Post on 15-Jul-2020
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 1
Credit Derivatives Overview
ICISA
Solvency II Expert Group
Paris, 19 November 2007
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 2
Today’s Agenda
Credit Markets & Products
Credit Derivatives
Definition, Categories, Characteristics
Collateralized Loan / Debt Obligations (CDO/CLO)
Comparison of Credit Risk Transfer Instruments
Credit Derivatives vs Credit Insurance
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 3
Credit Market Fragmentation
BankInsurance
Capital
markets
• Credit derivatives unite areas
that were previously separated
• Illiquid credits become
tradable
• Synthetic risk transfer possible
• Credit risk can be acquired
and transferred via capital
markets
The market distinctions for types of credit protection
are fading...
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 4
Structuring and transfer
Credit risks in the
capital market
Asset
Manager
Assets
Underwriter
Liabilities
Convergence
Convergence asset & liability management
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 5
Credit products overview
Typical
Products
Commercial and Investment Banks
Commercial and Investment Banks
Capital Markets
Solutions
Credit
Derivatives
Credit Default
Swap
Total Return
Swap
Synthetic
CDOs
Credit Linked
Notes
Cash CDOs
RMBS
CMBS
ABCP
Hybrid
Derivatives
Asset Backed
Securities
Insurance Markets
Solutions
Surety
Construction,
Supply, Customs,
Performance,
Bonds
Trade Credit
Insurance
Export Credit
Insurance
Financial
Guarantee
Credit
Insurance
Specialized
Surety Cos,
and Multilines
Monolines
Multilines
Credit
Insurance
Companies
Large
Construction
Companies
Large
Companies
Small and
Mid-Sized
Companies
Performance
Bond
Letter of
Credit
Factoring
CDS
LoC
ABCP Progr.
Typical
Provider
Typical
Client
Banking
Substitute
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 6
Credit Risk Transfer Instruments Characteristics
AccountingRisk transfer, CRM,
claims handling
Risk transfer,
3rd party substitution
Lower financing cost,
balance sheet mgnt
Capital and risk
management
Financing,
Risk transfer
Motivation
Trade
Receivables
Contract
Obligations
T/R, Mortgages,
Bonds, ABS etc.
Corporate Loans
& bonds
Corporate
Bonds, CLO etc.
Underlying Assets
Insurance
policy
Surety
Bond
Payment
Bond/Ins. Policy
Swap
Investment
Instrument
3 - 6m
1 – 5 y
1–30 y
< 5 y
< 30 y
No
No
No
Yes
Yes
Book
Value
Book
Value
Book
Value
MTM
Fair
Value
Tenor Traded
Default (protracted,
insolvency)
Non-performance &
Bankruptcy
Default (non-payment
to insolvency)
Negotiated ISDA
Triggers
Default/Negotiated
ISDA Triggers
Loss Trigger
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 7
Credit Derivatives• Highly efficient instrument allowing to isolate credit risk and make it tradable
under a standardised documentation framework (ISDA).
• Most prominent capital market instrument over the last decade which gained
high level attention of regulators, analysts, and rating agencies.
• Main concerns related to transparency and the potential impact on the stability
of the international financial system stemming from the transfer of credit risk
from the banking to the insurance industry.
• IMF GFSR, April 2004, p. 103: … The reallocation of credit risk to insurers
that has already taken place, improvements in risk management, and the
recovery in equity markets have reduced vulnerabilities and enhanced
financial stability…”
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 8
How does a Credit Default Swap really work?
Protection
buyer
Protection
seller
Fee/Premium
Contingent
payment
Risk transfer
Reference
entity
Trading/sales
relationships
A credit default swap transfers the
credit risk of a company (“reference
entity”) from one entity (“the protection
buyer”) to another entity (the
” protection seller” )
In return the buyer pays a fee to seller
Settlement and payment of the swap is
triggered by a credit event of the
reference entity
Settlement closes the swap contract
Most transactions are governed by
standardized legal documentation
drafted by the International Swaps
and Derivatives Association (ISDA)
Mark-to-market derivatives
accounting applies
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 9
ISDA 2003 Credit Events
Bankruptcy
Failure to Pay, [Grace Period Extension Applicable, Grace Period, Payment Requirement][3]
Obligation Default
Obligation Acceleration
Repudiation/Moratorium
Restructuring [Restructuring Maturity Limitation and Fully Transferable Obligation,
Modified Restructuring Maturity Limitation and Conditionally Transferable Obligation,
Multiple Holder Obligation, Default Requirement][7]
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 10
When is a buyer compensated?
• A buyer is compensated (“the swap is settled”) when a predefined “credit
event” occurs on the reference entity
• Contrary to an insurance policy, the payment is not triggered by an actual loss
incurred by the buyer and the buyer does not need to demonstrate that it lost
money to receive payment
• There are typically three main credit events covered:
– Bankruptcy of the reference entity
– Failure to pay borrowed money obligations
– Restructuring of borrowed money obligations e.g., extension of maturity,
increase of spread...
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 11
Settlement of a contract: how much money
does a buyer receive?
• The settlement mechanism is fixed upon inception of the
contract
• Three main mechanisms:
– Physical settlement
– Cash settlement
– Digital: both parties agree in advance to the amount to
be paid upon occurrence of a credit event. Typically
100% of the notional amount. Not used very often.
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 12
Physical settlement
Protection
buyer
Protection
sellerPhysical delivery of a bond or a loan
$10 million
Credit default swap:
Reference entity: XYZ Corp.
$10 million - 2 years
Physical settlement requires the buyer to deliver to the seller an asset, such
as a loan or a bond, typically any unsecured bond or loan. In exchange, the
protection buyer will receive the notional amount of the contract. Typical for
inter-bank trades.
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 13
Cash settlement
Protection
buyer
Protection
seller
$4 million
Credit default swap:
Reference entity: XYZ Corp.
$10 million - 2 years
Reference obligation Bond
XYZ 5¼ due 2005
Cash settlement: the protection buyer receives a payment reflecting the
difference between the notional amount of the contract and the market
value of a specific asset (a loan or a bond) called the “reference
obligation”
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 14
Risks associated with credit derivatives
• Credit Risk
– Reference entity for protection sellers
– Counterparty credit risk for production buyers
• Legal risk
– Occurrence of credit events are not always crystal clear
– Valuation
• Market risk (pricing and MTM valuation)
• Basis risk for protection buyers
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 15
A CDS is not an Insurance Contract!
• Protection buyer does not need to hold the asset
• Protection buyer does not need to have a loss to get
compensated
• Standardized documentation (ISDA) vs. tailor made
insurance contracts
• Evidence of loss is based on publicly available data (no
proof of loss from protection buyer)
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 16
Collateralized Debt Obligations Structure
David Rule, Bank of England, p. 4
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 17
Active CRT market participants
• Banks (balance sheet and conduits), Trading
houses
– entire capital structure, cash & synthetic
• Traditional CRT providers
– insurance companies (active credit risk
takers) such as monolines, specialized
multilines, and reinsurers
– mainly synthetic
• Asset managers
– institutional investors, insurance companies
(passive credit risk takers)
– mainly cash, move into synthetic
• Hedge funds, Specialized Asset managers
– mainly cash, move into synthetic
Investment Grade
Mezzanine (BBB-AAA)
Non-Investment GradeMezzanine (BB)
Equity
not rated
Super Senior
‘S-AAA’
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 18
Credit Insurance versus Credit Derivatives (I)
Credit Default Swap Credit Insurance
• No standard wording,
depending on local
jurisdiction
• illiquid
• insurance for specific
delivery of goods
• insured determines
jurisdiction
• insured is required to hold
risk / needs to prove actual
loss
• ISDA Master Agreement as
basis & confirmation (highly
standardised for single names)
• tradable
• reference entity (no relation
to specific transaction)
• predominantly US and UK law
• no requirement to actually
hold the asset (arbitrage
potential)
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 19
Credit Insurance versus Credit Derivatives (II)
Credit Default Swap Credit Insurance
• Credit event notification by
protection seller as well
• Payment following evidence
of credit event (materiality
clause no longer practice)
• Payment after 10 to 150 days
following credit event
notification
• Publicly available
information on credit event
• Subrogation only in case of
physical settlement
• Insurer can not influence
timing of loss notification
• Payment only upon evidence
of loss provided by insured
• Payment after waiting period
• Private credit event & loss
payment
• Subrogation as standard
characteristics of credit
insurance
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 20
Regulator’s View I
How does a credit derivative differ from credit insurance?
A credit derivative, like credit insurance, is a contract that is designed to transfer credit risk from one party to
another. Credit risk is the possibility that a debtor will default on financial claims due to an inability
or unwillingness to pay. Despite their similarity of purpose, a credit derivative differs from an
insurance contract in two significant ways:
Utmost good faith. In an insurance contract, both parties are subject to a duty of ‘utmost good faith’ that requires
pre-contractual disclosure of all facts material to the risk being insured. Under a derivatives contract,
by contrast, the terms are caveat emptor (let the buyer beware).
Insurable interest. Insurance policies indemnify the insured against its losses following an event. For the
transaction to be a valid insurance contract under English law, the insured must have an economic
exposure to the event (‘insurable interest’). For some credit derivatives, it would be possible to show
that the protection buyer has such an interest. In other cases, however, the protection buyer may have
no insurable interest.
FSA, p. 4
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 21
Regulator’s View II
Why are insurers active participants in the credit derivatives market? There are several reasons:
An insurance or reinsurance company may be underexposed to certain industries or geographic
areas. Writing default protection or, when needed, buying protection using credit default swaps
allows insurers to diversify their exposures.
During a soft insurance market, insurers can shift capital to the credit derivatives market in pursuit of
better returns.
The P/C exposure of large insurance and reinsurance companies is more diversified than the
financial risks of banks. Hence, the economic capital (amount financial institutions need to reserve)
of insurers is lower than banks. This translates into a lower cost of capital for insurance companies.
Many reinsurance companies have AA or AAA ratings. Credit protection buyers prefer purchasing
this coverage from highly rated financial institutions.
Credit insurers and their reinsurers have long offered credit protection products such as credit
insurance and financial guarantees that are very similar to credit derivatives. These companies can
leverage this experience to market and price credit derivatives.
Since credit default swaps and credit insurance are substitutes for trade credit management
instruments, several credit insurers and reinsurers have entered the credit derivatives market for
strategic reasons. By combining derivatives and tradition insurance, credit insurers can structure
deals that serve their clients better than those offered by banks, which can only offer credit
derivatives.
FSA, p. 5
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 22
Sources
The credit derivatives market: its development and possible implications for financial
stability, David Rule, G10 Financial Surveillance Division, Bank of England, June 2001
Credit Risk Transfer, Basel Committee on Banking Supervision, The Joint Forum, March
2005
European Central Bank, CREDIT RISK TRANSFER BY EU BANKS: ACTIVITIES,
RISKS AND RISK MANAGEMENT, MAY 2004
Morgan Stanley, Credit Derivatives Insights, 2007 Outlook – If You Build It, Will They
Come?, December 2006
FSA, Position paper on cross-sector credit risk transfers, May 2002
Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 23
Thank you for your attention!