Traditional Credit Risk Mitigation

• Banks have traditionally had several ways to reduce their exposure to credit risk – both on an individual name and an aggregate basis. Such credit protection techniques include
  • Purchasing insurance from a third-party guarantor/underwriter – When done on an individual obligor basis, this is termed a guarantee.
  • Netting of exposures to counterparties – This is done by looking at the difference between the asset and liability values for each counterparty and having in place documentation saying that these exposures can be netted against each other.
  • Marking-to-market/margining – This entails having an agreement in place among counterparties to periodically revalue a position and transfer any net value change between the counterparties so that the net exposure is minimized.
  • Requiring collateral be posted – Collateral can offset credit losses in the event of default. It is important to note that there are instances when the circumstances precipitating the default could negatively impact the value of the collateral. For example, with an oil company offering barrels of crude as collateral, the probability of the company defaulting increases as the price of oil falls (this is known as wrong-way risk).
  • Termination/Put option – At inception, the counterparties agree to a set of trigger events that, if realized, would require the unwinding of the position using a predetermined methodology (often the mid-market valuation). In the case of a put option, the lender has the right to force early termination at a pre-determined price
  • Reassignment of a credit exposure to another party in the event of some predefined trigger (e.g., a ratings downgrade).
  • Syndication and the secondary market – For larger loan transactions, banks syndicate loans to disperse the credit risk incurred through large transactions. Banks can also sell off the loans they originate (or own) in the secondary market. In these cases, the lead bank originates the transaction and makes arrangements to distribute the deal among a larger group of investors. For these efforts, the bank earns a percentage fee. Typically, the lead bank will hold about 20% of the loan for its own book. There are two basic types of syndicate arrangements: firm commitment and best efforts. With firm commitments, the banks guarantee the obligor will receive a set dollar amount and any failure of the bank to recruit additional investors will result in the bank taking a larger portion of the loan onto its own books. For best efforts, the amount raised is based on how well the bank does in generating interest in the deal, and there is no guarantee that the target amount will be raised. Syndicated loans form the backbone of the secondary market for bank loans, as the originating bank is obligated to ensure the ability of investors to trade the loan after initial distribution. As the secondary market (as well as the market for credit derivatives) has grown, pricing has become more transparent, and liquidity has increased.

Credit Derivatives

• Credit derivatives are financial contracts that allow parties to minimize their exposure to credit risk by transferring the credit risk of the underlying portfolio from one party to another party without having to transfer the underlying portfolio. These bilateral OTC contracts are generally negotiable and privately held between two parties. Effectively, these allow the creditor to transfer some or all of the risk of the debtor’s default to a third party. This third party charges a fee or premium to accept the risk.
• Hence, credit derivatives are instruments whose value is derived from the credit risk on an underlying portfolio (usually containing bonds, loans etc.). Their value depends on the creditworthiness or a credit event experienced by the party referenced in the contract. Generally, a credit event is a) failure to make a required payment b) restructuring that makes any creditor worse off c) invocation of cross-default clause d) bankruptcy. Generally, the required payment or the amount defaulted will have to exceed a minimum value (e.g., $10 million) for the credit event to occur.

Types Of Credit Derivatives

• Various types of credit derivatives include –
  • Credit default swaps (CDSs)
  • First-to-default puts
  • Collateralized debt obligations (CDOs) and Collateralized loan obligations (CLOs)
  • Total return swaps (TRS)
  • Credit spread options
  • Credit-linked notes (CLNs)

Credit Default Swaps

• • With a credit default swap (CDS), party A makes a fixed annual payment to party B, while party B pays the amount lost if a credit event occurs. Credit default swaps can be thought of as insurance against the default of some underlying instrument or as a put option on the underlying instrument. A typical CDS is shown in the following figure

• • The party selling the credit risk (or the “protection buyer”) makes periodic payments to the “protection seller” of a negotiated number of basis points times the notional amount of the underlying bond or loan.
  • The party buying the credit risk (or the protection seller) makes no payment unless the issuer of the underlying bond or loan defaults or there is an equivalent credit event. Under these circumstances, the protection seller pays the protection buyer a default payment equal to the notional amount minus a prespecified recovery factor.
  • Since a credit event, usually a default, triggers the payment, this event should be clearly defined in the contract to avoid any litigation when the contract is settled. Default swaps normally contain a “materiality clause” requiring that the change in credit status be validated by third party evidence.
• Advantages of CDSs are –
  • They result in more liquidity and access to capital becomes easy.
  • Improve market information and help in price discovery of credit risk.
  • They absorb shock and can sometimes prevent a systemic crisis.
• Disadvantages of CDSs are –
  • They can create a false sense of security, especially when CDS contracts are manipulated.
  • Occasionally, speculative trading in CDSs can increase the CDS premium which may push away investors.
  • Some default events are difficult to define and some are difficult to price, even if correctly defined.
  • They can lead to moral hazard problems.
  • Before 2007, their regulation was quite weak.

First To Default Puts

• • A variant of the credit default swap is the first-to-default put, as illustrated in the example in the following figure. Here, the bank holds a portfolio of four high-yield loans rated B, each with a nominal value of $100 million, a maturity of five years, and an annual coupon of LIBOR plus 200 basis points (bp).

• In such deals, the loans are often chosen such that their default correlations are very small, i.e., there is a very low probability at the time the deal is struck that more than one loan will default over the time until the expiration of the put in, say, two years. A first-to-default put gives the bank the opportunity to reduce its credit risk exposure – it will automatically be compensated if one of the loans in the pool of four loans defaults at any time during the two-year period. If more than one loan defaults during this period, the bank is compensated only for the first loan that defaults.
• If default events are assumed to be uncorrelated, the probability that the dealer (protection seller) will have to compensate the bank by paying it par—that is, $100 million—and receiving the defaulted loan is the sum of the default probabilities, or 4 percent. This is approximately, at the time, the probability of default of a loan rated B for which the default spread was 400 bp, or a cost of 100 bp per loan.
• In such a deal, a bank may choose to protect itself over a two-year period even though the loans might have a maturity of five years.

Collateralized Debt Obligations

• Collateralized debt obligations (CDOs) are structured products created by banks to lessen the burden of credit risk as they act as a tool for shifting risk and freeing up capital. To create a CDO, first, an investment bank collects assets which generate cash flows, e.g. bonds, mortgages, and other types of debt. Then, they repackage and slice them into different classes, (tranches) based on the level of credit risk assumed by the investor. Finally, they are sold to investor groups having different risk appetites.
• As a result of the prioritization scheme (also known as the “waterfall”) used in the distribution of cash flows to the tranche holders, the most senior tranches are far safer than the average asset in the underlying pool. Senior tranches are protected from default risk up to the point where credit losses deplete the more junior tranches. Losses on the mortgage loan pool are first applied to the most junior tranche until the principal balance of that tranche is completely exhausted. Then losses are allocated to the most junior tranche remaining, and so on.
• Senior tranches are usually rated higher than junior tranches, because they are safer, but they offer lower coupon rates. Conversely, junior tranches offer higher coupons to compensate for their greater risk of default. And as they are riskier, they will have lower credit ratings.
• Advantages of CDOs are –
  • Funds can be freed up by banks by selling CDOs and those funds can be loaned out to other customers.
  • CDOs can consider the different risk tolerance levels of different kinds of investors.
  • Higher turnover of loans leads to higher profit potential.
  • CDOs help banks to convert relatively illiquid securities (individual bonds or loans) into more liquid ones.
  • CDOs help in direct transfer of risk.
  • CDOs have flexible tenures.
• Disadvantages of CDOs are –
  • CDOs can be highly complex to understand.
  • CDOs can lead to increased risk-taking and relaxed lending standards.
  • CDOs can concentrate exposure to high-risk borrowers.
  • Too much liquidity resulting from CDOs can create real estate asset bubbles.
  • Debt grows quickly in the market.
  • Sometimes, panic in the market can lead to loss of liquidity and drop in values of CDOs.

Collateralized Loan Obligations

• Collateralized loan obligations (CLOs) are similar to collateralized debt obligations, where the underlying portfolio does not include mortgages but mainly bank loans. With a CLO, the investors receive scheduled debt payments from the underlying loans, and they take on most of the risk in case of default by the borrowers (i.e. when borrowers fail to make payments on a loan for an extended period of time). In exchange for taking on this default risk, the investors get the benefit of diversification and a potential for higher returns.
• A typical CLO might consist of a pool of assets containing, say, 50 loans with an average rating of, say, B1 (Moody’s rating system). These might have exposure to, say, 20 industries, with no industry concentration exceeding, say, 8 percent. The largest concentration by issuer might be kept to, say, under 4 percent of the portfolio’s value.
• CLOs also use a waterfall structure like CDOs to distribute cash flows.
• CLOs have similar advantages and disadvantages as CDOs.

Total Return Swaps

• Total return swaps (TRSs) mirror the return on some underlying instrument, such as a bond, a loan, or a portfolio of bonds and/or loans. The benefits of TRSs are similar to those of CDSs, except that for a TRS, in contrast to a CDS, both market and credit risk are transferred from the seller to the buyer
• TRSs can be applied to any type of security like floating-rate notes, coupon bonds, stocks, or baskets of stocks. For most TRSs, the maturity of the swap is much shorter than the maturity of the underlying assets, for example, 3 to 5 years as opposed to a maturity of 10 to 15 years.
• The purchaser of a TRS (the total return receiver) receives the cash flows and benefits (pays the losses) if the value of the reference asset rises (falls). The purchaser is synthetically long the underlying asset during the life of the swap.
• In a typical deal, like shown in the figure in the next page, the purchaser of the TRS makes periodic floating payments, often tied to LIBOR. The party selling the risk makes periodic payments to the purchaser, and these are tied to the total return of some underlying asset (including both coupon payments and the change in value of the instruments). Since in most cases it is difficult to mark-to-market the underlying loans, the change in value is passed through at the maturity of the TRS. Even at this point, it may be difficult to estimate the economic value of the loans, which may still not be close to maturity. This is why in many deals the buyer is required to take delivery of the underlying loans at a price, which is the initial value. At time T, the buyer should receive if this amount is positive and pay otherwise. By taking delivery of the loans at their market value, the buyer makes a net payment to the bank of in exchange for the loans
• A total return swap is equivalent to a synthetic long position in the underlying asset for the buyer. It allows for any degree of leverage, and therefore it offers unlimited upside and downside potential. It involves no exchange of principal, no legal change of ownership, and no voting rights.
• In order to hedge both the market risk and the credit risk of the underlying assets of the TRS, a bank that sells a TRS typically buys the underlying assets. The bank is then exposed only to the risk of default of the buyer in the total return swap transaction. This risk will itself depend on the degree of leverage adopted in the transaction.
  • If the buyer fully collateralizes the underlying instrument, then there is no risk of default and the floating payment should correspond to the bank’s funding cost.
  • If, on the contrary, the buyer leverages its position, say, 10 times by putting aside 10 percent of the initial value of the underlying instrument as collateral, then the floating payment is the sum of the funding cost and a spread. This corresponds to the default premium and compensates the bank for its credit exposure with regard to the TRS purchaser.

Credit Spread Options

• Credit spread options are option trading strategies which involve the purchase of one option and the sale of a second similar option with a different strike price. This strategy is framed such that the premiums received are greater than premiums paid.
• Exchanging two options of the same class and expiration transfers credit risk from one party to another. An initial premium is paid by the buyer in exchange for potential cash flows if a given credit spread changes from its current level. This means that credit spreads result in positive cash flows to the investor when the position is first established.

Credit Linked Notes

• • An asset-backed credit-linked note (CLN) embeds a default swap in a security such as a medium-term note (MTN). Therefore, a CLN is a debt obligation with a coupon and redemption that are tied to the performance of a bond or loan, or to the performance of government debt. It is an on-balance-sheet instrument, with exchange of principal; there is no legal change of ownership of the underlying assets.
  • Unlike a TRS, a CLN is a tangible asset and may be leveraged by a multiple of 10. Since there are no margin calls, it offers its investors limited downside and unlimited upside. Some CLNs can obtain a rating that is consistent with an investment-grade rating from agencies such as Fitch, Moody’s, or S&P.

• This figure presents a typical CLN structure where $105 million of non-investment-grade loans with an average rating of B, yielding an aggregate LIBOR + 250 bp, are purchased by the bank at a cost of LIBOR, which is the funding rate for the bank. The bank buys the assets and locks them into a trust. The trust issues an asset-backed note for $15 million, which is bought by the investor. The proceeds are invested in U.S. government securities, which are assumed to yield 6.5 percent and are used to collateralize the basket of loans. The collateral in our example is 15/105= 14.3 percent of the initial value of the loan portfolio. This represents a leverage multiple of 105/15=7
• The net cash flow for the bank is 100 bp, that is, LIBOR + 250 bp (produced by the assets in the trust) minus the LIBOR cost of funding the assets minus the 150 bp paid out by the bank to the trust. This 100 bp applies to a notional amount of $105 million and is the bank’s compensation for retaining the risk of default of the asset portfolio above and beyond $15 million.
• The investor receives a yield of 17 percent (i.e., 6.5 percent from the collateral of $15 million, plus 150 bp on a notional amount of $105 million) on a notional amount of $15 million, along with any change in the value of the loan portfolio that is eventually passed to the investor.
• In this structure, there are no margin calls, and the maximum downside for the investor is the initial investment of $15 million. If the fall in the value of the loan portfolio is greater than $15 million, then the investor defaults and the bank absorbs any additional loss beyond that limit. For the investor, this is the equivalent of being long a credit default swap written by the bank.

Usefulness Of Credit Derivatives And Risk Transfer

• Credit derivatives are off-balance sheet instruments that facilitate the transfer of credit risk between two counterparties without having to sell the given position.
• Credit derivatives permit the isolation of credit risk and transfers that risk without incurring any funding or client management issues. They are to credit what interest rate and foreign exchange derivatives were to market risk.
• Risk transfer and securitization enables institutions to effectively tailor pools of credit-risk exposures by facilitating the sale and repackaging of risk. Securitization is also a key source for funding consumer and corporate lending.
• When properly executed in a robust, liquid, and transparent market, credit derivatives contribute to the process of credit price discovery (i.e., they clarify and quantify the market value). In addition to putting a number to the default risk incurred by many large corporations, CDS prices also offer a means to monitor default risks in real time. Improvements in price discovery will eventually lead to enhanced liquidity, along with a more efficient market pricing of credit spreads for the full spectrum of instruments with credit risk exposure.

The Mechanics Of Securitization

• Securitization 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 buy-and-hold strategy. The securitization process is illustrated in this figure

• • The securitization process begins with the creation of a corporation called a special purpose vehicle (SPV). The SPV then purchases loan portfolios from several banks to create investment products. SPVs are mainly funded by several classes of bonds, arranged by seniority and/or credit rating, along with a relatively small equity tranche. This equity tranche, which is the most junior tranche, will usually provide less than 10% of an SPV’s total funding.

• The trend toward securitization began in 1968 with the birth of the Government National Mortgage Association (GNMA, also known as Ginnie Mae). Consumer ABSs in the United States and residential mortgage-backed securities (RMBS) in the U.K. emerged in the 1980s. The 1990s saw the development of commercial mortgage-backed securities (CMBS) in the United States Between 2000 and 2007, there was a surge in the issuance of very complex, risky, and opaque CDOs in the U.S. private label securitization market, which finally resulted in the great financial crisis.

From Buy-And-Hold To Originate-To-Distribute

• Traditionally, banks used to source a loan and then retain it on their balance sheets. They got periodic interest payments to compensate for holding the credit risk of these loans.
• Financial innovation like securitization has enabled financial institutions to shift their investment behavior from buy-and-hold to originate-to-distribute (OTD), where the originator of a loan sells it to various third parties. Starting in the 1980s, certain banking activities shifted from the traditional buy-and-hold strategy to this new OTD business model. Credit risk that would have once been retained by banks on their balance sheets was sold, along with the associated cash flows, to investors in the form of ABSs and similar investment products. In part, the banking industry’s enthusiasm for the OTD model was driven by the Basel capital adequacy requirements. Accounting and regulatory standards also tended to encourage banks to focus on generating the upfront commissions associated with the securitization process.
• The shift toward the OTD business model seemed to offer the financial services industry many benefits.
  • Originators benefited from greater capital efficiency and enhanced funding opportunities, as well as lower earnings volatility (at least in the short term), because the OTD model seemingly dispersed credit risk and interest rate risk across many market players.
  • Investors benefited from a wider array of investments, allowing them to diversify their portfolios and better sync their risk/return profiles with their goals and preferences.
  • Borrowers benefited from the expansion of available credit and product options, as well as from the lower borrowing costs resulting from these benefits.
• However, benefits of the OTD model progressively eroded as risks accumulated in the years leading up to the financial crisis. Risks of the OTD model can be understood by observing the following issues during the great financial crisis –
  • • The OTD model created moral hazard by lowering the incentives for lenders to monitor the creditworthiness of borrowers, and few safeguards were in place to offset this moral hazard.
    • There were misaligned incentives along the securitization chain, driven by the pursuit of short-term profits. This was the case among many originators, organizers, managers, and distributors. Investor oversight was weakened by complacency, as market growth beckoned many to “let the good times roll.”
    • The risks embedded in securitized products were not transparent. Investors had difficulty assessing the quality of the underlying assets and the potential correlations between them.
    • There was poor securitization risk management, particularly regarding the identification, assessment, handling and stress testing of market, liquidity, concentration, and pipeline risks.
    • There was an overreliance on the accuracy and transparency of credit ratings. This was problematic because rating agencies failed to adequately review the granular data underlying securitized transactions and underestimated the risks of subprime CDO structuring.

  

Securitization And The Financial Crisis

• Credit derivatives had many challenges.
  • Counterparties need to understand the following –
    • exact nature of the risks being transferred,
    • definition of a “credit event”,
    • liabilities in case of credit events.
  • Since there are less number of credit derivative providers, even one of the providers being in distress can lead to market-wide distress. This is systemic concentration risk.
• The trading volume as well as the value of credit derivatives began to fall with the fall in housing prices in 2007. Banks had a huge amount of mortgage risk on their books, and their health suffered when the value of the mortgage-backed securities decreased significantly.
• Banks themselves had played a role in worsening this situation. Leading up to the financial crisis, banks deviated from the OTD business model by taking up the role of the investors rather than acting solely as intermediaries, many banks took on. Risks that should have been broadly dispersed under the OTD model were instead concentrated in entities mainly established to avoid mandatory capital requirements.

• Banks also misjudged the risks (e.g., reputation risk) contained in the commitments made to investors. They falsely assumed that there would be a substantial ongoing access to liquidity funding and that markets in these assets would be sufficiently liquid to support securitization.
• Firms that were selling their credit exposures found themselves retaining a growing pipeline of credit risk. Furthermore, they did not adequately measure and manage the risks that would materialize if assets could not be sold. Significant liquidity and maturity mismatches started to develop, which made the system vulnerable.
• The main factors that exacerbated these weaknesses included bank leverage, faulty origination practices, and concentration risk resulting from the fact that many financial firms chose to retain (rather than fully transfer) the credit risk embedded in the securities they originated.
• The Fed’s management of the federal funds rate also had a negative influence on the crisis. This rate was increased from 2004 to 2006. This time period coincided with rate reset dates on adjustable-rate mortgages. This meant that housing prices home prices were falling at the same time when they had to make more payments.

Securitization And The Financial Crisis – Regulatory Response

• The Dodd-Frank Wall Street Reform Act of 2009 was created to address regulatory issues, which allowed the situation to worsen before the financial crisis. The Volcker rule which was a part of this act prohibited commercial (depository) banks from proprietary trading and from investing in derivatives (i.e., CDSs). It also required that the Commodity Futures Trading Commission (CFTC) should regulate all swap contracts, including CDSs.
• The Securities and Exchange Commission, in conjunction with U.S. federal banking regulators, finalized Section 15G of the Securities and Exchange Act in 2014.
  • This imposed risk retention provisions on asset-backed securities, including CLOs. Specifically, the rules require securitizers to retain, without recourse to risk transfer or mitigation, at least 5% of the credit risk.
  • These provisions were designed to align securitizers’ interests with those of investors, requiring the former to “have skin in the game.”