Credit Derivatives Overview · Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/...

Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/ Paris 1

Credit Derivatives Overview

ICISA

Solvency II Expert Group

Paris, 19 November 2007

http://www.swissre.com/





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


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...


Structuring and transfer

Credit risks in the

capital market

Asset

Manager

Assets

Underwriter

Liabilities

Convergence

Convergence asset & liability management


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


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


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…”


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


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]


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...


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.


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.


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”


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


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)


Collateralized Debt Obligations Structure

David Rule, Bank of England, p. 4


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’


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)


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


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


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


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


Thank you for your attention!

Credit Derivatives Overview · Rob Lewis, Dirk Schäfer, Markus A. Eugster / November 19, 2007/...

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