FIN344: Credit Risk Management

Topic 7: Credit Derivatives and their Role in Credit Risk Management

Presented by Darren O’Connell

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Disclaimer

• The views expressed are those of the presenter,and may not reflect those of Kaplan OHE.

•Use of information contained in this presentationis at your own risk. The presenter recommendsyou seek independent professional advice priorto making any investment decisions.

• The information in this presentation is notintended as investment advice. The presenter isnot offering or making recommendations inrelation to securities or other financial orinvestment products.

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Subject & Topic learning outcomes

• On completion of this topic, students should be able to:

- Compare and contrast various financial instruments, in particular structured products

- Explain the credit risk implications of each of these products

- Understand the family structure of securitised assets and how they are valued

- Explain the structure of synthetic products and what advantages these offer investors and risk managers

- Discuss the market evolution of these products over the past decade

• This topic specifically addresses the following subject learning outcomes:

4. Evaluate credit derivatives and how they are used in a range of different scenarios.

5. Analyse a range of credit products.

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1.0 Credit Derivatives

• Credit derivatives (CDs) insure and protect against adverse

movements in the credit quality of the counterparties or borrowers.

• If a borrower defaults, the investor will suffer a loss on the investment.

• With CDs, losses suffered from a default will be offset by a

corresponding gain from the CD transaction.

• CDs offer lower transactions costs, quicker payment and greater

liquidity compared to a comparable product in the insurance market.

• CDs were initially invented to hedge an offsetting position in the

physical market, but now trading includes speculators which led to

CDs being a superior product to reducing credit risk compared to

traditional insurance.

• CDs are OTC products which are privately negotiated instruments and

thus lie somewhere between traditional credit insurance products and

exchange traded derivatives.

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Credit Derivatives (cont.)

• There are risks associated with using OTC CD contracts. These

include:

- Counterparties (the one offering the derivative);

- Liquidity (being unable to find a counterparties to offset the derivative

contract);

- Legal risk (the OTC CD contract may not be enforceable); and

- Valuation (CDs have many and varied valuation mechanisms which

make them hard to market or evaluate for two-way pricing).

• Most markets for derivatives assume risk neutrality and arbitrage

free conditions which may not necessarily exist for credit products

due to the unique bilateral situation between borrower and lender.

• By allowing credit risk to the freely traded, risk management of a

credit portfolio becomes far more flexible.

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Credit Derivatives (cont.)

• For valuation, CDs are classified into two main

categories:- Replication products: priced on the capacity to replicate a money

market transaction (e.g. Credit spread options).

- Default products: priced as a function of the exposure underlying the

security, the default probability of the reference asset, and the expected

recovery rate (e.g. Credit default swaps).

• Other classifications include protection-like products

(e.g. Credit default options); and exchange-like products

(e.g. Total return swaps).

• We consider a selection of credit derivatives in more

detail.

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1.1 Total Return Swaps (TRS)

• In a TRS, the buyer receives the

income and capital gain of a credit

asset.

• The TRS seller receives a set fee

from the buyer over the life of the

swap.

• If the price of the asset declines then

the buyer must compensate the

seller by the lost amount.

• The TRS allow the buyer to gain

exposure and benefit from a credit

asset without the ownership.

• The TRS is popular with hedge funds

because they get the benefit of a

large exposure with a minimal cash

outlay.

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1.2 Credit Default Swaps (CDSs)

• A CDS is a financial agreement that the seller compensates the buyer

(the creditor of the reference loan/bond) in the event of default (by the

debtor).

• The buyer makes a series of payments (a "fee" or "spread") to the

seller and receives a payoff if the loan defaults.

• This effectively removes the need for specific insurance and is cheaper.

• If ‘No Default’:

- The protection buyer pays quarterly to the seller until maturity.

• If ‘Default Occurs’:

- The protection seller pays par value of the bond to the buyer; and

- The buyer transfers ownership of the defaulted bond to the seller.

• Maturities range from one to ten years.

• CDS data can be used by third parties to monitor how the market views

credit risk of any entity on which a CDS is available, this is similar to

that provided by the Credit Rating Agencies.

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1.3 Credit Linked Notes (CLNs)• A CLN is a form of funded derivative

backed by a high quality asset such as

a US Treasury bond.

• It also contains an embedded credit

default swap allowing the transfer of

specific credit risk to investors.

• The note issuer is not obligated to

repay the debt is a specific event of

default occurs.

• CLNs pass the risk of specific default

onto investors willing to bear that risk

in return for higher rates of return.

• CLNs are issued by a SPV company

or trust, designed to offer investors par

value at maturity unless the referenced

entity defaults. In the case of default,

the investors receive a recovery rate.

• CLNs have been subject to fraud and

other malfeasance (e.g. Parmalat)

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2.0 Common Structured Products

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2.1 Collateralised Debt Obligations (CDOs)

• A CDO is an important class of ABS and MBS.

• Think of it as a promise to pay investors in a

pre-determined way, based on the cash flow

the CDO collects from the pool of bonds or

other assets it owns.

• It is sliced into "tranches“ based on credit

quality, which "catch" the cash flow of interest

and principal payments.

• If some loans default and the cash collected by

the CDO is insufficient to pay all of its investors,

those in the lowest tranches suffer losses first.

• The last to lose payment from default are the

safest, most senior tranches.

• Consequently interest rates and payments vary

by tranche with the safest tranches paying the

lowest rates of return and the lowest tranches

paying the highest rates - this compensates for

the risk of default across the tranches.

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2.2 Collateralised Loan Obligations (CLOs)

• Under a CLO payments from multiple business loans are pooled and

are passed on to different classes of investors in various tranches.

• The loans are multi-million dollar syndicated loan originated by a bank

which then discharges it off the balance sheet through a CLO.

• CLOs were “invented” to increase the liquidity of the investor pool

thereby lowering the cost of borrowing to businesses.

• They also allow for lower quality loans to exit the balance sheet (of a

bank) which then diverts capital into higher quality assets.

• A CLO consists of “tranches” which are layers of investments

differentiated by credit quality.

• The lowest class of investor bears the greatest risk of default but do, on

average, receive the highest rate of interest income.

• By pooling loans into tranches, diversifies risk and return in the one

vehicle.

• Firms with bad or no ratings can borrow cheaply through CLOs.

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2.3 Synthetic CDOs and CLOs

• Synthetic CDOs do not rely on the cash flows of the collateral asset

(e.g. Mortgage) pool.

• Instead, credit derivatives are used to link the performance of

securities issued by the SPV to the performance of some reference

pool of assets (e.g. An MBS index).

• There is no asset sale under a synthetic CDO, they stay on the

originator’s balance sheet;

• Such synthetic structures involve triggers based on:- Ratings distributions;

- Diversity scores;

- Collateral values;

- Losses;

- Defaults.

• These triggers are structural elements providing protection to note

holders, comparable to coverage tests.

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3.0 Market Observations

• Up to 2007 there was an

abundance of cheap money

available for financing all kinds

of assets.

• Too much money chasing too

few deals e.g. Subprime

mortgages.

• Investment grade CDOs

offered returns far greater than

other investment grade assets.

• For example, in 2006 BBB-

rated CDOs yielded up to 900

basis points above LIBOR or

about 13% return per annum.

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3.0 Market Observations

• During the GFC demand for CLOs

tumbled markedly from the Q1

2007 peak.

• During 2008 there were virtually

no new issues of CLOs.

• During 2012, the issuance of

CLOs has increased to around

US$55 billion, a level not seen

since Q2 2005.

• In 2013 alone this had increased

to $US82 billion last seen in Q4

2005.

• Whether CLO issuance will repeat

its 2007 performance remains to

be seen.

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4.0 Summary

• In this topic we considered credit derivatives and their

application to credit risk management.

• We examined a number of popular products such as- Total Return Swaps (TRS);

- Credit Default Swaps (CDS);

- Credit Linked Notes (CLN);

- Collateralised Debt Obligations (CDO);

- Collateralised Loan Obligations (CLO); and

- Synthetic CDOs and CLOs.

• We considered the growth in credit derivatives from 2006

and how the GFC impacted the need for credit protection.

• Topic 8 considers the management of credit risk on a

portfolio basis.

Thank you and good luck!