparency. Investors could not easily judge the quality of the underlying assets or the correlations among them.
- Poor securitization risk management, especially in identifying, measuring and stress testing the market, liquidity, concentration and pipeline risks.
- Overreliance on credit ratings. Rating agencies did not adequately review the detailed data behind securitized deals and underestimated the risks of subprime CDO structures; “ratings shopping” by issuers may have pushed ratings upward.
These links reinforced one another. Volume-based origination fed fee-rich securitization, generous ratings made the products easy to sell, and investors searching for yield in a period of easy monetary policy bought them, which created demand for more origination. The chain amplified systemic risk by allowing leverage and concentration to build across the financial sector.
The role of credit derivatives
Credit derivatives themselves were not the main cause, but they spread and concentrated the damage in two ways. Complex products such as CDOs-squared and synthetic CDOs multiplied exposure to the same subprime risk and made it harder to see. And CDS turned credit risk into counterparty risk, concentrated on a few large protection sellers. AIG was the clearest case: it had sold large amounts of protection, much of it on super-senior tranches of mortgage-related CDOs, and when the value of that protection rose and collateral calls followed, the Federal Reserve authorized a loan of up to USD 85 billion on 16 September 2008 to prevent its disorderly failure. The fear regulators had voiced before the crisis, a disruption caused by distress at a dominant market participant, had come true.
The instruments that failed were opaque: investors could not see what they owned, and the complexity existed mainly to make the products easier to market rather than better at hedging. The instruments that worked, such as single-name and index CDS and plain consumer ABS, were transparent and standardized. The crisis discredited complexity and concentration, not credit risk transfer as such.
How the Credit Risk Transfer Market Changed
Credit transfer markets did not all suffer equally. Some instruments disappeared, some are returning in a different form, and some were barely affected.
- Survivors. CDS and plain ABS backed by auto loans, credit card receivables, equipment leases and student loans held up, and ABCP and private-label MBS were expected to draw renewed interest. The CLO market went quiet for a few years, then revived from around 2011, with new issuance surpassing pre-crisis volumes, because CLO structures are transparent and their collateral relatively easy to value.
- Casualties. CDOs-squared, single-tranche CDOs and complex ABCP are unlikely to come back.
- New channels. Insurance companies have been buying bank loans to build portfolios that match their long-term liabilities. Higher post-crisis capital costs suggest that buy-and-hold will remain an inefficient way for banks to carry lending risk, which keeps regulators and the industry interested in securitization reforms that support bank funding, sound risk management, liquidity and growth.
The market infrastructure was rebuilt as well. ISDA’s CDS “Big Bang” in April 2009 standardized contracts, with fixed coupon rates and an upfront payment for the difference, determinations committees to rule on whether a credit event had occurred, and auctions to fix the settlement price after a default. Under Dodd-Frank, US regulators required standardized index CDS to be cleared through central counterparties, phased in during 2013, which replaced bilateral counterparty exposure to dealers with exposure to a clearing house.
Risk retention: skin in the game
The most direct fix for the OTD incentive problem is to make the securitizer keep some of the risk. Section 941 of the Dodd-Frank Act led the Securities and Exchange Commission and the federal banking regulators to finalize, in 2014, risk retention rules for asset-backed securities, including CLOs. Securitizers must retain at least 5 percent of the credit risk, and may not hedge or otherwise transfer it. The retained piece can be a vertical slice of every tranche, a horizontal first-loss piece, or a combination. In February 2018, a US appeals court ruled that managers of open-market CLOs, who neither originate nor hold the loans before they are securitized, are not securitizers under the Act, which removed them from the rule.
Granite Lending securitizes a USD 800 million pool of auto loans and must retain 5 percent of the credit risk. Compare the amount retained, and Granite’s loss if the pool loses USD 30 million, under a vertical slice of every tranche and under a horizontal first-loss piece.
Step 1. Amount retained.
Step 2. Vertical slice: Granite bears 5 percent of every loss.
Step 3. Horizontal first-loss piece: Granite bears the first USD 40 million of losses.
Answer: both forms hold USD 40 million, but a USD 30 million pool loss costs Granite USD 1.5 million under vertical retention and USD 30 million under horizontal retention. The horizontal piece puts far more skin in the game for ordinary losses, so it gives the strongest incentive to underwrite well; the vertical slice simply mirrors what investors as a whole experience.
The securitization market has recovered from its post-crisis low, although private-label mortgage securitization remains well below its pre-crisis peak, with agency MBS dominating outstanding volume, issuance and trading, and consumer ABS holding their ground. Regulatory uncertainty has slowed the comeback, and it remains to be seen whether the new rules will prevent a repeat of the incentives, actors and circumstances that undermined securitization before 2007. The case for credit risk transfer is still strong: demand for instruments that move credit risk efficiently and improve risk management persists, and an OTD model that genuinely transfers and disperses credit risk still promises greater financial stability.
A sponsor securitizes USD 600 million of loans and retains 5 percent as a horizontal first-loss piece. Pool losses are USD 45 million. How much does the sponsor lose, and what would it lose with a vertical slice instead?
Show answer
The horizontal piece is wiped out, because the pool losses exceed it, while the vertical holder loses only its 5 percent share. Horizontal retention exposes the sponsor to the first losses, which is the stronger incentive to lend carefully.
Chapter Summary
- Credit risk transfer lets banks manage their core risk actively; the crisis showed the danger of misusing the tools rather than of the tools themselves.
- Guarantees, netting, margining, collateral, termination triggers and reassignment reduce exposure but cannot isolate or slice credit risk, and collateral can be wrong-way.
- Credit derivatives move credit risk without moving the asset; CDS, index CDS, CLNs, TRS and synthetic tranches each trade off precision, funding and complexity.
- CDS spreads price default risk continuously, turning credit risk into the market risk of credit risk; spread divided by one minus recovery approximates the implied default intensity.
- An SPV buys the sponsor’s pool and issues tranches; losses run from equity to mezzanine to senior, and subordination supports the senior rating.
- Originate-to-distribute removes credit, price and liquidity risk from originators and frees capital, at the cost of moral hazard.
- Before the crisis banks retained and concentrated securitized risk in leveraged conduits and SIVs, amid misaligned incentives, opacity, weak risk management and overreliance on ratings; AIG showed how CDS could concentrate counterparty risk.
- Simple, transparent products survived and CLOs revived; reforms brought CDS standardization, central clearing and 5 percent risk retention.
Frequently Asked Questions
What are credit risk transfer mechanisms?
Credit risk transfer mechanisms are ways for a lender to reduce or pass on the risk that borrowers default. They include traditional techniques such as guarantees, netting, margining, collateral and termination triggers; credit derivatives such as credit default swaps, credit-linked notes and total return swaps; and securitization, in which a pool of loans is sold to a special purpose vehicle that issues securities to investors.
How does a credit default swap transfer credit risk?
The protection buyer pays the protection seller a periodic premium, quoted as a spread on the notional amount. If the reference entity suffers a credit event, the seller pays the buyer the notional times one minus the recovery rate. The buyer keeps the underlying loan or bond, needs no funding and does not involve the borrower, but takes on counterparty risk to the seller.
What is a special purpose vehicle in securitization?
A special purpose vehicle is a separate legal entity set up by the sponsor to buy a pool of loans and issue the securities backed by it. Because the SPV owns the collateral and issues the securities, investors are exposed to the pool’s performance rather than to the sponsor, and the sponsor no longer bears the pool’s credit, price or liquidity risk.
What is the difference between buy-and-hold and originate-to-distribute?
Under buy-and-hold, a lender keeps the loans it makes and bears their credit, price and liquidity risk for life. Under originate-to-distribute, it pools the loans and sells them, with their risk, to investors through securitization, freeing capital and earning upfront fees. The drawback is moral hazard: a lender that will not bear the losses has weaker incentives to underwrite and monitor carefully.
What is wrong-way risk?
Wrong-way risk arises when the exposure to a counterparty, or the loss given its default, rises at the same time as its probability of default. A typical case is a producer that pledges its own output as collateral: a fall in the price of that output both weakens the borrower and reduces the value of the collateral.
What role did credit derivatives play in the 2007 to 2009 financial crisis?
The tools were not the main cause; the failings were in the securitization process and in how the instruments were used. Complex products such as CDOs-squared multiplied and hid subprime exposure, and CDS concentrated counterparty risk on a few large protection sellers, most visibly AIG, which received a Federal Reserve loan facility of up to USD 85 billion in September 2008. Single-name and index CDS markets themselves functioned relatively smoothly.
What is the 5 percent risk retention rule?
Rules finalized in 2014 under Section 941 of the Dodd-Frank Act require securitizers of asset-backed securities to retain at least 5 percent of the credit risk, without hedging or transferring it, so that they have skin in the game. The retained interest can be a vertical slice of every tranche, a horizontal first-loss piece or a combination. A 2018 court ruling exempted managers of open-market CLOs.
