AF 4322 MANAGEMENT OF FINANCIAL INSTITUTIONS

Managing credit risk using credit derivatives & problems with the credit default swaps markets

Learning Objectives

Credit risk transfer using credit derivatives. The features of the following common credit derivatives: CDS, CLN, CDO and TRS. How these credit derivatives are used either for hedging or participating (speculating) credit risk. The problems with the CDS markets.

Readings

This Powerpoint notes.

Lee, A. & Law, E.(2003). Credit risk transfer using derivatives and implications for financial market functioning, HKMA Research Memorandum, December. (focus on p2-4 only) Fortune (2008). The $55 trillion question, October 13, p57-60.
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Credit Derivatives

Credit derivatives are a relatively new derivative offering payoffs based on changes in credit conditions along a variety of dimensions. Almost nonexistent twenty years ago, the notional amount of credit derivatives today is in trillions of dollars. We discuss the most popular credit derivatives used in the market: credit default swaps, credit linked notes, synthetic collateralized debt obligation and total return swaps.
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Credit Risk Transfer Using Credit Derivatives

Facilitates the transfer of credit risk without trading the underlying assets that give rise to credit exposures. Initiated by parties who may or may not own the underlying assets. Allow either full or partial credit protection under specified circumstances for the protection buyer.
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Definition of Credit event

Settlement of credit derivatives are usually initiated by the occurrence of some pre-defined credit events. Examples of credit events: Failure or credit rating downgrading of the reference entity / security / indexetc. Bankruptcy Obligation default Restructuring Repudiation/moratorium

Credit Derivative Instruments

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Credit default swaps (CDSs) Credit linked notes (CLNs) Synthetic collateralized debt obligations (CDOs) Total return swap (TRS)
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2.

3.

4.

1. Credit default swaps (CDSs)

Credit default swaps involve one party who wants to hedge credit risk to pay a fixed payment (premium) on a regular basis, in return for a contingent payment that is triggered by a credit event. Counterparty agreement

Allows the transfer of third party credit risk from one party (protection buyer) to the other (protection seller)

Protection buyer pays premiums regularly in return for credit risk protection and protection seller receives the regular premiums and takes up the credit risk (similar to insurance business).
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1. Credit default swaps (CDSs)

It is unfunded in nature in that the protection seller does not have to provide upfront funding at the initiation of the CDS. When a credit event happens, the CDS will be settled according to pre-determined arrangement. Existence of counterparty risk of protection seller

It is because CDS is unfunded in nature, protection buyer faces the counterparty risk of the protection seller in that the seller may not be able to meet the obligation to settle the CDS when needed.

1. Credit default swaps (CDSs)

Premium

Protection buyer

Protection seller

Contingent payment in case the specified credit event occurs

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2. Credit linked notes (CLNs)

Regular coupon paying note

CLN is just a kind of coupon paying note with a higher yield offered and issued by the protection buyer. The protection seller of the CLN makes an upfront payment in buying the CLN and in return receives periodic coupon payments and principal at maturity if no credit event occurs. When a credit event occurs, the protection seller is either delivered the reference security which has defaulted (physical settlement) or paid a net settlement amount equal to the market price of the asset, but in this case, the protection seller faces the counterparty risk of the protection buyer..

Funded in nature

Physical or cash settlement

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2. Credit linked notes (CLNs)

CLN proceeds Issuer of CLN (protection buyer) Principal + coupon On credit event occurrence: cash / physical settlement less unwind costs Investor (protection seller)

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3. Synthetic collateralized debt obligations (CDOs)

Reduced the counterparty credit risk of both the protection buyer and seller by setting up a SPV that are at least partly backed by the collateral securities. The SPV makes a CDS with the protection buyer. The SPV issues CDOs to the protection seller and invests the proceeds in high-quality bonds and asset-backed securities.
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3. Synthetic collateralized debt obligations (CDOs)

The protection seller receive the return on the collateral and the premium on the CDS the SPV sells to the protection buyer. In case the credit event occurs, the payment to the protection buyer will take priority over that to the protection seller, thereby reducing the principals and / or the interest payments to the investors.

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3. Synthetic collateralized debt obligations (CDOs)

CDO proceeds CDO proceeds

High quality securities

Risk-free cashflow CDS premium

SPVprotection seller Interest+principal

CDS settlement

Investorsend-seller

Protection buyer

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4. Total Return Swap (TRS)

A bilateral financial contract designed to exchange cash flows related to the return of a reference asset. Protection buyer agrees to pay the protection seller the total return of a defined underlying asset. In return, the protection buyer receives a stream of LIBOR-based cash flows. TRS is importantly distinct from a CDS in that it exchanges the total economic performance of a specified asset for another cash flow irrespective of whether a credit event has occurred.

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4. Total Return Swaps (TRS)

Returns from coupons and gains due to changes of market value of the reference obligation
TR payer (Protection buyer) TR receiver (Protection seller)

LIBOR + margin + losses due to changes of market value of the reference obligation

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Problems with the CDS Markets

Mainly OTC transactions between FIs which were mostly unregulated. Instead of using CDS for managing credit risk, many participants used CDS for speculative purposes. CDS became popular speculative tools because of the easiness of entering into a CDS agreement.

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Problems with the CDS Markets

CDS buyers are not required to own the underlying default risky assets (naked CDS). Usually no cash upfront requirement for the CDS sellers. As a result, CDS markets became the worlds largest casino before the financial crisis.

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Problems with the CDS Markets

Counterparty risk of CDS seller exists for the CDS buyer but no idea of CDS sellers exposure to CDS due to non-transparency of CDS transactions.

The problem with AIG reflected that credit risk was not diversified across different CDS sellers.

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Problems with the CDS Markets

Similarly, many CDS sellers did not have sufficient capital to support their exposure to CDS and default of CDS sellers would induce a domino effect within the financial system. US commercial banks believed that credit risk could be transferred away through CDS which in turn encouraged their more aggressive lending activities such as in subprime mortgages.
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