Case Analysis Report

On
First American Bank: Credit Default Swaps
Case Overview
It was April 2002, when Chris Kittal (Managing director at first American
Banks credit derivatives in Newyork City) received an urgent call from a
contact at Charles Bank International (CBI), CBI is a medium-sized bank
approached by one of its corporate clients in need of additional financial
funding. The client CapEx unlimited (CEU) a fast growing telecommunication
company has been one of the most loyal customers of the CBI since last five
years, as the company is facing a tough time due to the industry shakeout,
company needs money to overcome these circumstances and asked the
bank to lend them $50 million (to expand its network) additionally along with
existing $100 million loan. This doesnt sound much fascinating for both the
parties (Lender & borrower) because this increases the exposure of risk
(Default risk) for the CapEx and this will also be above the limit to give loan
to a single customer, whereas bank could get the higher interest charges but
the default risk was twofold, a threat for bank too, of not getting money
back. But bank did not have the option to deny the loan request immediately
because this could hurt their relationships with CapEx, so the bank had to
decide a way between, which could provide some cushion to bank as well, so
the bank called Kittal and he readily suggested them credit default swaps.
First American Bank had First American Credit Derivatives as an independent
business unit housed within first American structured products branch. The
group had expertise in risk management & financial engineering to provide
clients with risk management and investment products.
CapEx unlimited on the other hand had continuously upgraded and
expanded its infrastructure in order to keep pace with growing customer
demand, this is the reason they wish to borrow additional money from CBI.
Kittal suggested Credit Default Swaps to this situation because they were
simple and confidential and made the credit risk accessible to a broad range
of investors.

For this CBI would make a periodic fee payment to FAB in exchange for
receiving credit protection. Credit default swaps are more like a hedging tool,
which has a long position (Protection Seller) and short position (Protection
buyer). Protection buyer pays the fees to protection seller. Investor can also
specify the maturity of the Swaps.

Isolating Credit Risk:

As the risk is being transferred from CBI to FAB, so now Kittal needed all the
necessary information to isolate and value credit portion of CEU's risky debt.
If CEU received $50 million from CBI their long term debt became $5 billion,
but CBI wanted protection on additional $50 million only. Another matter of
concern was the rating of the CEUs publically traded debt, which was below
investment grade (with a B2 rating from Moodys). The coupon rate of this
new debt was 9.8% and a maturity of two years. CEUs existing debt had
average maturity of five years and a semi-annual coupon payment of $130
million, debt had a market value of $4.1 billion and average yield of 9.6%.
Keeping in view all the payments, risk returns & some limitations of Credit
default Swaps, now Kittal has to do a cost and benefit analysis of this option
to be decisive about the matter.
Q.no 1. What is Credit Default Swap? How does it work?
When a person have reference obligation i.e. corporate bond, municipal
bond, mortgage-back securities, credit risk ( inability to repay the coupon
and principal amount within specified time), wants to transfer the credit risk
to third party. In this case, The Credit Default Swap helps him, which is
bilateral contract between two parties in order to transfer the risk from one
party to another party. It is like insurance against a company defaulting on
its debt obligation. A person who wants to transfer the credit risk or buy the
credit default swap is called protection buyer and the other party is known as
protection seller.
When protection buyer got involve in CDS he periodically pays the protection
seller the pre-specified CDS fee/CDS spread which is some basis point on the
notional amount quarterly. When protection buyer bears the default on its
notional amount and only able to recover some portion of notional amount,
he stops the payment to the protection seller and give him the recovered

amount and in against the protection seller protect him by providing him his
full notional amount.

Q2. A) What is the probability of default for CEU?

From the given data in the exhibit 10(b) the probability that CEU will default
in its tenure of 2 years with the rating of Ba2 is 13.7% while the probability of
default in the 1st year is 6.23% and the probability that CEU defaults during
the second year (given it didnt default during the first) is 13.7% - 6.23%.
Therefore the survival rate is the difference of the 100% and the cumulative
default probability.
Q.no 2. B) What are expected cash flows for default Swaps?

The first table shows the expected cash flows in form of Expected
cost of default and expected payment of the principal of $1 and their
present value in order to determine current worth of the credit default
swap. The discount factor used in discounting the future cash flow is
the risk-free rate because as we wanted to calculate value on the basis
of the risk neutral cash flows.
While the second table shows the cash flows specifically related to
the CEU amount they want to borrow by following the same discount
factor the value is determined.
Q.no2 C). What discount rate should be used to discount expected
cash flows?
The discount factor which we have taken for discounting the expected future
cash flows is as follow:

These are calculated on the basis of the risk free rate as 4.5% (Discount rate)
by the formula as:
Discount factor=1/ (1+0.045) ^t
We have taken risk free rate for finding out the discount factor because with
this we assume CDS to be less risky as compared to the other hedging
securities and if we see the data given in exhibits the probability of survival
is high and probability of default is very low.

Q.No.3. Should FAB hold on the credit risk of CEU? How should Kittel
transfer this credit risk from FABs balance sheet?
Whether to keep or pass on the credit risk of CEU depend upon the risk
tolerance level of FAB and risk-adjusted return from keeping the credit risk of
CEU and from passing it to another party.
If FAB wants to keep the credit risk, it will receive the periodic fee for 2 years,
which is calculated in the previous question. To earn the periodic amount as
a fee FAB has to put aside an additional amount from his capital equal to
insured amount, which CBI gave to CEU. The more the additional capital they
put aside from their capital the more they can bear the risk and vice versa.
In order to determine the risk-adjusted return, FAB should calculate the
return after keeping the credit risk of CEU and calculate the return on the
same amount, which they put aside to keep the credit risk by investing it in
any other source. If the return generated via keeping the credit risk is more
than investing the same amount elsewhere, then going towards keeping the
credit risk is suitable option.
If FAB do not want to keep the credit risk, it can pass it to any third party like
Hedge Funds or Low-rated Banks, via credit default swap contract, which
keep safe the FAB from Defaulting. However, this method has a problem

because when the protection seller has a low rated credit worthiness, this
means they might default even before completion of contract. Here the CBI
has default risk from two parties first default risk of CEU and the default risk
of FAB, because FAB is entering via contract with low-rated banks, which has
high chances of default. So in order to protect himself from default FAB
needs to find a way, which is more attracted than default swap.
So issuing a credit-linked note is the best option to attract the investors
(swap buyers), because it is a funded credit derivative that has embedded
credit default swap. CNL (it is like the securitization mechanism) enable the
FAB to transfer its credit risk to investors (who purchase the notes) via note
and receive the money from them and gives them the yield, which FAB
receives from CDS.

Submitted
Date:
Roma
02/12/2016
Ruqaiya Kalhoro
Arslan Khan
Syed Shams Uddin

By:
Israni