Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives [1 ed.] 9783836608428, 9783836658423

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Diplomarbeit ISBN: 978-3-8366-0842-8

Harald Seemann

Applications of Credit Derivatives

Copyright © 2008. Diplomica Verlag. All rights reserved.

Opportunities and Risks involved in Credit Derivatives

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Harald Seemann Applications of Credit Derivatives Opportunities and Risks involved in Credit Derivatives ISBN: 978-3-8366-0842-8 Druck Diplomica® Verlag GmbH, Hamburg, 2008 Zugl. Fachhochschule Regensburg, Regensburg, Deutschland, Diplomarbeit, 2007

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Applications of Credit Derivatives Table of Contents

Page

Illustration Index...................................................................................................................... 3 Table Index ............................................................................................................................... 4 Abbreviation Index .................................................................................................................. 5 Index of Appendices ................................................................................................................. 5 1. Current Issue ........................................................................................................................ 7 1.1. Purpose of the thesis........................................................................................................ 9 1.2. Structure of the thesis.................................................................................................... 10 2. Credit Risk Management - Foundations.......................................................................... 11 2.1. Credit Risk versus Market Risk .................................................................................... 11 2.2. Impacts of Basel II ........................................................................................................ 12 2.3. Classification and Evolution of Credit Derivatives....................................................... 13 2.4. Main Types of Credit Derivatives................................................................................. 15 2.4.1. Total Return Swap.................................................................................................. 16 2.4.2. Credit Default Swap ............................................................................................... 17 2.4.2.1. Variations of Credit Default Swaps ................................................................ 18 2.4.3. Credit Linked Notes – Rationale............................................................................ 19 2.4.3.1. Collaterized Debt Obligation .......................................................................... 21 2.4.3.2. Synthetic Collaterized Debt Obligation .......................................................... 22 2.5. Contract Characteristics ................................................................................................ 24 2.5.1. Reference Asset...................................................................................................... 24 2.5.2. Risk Premium......................................................................................................... 25 2.5.3. Credit Event............................................................................................................ 26

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2.5.4. Recovery Rate ........................................................................................................ 29 2.5.5. Forms of Default Payment ..................................................................................... 32 2.5.5.1. Cash Settlement............................................................................................... 32 2.5.5.2. Physical Settlement ......................................................................................... 32 2.6. Standardized Documentation ........................................................................................ 33 2.6.1. International Swaps and Derivatives Association.................................................. 33 2.7. Succession of CDS Reference Entities.......................................................................... 35

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

3. Applications of Credit Derivatives.................................................................................... 37 3.1. Portfolio Diversification................................................................................................ 37 3.2. Short Positioning ........................................................................................................... 37 3.3. Concentration Risk........................................................................................................ 38 3.4. Hedging ......................................................................................................................... 43 3.4.1. Distressed Buyer .................................................................................................... 43 3.4.2. Vendor Financing................................................................................................... 44 3.4.3. Leasing Exposure ................................................................................................... 45 3.4.4. Managing Funding Cost Risk................................................................................. 46 3.4.5. Synthetic Debt Repurchase .................................................................................... 48 3.5. Basics of Target Profiles ............................................................................................... 49 3.5.1. Cash Bonds versus Synthetic Securitization .......................................................... 49 3.6. Regulatory Arbitrage..................................................................................................... 50 4. Pricing of Credit Derivatives............................................................................................. 53 4.1. Firm Value Model ......................................................................................................... 54 4.1.1. Valuation Approach ............................................................................................... 55 4.1.2. Advantages and Disadvantages of the Firm Value Model..................................... 59 4.1.3. Moody’s KMV Risk Management Tools today..................................................... 60 4.1.4. Equity Prices and Bankruptcy ................................................................................ 61 4.2. Market Pricing Model for Credit Correlation Products ................................................ 62 4.2.1. 100% Credit Default Correlation ........................................................................... 65 4.2.2. -100% Credit Default Correlation .......................................................................... 66 4.2.3. 0% Credit Default Correlation ............................................................................... 67 4.2.4. Findings from Default Correlation Analysis.......................................................... 68 4.3. Credit Rating Transition Models................................................................................... 69 4.3.1. Valuation Approach ............................................................................................... 69 4.3.2. Advantages and Disadvantages of Credit Rating Transition Models .................... 71 Copyright © 2008. Diplomica Verlag. All rights reserved.

5. Evaluation of Credit Derivatives ...................................................................................... 73 5.1. Opportunities and Risks involved in Credit Derivatives............................................... 73 5.2. Role and Responsibility of Regulators.......................................................................... 77 5.3. Credit Derivatives in the Global Credit Markets .......................................................... 78 Bibliography ........................................................................................................................... 81

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Illustration Index

Illustration 1: Global Credit Derivatives Market Growth .......................................................... 8 Illustration 2: Most common product types among Credit Derivatives ................................... 15 Illustration 3: Funded structure of a Total Return Swap.......................................................... 16 Illustration 4: Graphical illustration of a Credit Default Swap ................................................ 18 Illustration 5: Synthetic Collaterized Debt Obligation............................................................. 23 Illustration 6: Cash Flows without a Credit Event ................................................................... 29 Illustration 7: Cash Flows with Credit Event (Physical Settlement)........................................ 29 Illustration 8: Example for Succession of CDS Reference Entities ......................................... 36 Illustration 9: Nokia raises funds and hedges credit risk of the Algerian operator .................. 44 Illustration 10: Elad Properties monetizes the lease - sale of its credit risk on Rite Aid ......... 45 Illustration 11: Example of Synthetic Debt Repurchase from Wal-Mart................................. 48 Illustration 12: Distribution of terminal firm value at maturity of debt ................................... 58 Illustration 13: Global Loan Defaults from 1996 to 2005........................................................ 62 Illustration 14: Global Bond Defaults from 1996 to 2005 ....................................................... 62 Illustration 15: Default Realization in a Venn diagram ........................................................... 64 Illustration 16: 100% Credit Default Correlation..................................................................... 65 Illustration 17: -100% Credit Default Correlation ................................................................... 66

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Illustration 18: 0% Credit Default Correlation......................................................................... 68

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Table Index Table 1: Classification and Evolution of Credit Derivatives ................................................... 13 Table 2: Example of a Reference Asset ................................................................................... 24 Table 3: Average Recovery Rates by Industry......................................................................... 31 Table 4: An example of the effect of diversification on portfolio credit risk .......................... 41 Table 5: 5-year Funding Levels ............................................................................................... 44 Table 6: Credit spread structure of Continental for different maturities.................................. 46 Table 7: Balance sheet CDO introduction................................................................................ 50 Table 8: CDO Capital Structure ............................................................................................... 51 Table 9: Regulatory Capital Position before CDO Transaction............................................... 51 Table 10: Regulatory Capital Position in a Traditional CDO .................................................. 51 Table 11: Regulatory Capital Position in a Synthetic CDO..................................................... 51 Table 12: Balance sheet CDO Net Capital Savings ................................................................. 52 Table 13: Ongoing Benefit each year from Traditional and Synthetic CDOs ......................... 52 Table 14: Balance Sheet CDO Return on Capital .................................................................... 52 Table 15: Simplified Example of Firm Value Model .............................................................. 56 Table 16: EDF versus Ratings agency default measures ......................................................... 56 Table 17: Comparison of Credit Default Swap and Equity Default Swap............................... 61 Table 18: Nth-to-default basket vs. Synthetic CDO ................................................................ 63 Table 19: Sample Basket for a Credit Correlation Product...................................................... 64 Table 20: Cumulative default probabilities in percent from 1970 - 2003 by Moody’s ........... 70

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Table 21: Marginal default probabilities in percent from 1970 - 2003 by Moody’s ............... 70

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Abbreviation Index BCBS

Basel Committee on Banking Supervision

BIS

Bank for International Settlements

CDO

Collaterized Debt Obligation

CDS

Credit Default Swap

CLN

Credit Linked Note

EAD

Exposure at Default

EDF

Expected Default Frequency

EDS

Equity Default Swap

FSA

Financial Services Authority in the United Kingdom

IAS

International Accounting Standards

IRB

Internal Rating Based

ISDA

International Swaps and Derivatives Association

KDB

Korean Development Bank

LBO

Leveraged Buyout

LGD

Loss Given Default

LIBOR

London Interbank Offered Rate

MTM

Mark To Market

OECD

Organisation for Economic Co-operation and Development

OTC

Over The Counter

PD

Probability of Default

RoC

Return on Capital

SPV

Special Purpose Vehicle

S&P

Standard & Poor’s

VaR

Value at Risk

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Index of Appendices Appendix 1: ISDA’s Risk Management Activities………………………………………….. 86 Appendix 2: EXHIBIT A to 2003 ISDA Credit Derivatives Definitions………………….... 88

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

1. Current Issue The traditional bank credit is a central business activity of financial institutions1. Globalization and the dispersion of large companies have lead to fierce competition in terms of capital market financings versus classical credit financings. This scenario has increased product innovation tremendously. As a consequence of rising credit defaults and failed evaluation of default probabilities during various crises in the past, banks have created an attractive field of profit to trade credit risks based on a pooled portfolio or on single credits: the credit derivatives market. It allows trading of credit risks between various parties, ranging from commercial banks, asset managers, insurance companies, investment banks and hedge funds to corporations. Credit derivatives are financial instruments which allow the splitting and transfer of credit risk without influencing the original credit relationship between the credit originator and the credit borrower. Credit derivative deals can be negotiated between the counterparts and transfer only the defined credit risk against payment of a certain risk premium. A risk seller, the party seeking credit risk protection, may want to reduce exposures while maintaining relationships that may be endangered by selling their loans, reduce or diversify illiquid exposures, or reduce exposures while avoiding adverse tax or accounting treatment. A risk buyer, the party assuming credit risk, may want to diversify credit exposures, get access to credit markets which are otherwise restricted by corporate statute or which are off-limits by regulation, or simply exploit arbitrage pricing discrepancies. For example, arbitrage opportunities in the credit derivatives market result from perceived mispricings between bank loans and subordinated debt of the same issuer. At first sight, credit derivatives offer attractive benefits to the counterparts involved. The transfer of credit risk against a premium makes credit markets more efficient, facilitates credit offerings from banks to young start ups and supports economic growth and innovation. Copyright © 2008. Diplomica Verlag. All rights reserved.

Concentration risk can be avoided easily. Compared to bonds, for which companies have to fulfil huge amounts of regulation documents, credit derivatives do not require long approvals. Deals are completed directly between counterparts over the counter (OTC) or in cooperation with the major players in this market. The legal frame for this market is still underdeveloped and transactions cannot always be fully tracked by legal authorities. This explains the explosive growth of the credit derivatives 1

See Brealey, Richard A. and Myers, Stewart C. – Principles of Corporate Finance, 8th edition New York (McGraw-Hill/Irwin) 2005, Pages 725 – 736

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

market: the current volume amounts to more than 20.2 trillion US-Dollars2 on aggregated terms. Since 2006, the relative size of the credit derivatives market is higher than the corporate bonds market.3 Illustration 1: Global Credit Derivatives Market Growth4

It is interesting to note that the credit derivatives market has tripled in the span of a few years. Efficient execution and risk management systems as well as high liquidity and easy accessibility allow market participants to trade credit protection whenever they need it. The application of credit derivatives reaches a constantly growing target. Hedge funds have become a major force in the credit derivatives market; their share of volume in both buying and selling credit protection has almost doubled since 2004. Banks constitute the majority of market share and almost two-thirds of the volume in credit derivatives by banks is due to

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trading and a third is related to their loan book only.5 2

See British Banker’s Association, Credit Derivatives Report 2006 Page 3: (http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf Consulted on 14/04/2007) 3 Salas, Caroline – Around The Markets: Technology transforms Bond Market, International Herald Tribune, 10/05/2006: (http://www.iht.com/articles/2006/05/09/bloomberg/bxatm.php Consulted on 28/03/2007) 4 Source: British Banker’s Association, Credit Derivatives Report 2006 Page 3 - Credit Derivatives Products in 2006 (http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf Consulted on 15/04/2007) 5 See British Banker’s Association, Credit Derivatives Report 2006 Pages 4 - 5 (http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf Consulted on 15/04/2007)

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Asset managers sometimes prefer to take a certain credit view of a company in which they see an opportunity for profit. This is another way to participate in the upside potential rather than investing directly in the stock. Another macroeconomic factor explains the explosive growth of the credit derivatives market as well: the attractive interest rates. This makes money cheap and avoids credit defaults. The impact of rising interest rates could lead to a decrease in the dynamics of this market.

1.1. Purpose of the thesis The purpose of this thesis is to give a general introduction to the credit derivatives market and its instruments. The analytical focus will be about the business fields where credit derivatives are applied. This work aims to analyze the usage of credit derivatives in economic life and describes the different financial players who are involved in those deals. Explanations for certain decisions and credit views are presented. The reader should get a better understanding of these complex financial structures and their importance for businesses, banks and the overall global financial system. The pricing of such pooled financial structures is not as simple as the pricing of a stock or a bond; therefore selected pricing models are presented with the intention to show all the different factors which determine credit spreads and finally the price of a credit derivative. The thesis concludes with an evaluation of this young, but highly dynamic market, including the role and responsibility of regulators. Opportunities and threats are outlined, so that the reader is able to draw an opinion about these modern financial

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instruments.

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

1.2. Structure of the thesis This study begins with a general introduction to the credit derivatives market and gives arguments for the growth catalysts which have driven the development to the current state. The financial participants in this market are presented as well. A comparison between market risk and credit risk follows to show the clear transition that helped credit risk to become an asset class. After that, a link to the recent Basel II guidelines is established in order to show the policies that banks have to consider when trading with credit risk. Chapter 2 deals with the historical evolution of credit derivatives and classifies different structures. A presentation of the main types of credit derivatives and their contract elements follow; these are mainly credit default swaps (CDS) and collaterized debt obligations (CDO). Chapter 2 also deals with definitions of a credit event and the calculation of risk premiums. Forms of default payment illustrate the possible settlement of a credit derivative contract. Afterwards, an account of the International Swaps and Derivatives Association (ISDA) is presented. This association serves as a supplier of standardized documentation to all market participants and facilitates transactions. Chapter 3 is the key element of this thesis and shows the applications of credit derivatives: they serve as portfolio diversifiers for asset managers, hedging instruments for banks or corporations and offer arbitrage possibilities for hedge funds and other institutions that monitor mispricings in bond and credit markets. This part delivers essential information for the final evaluation of such instruments from a practical point of view in Chapter 5. In Chapter 4, the thesis covers the most important pricing tools for credit derivatives. Three generally accepted and widely used models are presented and evaluated concerning their suitability for various parties. These models vary greatly. Recently, a German governmental organization has set a standard evaluation system in place; whereas multinational investment banks form their own capacities in house or through joint ventures. An efficient valuation system gives market participants a major competitive advantage because they can observe default probabilities on an ongoing basis under changing market conditions. Copyright © 2008. Diplomica Verlag. All rights reserved.

Chapter 5 deals with an evaluation of credit derivatives from a practical point of view and discusses the opportunities and risks involved in credit derivatives. The author concludes with a critical evaluation about the role and responsibility of regulators in this market and a view on the current situation of the global credit markets.

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

2. Credit Risk Management - Foundations 2.1. Credit Risk versus Market Risk Until the early 1990s, credit and market risk were two different functions within a bank and had different evaluation methods. Banks are financial intermediaries originating loans and consequently facing credit risk. Credit risk6 can be defined as the risk of losses caused by the default or by the deterioration in credit quality of a borrower. Default occurs when a borrower cannot meet key financial obligations to pay principal and interest. Banks increasingly recognize the need to measure and manage the credit risk of the loans they have originated; not only on a loan-by-loan basis but also on a portfolio basis. A pre-condition for diversification after the origination of the loans is their transferability. It is well-known that transferring credit risk of loans is difficult due to severe adverse selection and ethical issues. For this reason the use of existing tools like loan sales has not been very successful in transferring the credit risk on a broad scale. However, in recent years, the developments of markets for credit securitization and credit derivatives have provided new tools for managing credit risk. Credit derivatives are often described as “synthetic loans“, which reflects their common use and enormous potential. More broadly defined, credit derivatives7 are sophisticated financial instruments that enable the unbundling of credit risk from the credit originator and allow easier intermediation of credit due the separation of the risks involved in such a transaction. Market risk8 is the risk that the value of an investment will decrease due to moves in market conditions. The four standard market risk factors are: •

Equity risk, or the risk that stock prices will change

•

Interest rate risk, or the risk that interest rates will change

•

Currency risk, or the risk that foreign exchange rates will change

•

Commodity risk, or the risk that commodity prices (i.e. grains, metals, etc.) will change

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Market risk is typically measured using a Value at Risk (VaR) methodology.9 Market risk can also be contrasted with specific risk, which measures the risk of a decrease in an investment due to a change in a specific industry or sector, as opposed to a market-wide move. Value at 6

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 1 – 5 7 See Chris Francis, Atish K., Barnaby M. - Merill Lynch Credit Derivative Handbook, London 2003, Page 3 8 See Joshi, Mark - The Concepts and Practice of Mathematical Finance, 5th edition Cambridge (Cambridge University Press) 2005, Pages 1-15; Brealey, Richard A. and Myers, Stewart C. – Principles of Corporate Finance, 8th edition New York (McGraw-Hill/Irwin) 2005, Pages 127 - 136 9 See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 128 and 135

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Risk calculates the maximum loss expected (or worst case scenario) on an investment, over a given time period and given a specified degree of confidence. Traditionally, credit and market risk had to be distinguished from one to the other, because credit risk was often based on party-specific factors related to corporate finance while market risk also covered macroeconomic events. Credit derivatives allow investors to trade credit risk in very much the same way as market risk. 2.2. Impacts of Basel II In 1988, Basel I was the first big step towards efficient credit risk management. If a bank lends to a company, it has to hold a minimum of 8% in equity for every loan. Basel I made the credit risk specification dependent on the counterparty.10 The amount of regulatory capital that had to be held against counterparts for the purchase of e.g. a government bond favoured Organisation for Economic Co-operation and Development (OECD) members. There was a weakness in Basel I as countries like Turkey (member of the OECD, credit rating BB) had a risk weighting of 0%, while countries like Singapore (not a member of the OECD, credit rating AAA) had a risk weighting of 100%. Even if Singapore had a good credit rating, it would have been expensive to purchase government bonds from this country due to the equity requirement. In a world of shareholder value, a bank has to minimize equity to increase its return. Only the purchase or sale of protection from OECD governments and banks was a good hedge. Emerging countries like Singapore, Hong Kong, China or India which became part of a well-diversified global credit portfolio were not considered. In June 2004, the Basel Committee on Banking Supervision issued the long-awaited “International Convergence of Capital Measurement and Capital Standards: a Revised Framework” describing changes to the regulatory capital requirements for banks. These changes are known as the New Basel Capital Accord, or more commonly as “Basel II.” The new accord, under discussion since June 1999, has been designed to replace the 1988 Basel accord with a more risk-sensitive set of regulations. A key element of the new accord is Copyright © 2008. Diplomica Verlag. All rights reserved.

greater reliance on the internal rating systems of the banks in the calculation of regulatory capital charges.11 Basel II was adopted by most banking regulators in 2007. The Internal Rating Based (IRB) approach can only be adopted with regulatory approval and the new

10

See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, page 352 11 See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, page 357

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

standardized approach says that the counterparty risk weighting is based on the entity type and entity rating. Consequently, the major international banks will choose the IRB approach while smaller commercial banks are likely to take the standardized approach. Hence there are two constituencies that have different capital requirements for the same position. A possible impact of Basel II could be the transfer of sub-investment grade assets from IRB to standardized approach using institutions. Based on this fact, a future issue of Basel II will be if risk in commercial banks increases inadvertently or not.12 Additionally, banks are able to minimize regulatory capital through an efficient structuring of balance sheet Collaterized Debt Obligations (CDOs). An explanation of this approach will follow in detail when it comes to Chapter 3.6. “Regulatory Arbitrage”. 2.3. Classification and Evolution of Credit Derivatives Table 1: Classification and Evolution of Credit Derivatives13 Credit Event Options Æ

Forwards Æ

Swaps Æ

Structured Notes

Changes in

Credit Spread

Credit Spread

Credit Spread

Credit Linked Note /

Credit

Option

Forward

Swap / Total

Collaterized Debt Obligation

Return Swaps

Spread Default

Credit Default

Credit Default Credit Linked Note /

Option

Swap

Collaterized Debt Obligation

Table 1 displays the main types of credit derivatives. When the market in credit derivatives emerged, the first structures were similar to call and put-options on the underlying credit, in Copyright © 2008. Diplomica Verlag. All rights reserved.

which the buyer would wager on a certain market movement of the underlying reference asset. Credit spread products exist in two ways; first relative to the benchmark (absolute spread) and second between two credit sensitive assets (relative spread). A change in market value or credit rating could be beneficial or not. Call options on credit spreads would benefit from a decreasing spread, while put options on credit spreads would benefit from an increase 12

See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, page 357 13 Table created by the author

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

in the spread. The same accounts for possible default events. In a credit default option, investors can wager on the fact if one entity defaults ahead of another. Structurally, credit spread forwards and credit spread swaps are very similar. They are both structured as a forward rate agreement where at maturity of the contract, there is a net cash settlement based on the difference between the agreed spread and the actual spread. This shows that forwards have a linear payoff profile while options have a non-linear payoff format. The main applications of credit spread derivatives are: •

To benefit from relative credit value changes independent of changes in interest rates

•

To trade forward credit spread expectations

•

To trade the volatility of credit spreads

Due to the enormous evolution of the credit derivatives market, product innovation never stops and the trend has gone towards swap and structured note products. As stated above, they account for the major market share and are the most important instruments for dealers and investors. For this reason, option and forward products will not be discussed in this thesis.

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The focus lies on swaps and structured notes linked to credit.

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

2.4. Main Types of Credit Derivatives The credit derivatives market is dominated by two major instruments: The Credit Default Swap (CDS) and the Synthetic Collaterized Debt Obligation (CDO). These two types represent approximately 50% of the market volume.14 Synthetic CDOs derive from CDSs and are often pooled so that they can be offered to investors on a portfolio basis to diversify risk. Not only the size of the credit derivatives market has grown rapidly but also product innovation has moved forward quickly. Examples of heavily traded products are e.g. index trades, tranched index trades15 and equity-linked products. These simple structures account for approximately 40% of the market volume.

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Illustration 2: Most common product types among Credit Derivatives16

14

See British Banker’s Association, Credit Derivatives Report 2006 Page 4 (http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf Consulted on 15/04/2007) 15 Tranched index trades derive from an index, but just comprise certain parts in it 16 Source: British Banker’s Association - Credit Derivatives Products in 2006, Credit Derivatives Report 2006 Page 4 (http://www.bba.org.uk/content/1/c4/76/71/Credit_derivative_report_2006_exec_summary.pdf Consulted on 15/04/2007)

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

2.4.1. Total Return Swap A total return swap aims to replicate the total performance of a loan asset17 and is a way to pass on changes in credit spreads. The motivation from the viewpoint of the dealer is to get rid of an asset without entering into a transaction that might upset the borrower, while the investor seeks to leverage his return in the underlying bond. Illustration 3: Funded structure of a Total Return Swap18 Libor + Margin Dealer (=bank)

Investor (=another bank)

Bond interest Bond price changes

Libor Bond from company

Cash investment of bond’s nominal value (money market)

•

Most total return swap transactions are on traded bonds and loans as security

•

The final investor assumes all risk and cash flow of the underlying asset and has to pay the funding cost for this return

•

The dealer has to pass through all the interest payments of the asset to the investor

Since bonds are traded and are subject to price fluctuations over their lifetime, the dealer has to pay out the investor if the bond trades above par value or the investor has to compensate the dealer when the bond trades below par. This payoff mechanism is determined at specific dates over the life of the transaction based on the current market value of the underlying asset. The investor has to pay the money market return plus a margin as funding cost. This serves to adjust the return to the purchaser of the underlying bond or loan asset. The final investor does Copyright © 2008. Diplomica Verlag. All rights reserved.

not own the bond. This enables the investor to fully fund the structure by investing the cash of the underlying asset in a money market instrument in order to match payments to the dealer. If the swap maturity matches the one of the reference asset, it is simply a synthetic version of the asset that allows the dealer to go long or short without funding. Total return swaps exist in funded and unfunded structures. 17

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 8 - 9 18 Source: Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Page 10

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

2.4.2. Credit Default Swap Credit Default Swaps (CDSs) have proved to be one of the most successful financial innovations of the 1990s. Prior to credit derivatives, investors relied on insurance policies to hedge against losses.19 The structure of insurance policies is similar to CDSs but there are some differences. Insurance policies require an underlying insurable interest and actual loss, while CDSs do not have such a requirement. Credit protection can be bought in both cases: the buyer has risk exposure to the underlying asset and can decide about a hedging strategy. Definition A Credit Default Swap (CDS) is an over the counter (OTC) agreement to transfer a defined credit risk from one party to another. The buyer of credit protection pays a periodic fee, most of the time a fixed rate including a premium over the current reference swap rate on the market in order to price the relevant default risk. This fixed rate protects the buyer against a “Credit Event” based on the financial status of the entity underlying the CDS contract. The seller of credit protection takes the credit risk and “bets” on a positive financial development of the underlying entity in the future and pays a floating rate to the protection buyer which is most of the time linked to the London Interbank Offered Rate (LIBOR). It is important to note that a CDS is not settled unless there is a credit event or the CDS reaches maturity. Market changes of the underlying credit are not taken into consideration. More concretely, this means that a CDS never transfers any price risk arising from a change in credit quality. In general, CDSs deal with the transfer of credit risk between counterparties because of different market views. They allow the unbundling of credit risk from other transactions so that credit risk can be traded separately. The sellers of credit protection do not need to be

Copyright © 2008. Diplomica Verlag. All rights reserved.

related to the business of the loan-taking company.

19

See Das, Satyajit, Traders, Guns & Money – Knowns and Unknowns in the Dazzling World of Derivatives, Dorchester (Financial Times Prentice Hall) 2006, Pages 271 - 273

17

Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Illustration 4: Graphical illustration of a Credit Default Swap20

Credit Default Swap

Periodic risk premium Credit Risk Seller

Credit Risk Seller Compensation or 0

Client relationship

Debtor

Synthetic Risk Position

2.4.2.1. Variations of Credit Default Swaps There are a number of variations of the standard credit default swap.21 The most common forms used in practice are: Binary Credit Default Swap The payoff in the event of a default corresponds to a specific dollar amount. This amount is determined at the establishment of the contract, depending on the severity of the default. Basket Credit Default Swap Here, a group of reference entities are specified and there is a payoff when the first of these reference entities defaults. Contingent Credit Default Swap The payoff requires two factors: A credit event and an additional trigger. The additional trigger could be a credit event with respect to another reference entity or a specified movement in some market variable. Copyright © 2008. Diplomica Verlag. All rights reserved.

Dynamic Credit Default Swap The notional amount determining the payoff is linked to the mark-to-market value of a portfolio of swaps.

20

Graph created by the author See Hull, John; White, Alan – Valuing Credit Default Swaps I: No counterparty default risk, Toronto (Joseph L. Rotman School of Management, University of Toronto, Canada), 2000, Page 4 (http://www.rotman.utoronto.ca/~hull/DownloadablePublications/CredDefSw1.pdf Consulted on 19/05/2007)

21

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Harald Seemann - Applications of Credit Derivatives

2.4.3. Credit Linked Notes – Rationale The size of the bond markets compared to the amount of existing credit risk shows a huge gap. Bond markets do not reveal all the credit risk. Even if bonds have always played an important role in funding activities of corporations, they were mainly accessible to large, rated issuers with considerable funding needs. Furthermore, bond markets are still dominated by government bonds, which limit exposure of a corporation to credit risk. Outside the major European and North American high yield markets, there is limited availability of bonds from non-investment grade issuers. This makes it difficult to create diversified investment portfolios. Credit risk can only be taken through the purchase or sale of a bond and is restricted to institutional market participants. The direct bond market does not provide investors with the ability to create structured exposure to credit risk which becomes an emerging need in a more and more complex financial world. Lack of liquidity and high transaction costs scare investors from investing in certain types of fixed income assets. Structuring of credit risk in credit linked notes helps to avoid this deficit. These circumstances drive investment interest in credit risk exposure. Furthermore, reduced government deficits in certain western countries (e.g. the United Kingdom, Australia and Canada) lead to a short supply of fixed income securities.22 This makes investors search for substitutions to the corporate bond universe. Credit risk has quickly gained recognition and is considered an asset class nowadays. The returns on credit risk are considerable and low correlation to other asset classes such as equities, real estate, currencies or commodities support portfolio diversification needs to achieve risk adjusted return on capital. Furthermore, credit risk offers different segments of volatility (credit spreads and actual default) and offers a full range of trading opportunities to active players like banks and financial institutions on the market. Credit linked notes offer significant benefits to investors. They enable investors to rate a Copyright © 2008. Diplomica Verlag. All rights reserved.

security based on the credit risk of both the issuer and the reference credit with an expected loss approach23. The rating of a credit linked note is derived from the probability of default and loss given default of the issuer and the defined reference entity of the credit linked note.

22

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Page 342 23 See Tzani, Rodanthy, Leibholz, Maria, Gregory, Jon (Editor) - Credit Derivatives: The Definitive Guide, 2nd edition London (Risk Books) 2003, Pages 440 - 447

19

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Harald Seemann - Applications of Credit Derivatives

Regulatory treatment of credit linked notes is not complicated for the issuers, because they fully cash collateralise against loss through default or a specified credit event. This means that there is no capital requirement for the issuer in respect of the counterparty risk of the seller of default protection. The seller of credit protection has to hold sufficient capital requirements

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against the higher risk carried party among the issuer and the underlying reference credit.

20

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Harald Seemann - Applications of Credit Derivatives

2.4.3.1. Collaterized Debt Obligation Collaterized Debt Obligations (CDOs) can basically be of two types: balance sheet CDOs and arbitrage CDOs24. Balance sheet CDOs are those which result in transfer of loans from the balance sheet and hence impact the balance sheet of the originator. Arbitrage CDOs are those in which the originator is merely a repackager, e.g. asset management companies: buying loans or bonds or asset backed securities from the market, pooling them together and securitizing the same. The prime objective in balance sheet CDOs is the reduction of regulatory capital and the enhancement of return on capital, while the evident purpose in arbitrage CDOs is making arbitraging profits from market inefficiencies25. When the assets yield more than structured liabilities plus fees, the arranger gets the arbitrage spread. Balance sheet CDOs can be further classified into cashflow CDOs and synthetic CDOs. Synthetic CDOs are the most common ones used as explained in detail in the following sections. Cashflow CDOs are the usual CDO tranches where the originating bank transfers a portfolio of loans into a Special Purpose Vehicle (SPV). Master trust structures are commonly employed in CDOs to enable the bank to keep transferring loans into the pool on a regular basis without having to do complex documentation every time. Commercial loans are not regular-repaying in the sense of mortgage loans or auto loans. Hence, there is no question of regular retirement of CDOs like pass troughs in the mortgage market. Most of the cash flow CDOs repay by way of bullet loans at the end of maturity. Synthetic CDOs do not intend to raise cash by transferring loans, but instead merely transfer the risk inherent in the loans. The first CDOs emerged in the late 1990s and were basically imitations of a mortgage-backed security structure with banks who had given out corporate loans26. Banks took their bonds and loans to corporate clients and sold them to a SPV; the SPV issued debt in the capital markets and the money raised was used to pay for the loans. It should be noted that the SPV belongs to the bank. It is an independent legal entity to facilitate the sale process to investors and unlike Copyright © 2008. Diplomica Verlag. All rights reserved.

a bank security, it is entirely unregulated because the loans are shifted outside the reach of regulators.

24

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 308 and 316 25 See Marmery, Nikki – The Reason to Issue, Credit Magazine May 2004: (http://www.creditmag.com/public/showPage.html?page=133178 Consulted on 02/04/2007) 26 See Das, Satyajit, Traders, Guns & Money – Knowns and Unknowns in the Dazzling World of Derivatives, Dorchester (Financial Times Prentice Hall) 2006, Pages 282 - 284

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Harald Seemann - Applications of Credit Derivatives

The SPV passed the CDOs in different risk tranches on to investors. Borrowers were not always satisfied with the shifting of their loans from one financial institution to another and so the banks searched for an efficient way to offer the portfolios of bonds and loans to investors while maintaining the original lender – borrower relationship and pooling the credit risk on loans and bonds. The idea of the modern synthetic securitization process of CDOs was born. The CDO consists of a portfolio of CDSs. More precisely, the bank does not sell its loans; instead it enters into a CDS on the loans with the SPV. Synthetic CDOs enable investors to repackage credit risk and apply leverage to a credit position. 2.4.3.2. Synthetic Collaterized Debt Obligation Synthetic CDOs allow investors to tailor their risk exposure to a large and diversified credit portfolio through different tranches of synthetic securitization. A synthetic CDO is an investment in which the underlying collateral is a portfolio of single-name credit default swaps.27 The SPV is an entity which owns loans indirectly on the one side and has equity, mezzanine28 and normal debt on the other side. These liabilities are issued in the form of multi-tranche credit linked notes (CLNs) with credit ratings from triple-A through non-rated equity. The funds collected from the investors are not used to purchase collateral, but to create a credit support account, and are usually invested in safe and liquid assets like government bonds to absorb losses in the case of a default on any of the reference assets. On a regular basis, the CDS premiums combined with the interest from the cash collateral account are paid to the investors according to a pre-defined priority of payments. Following a credit event, a trustee is expected to liquidate assets from the cash collateral account in an amount equal to the losses used to pay the protection buyers. This typically leads to a write-down of liability principal. For example, the first tranche to experience losses due to credit events is the equity tranche, then the mezzanine tranche (BBB-rated notes) and

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afterwards only the senior notes.

27

See Chris Francis, Atish Kakodkar, Barnaby Martin - Merill Lynch Credit Derivative Handbook, London 2003 Page 95 28 Mezzanine stands for subordinated debt and pays higher returns whilst standing in line after the senior note holders to be paid back if a default occurs

22

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Harald Seemann - Applications of Credit Derivatives

Illustration 5 shows an “unfunded” senior tranche of 800 million Euros in which investors do not put up cash, but are paid a premium to enter into a default swap with the SPV. This unfunded risk transfer creates a more efficient capital structure. For example if there are 100 firms with loans of 10 million Euros each in the portfolio, equity and mezzanine investors take the risk of the first seven firms out of the 100 in the portfolio to default.

Illustration 5: Synthetic Collaterized Debt Obligation29

Portfolio of CDSs with 1 billion Euros notional, 80% unfunded due to Super Senior debt (S-AAA rated)

Interest & Principal to Investors

CDS Premium

Credit Protection

Special Purpose Vehicle (SPV)

Proceeds of Issuance

Proceeds of Issuance and exposure to Credit Risk

Investment Income

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Credit Support Account

SENIOR Class AAA 50 Million Euro Class AA 40 Million Euro Class A40 Million Euro MEZZANINE Class BB+ 30 Million Euro Class BB20 Million Euro EQUITY 20 Million Euro

29

Source: Chris Francis, Atish Kakodkar, Barnaby Martin - Merill Lynch Credit Derivative Handbook, London 2003 Page 96

23

Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

2.5. Contract Characteristics In the following section, essential features of a credit derivative contract are presented, especially for CDS and CDO. Maturities in such contracts can vary; they last from 0.5 to 10 years. 2.5.1. Reference Asset A reference asset is the heart of a credit derivatives contract. First of all, the reference entity has to be defined. For a CDS, this can either be a company or a country. The full legal name of the entity has to be specified. Here are some examples: Countries •

Brazil: Federative Republic of Brazil

•

Uruguay: Oriental Republic of Uruguay

Companies •

Deutsche Bank AG, Frankfurt

•

Adidas-Salomon AG, Herzogenaurach

Secondly, the reference obligation has to be defined. This obligation specifies the position in the capital structure of the company or country

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Table 2: Example of a Reference Asset30 Issuer

ProSiebenSat.1 Media AG

Total nominal value

200.000.000 Euros

Coupon

11.25%

Maturity

31 July 2009

Nominal value

1.000 Euros

ISIN

XS0151428470

WKN

707328

Common Code

015142847

30

Source: Boerse Stuttgart (http://www.kbl.boersestuttgart.de/online/kb/list.php?node=227&emittentnr=&ORDER=s_umsatz_euro+DESC&tabledate=20050726 Consulted on 17/09/2007)

24

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Harald Seemann - Applications of Credit Derivatives

While a CDS usually consists of a bond or a loan, CDO assets can be more complicated. Since the tranche technology is transferable, a SPV can refer to any asset that can be modelled and has a rating. The possible asset classes in a CDO are as follows: •

Bonds

•

Loans

•

Aircraft Leases

•

Real Estate Leases

•

Real Estate

•

Credit Default Swaps

•

Asset-Backed-Securities

•

Project Finance Deals

•

Home loans

•

Mortgage-Backed-Securities

2.5.2. Risk Premium In exchange for the guarantee to the credit protection buyer, a risk premium has to be determined and paid to the credit protection seller. With options, such a premium is always paid at the beginning of a contract. In the case of a CDS, the risk premium is paid periodically, most of the time on a quarterly basis until a credit event happens or the CDS matures. The risk premium can also be called credit spread. Credit spreads are traded and constantly moving. In general, credit spreads are tight under good economic conditions and widen when more companies go bankrupt and the economy hits a phase of slow growth or even a recession. With a decrease in credit quality of the underlying reference entity, the protection buyer pays an increasing risk premium. This happens often in the form of an additional upfront fee. While bonds would directly decrease in value (“distressed bonds”), the higher risk premium

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has to be equalled through an upfront payment.

25

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Harald Seemann - Applications of Credit Derivatives

2.5.3. Credit Event The ISDA defines 5 different standard credit events31, but in reality there are many factors depending on the contract characteristics and external influence such as a rating downgrade below an agreed threshold or a merger, where no succession for the CDS is regulated in the contract. In general, credit events are caused through the following (ranked after severity of default): 1. Bankruptcy 2. Liquidity problems, no more equity. Failure to pay above a nominated threshold level after expiration of a specific grace period (3 - 5 business days) 3. Obligation default or obligation acceleration 4. Repudiation or moratorium 5. Restructuring Investors have to distinguish between sovereign and non-sovereign entities underlying the credit. Bankruptcy is less probable for sovereign entities; non-sovereign entities always face this risk, including liquidity problems or restructuring issues. In the case of sovereign entities, only some of the liabilities may be affected. Sometimes only foreign currency obligations from commercial lenders have to be served. 1. Bankruptcy Definitions of bankruptcy vary from country to country, but the overall understanding is clear. Bankruptcy usually does not happen from one day to another; normally long-term indicators show whether the business is in trouble or not. Insolvency proceedings depend on the jurisdiction of incorporation of the reference entity. In general, the credit event applies from that day on which the underlying entity communicates the insolvency proceeding in public. In emerging markets there are often severe deficits in bankruptcy legislation. The bankruptcy and insolvency laws may not be clearly defined.

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2. Liquidity problems If the reference entity cannot even meet a minimum payment requirement (which is usually one million US-Dollars), it is in serious liquidity trouble. This can be due to temporary problems with high interest rates or the inability of debtors to serve outstanding bills. Once a credit event has taken place, the CDS contract ends, even if the reference entity recovers later on from financial trouble. 31

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 77 - 85

26

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Harald Seemann - Applications of Credit Derivatives

3. Obligation default or acceleration The 2003 ISDA definitions outline two possible credit events. An obligation default allows creditors to demand immediate payment of the relevant obligation although it is not compulsory. Obligation default enables creditors to extend loan or credit exposure if there is confidence in the turnaround possibilities of the reference entity. On the other hand, obligation acceleration obliges creditors to take action without any grace period. Credit obligation is factual and can accelerate the bankruptcy of the reference entity. But it also protects creditors from further losses if obliged to withdraw money as soon as possible before a workout process starts. 4. Moratorium or Repudiation Such a credit event can either be triggered by the reference entity or by a government policy. The company can declare a moratorium on its obligations or repudiate them. The government can also declare a moratorium on the obligations of the reference entity. This form is mainly related to sovereign reference entities. Normally, the credit protection seller has no other duties than completing the cash flow definitions in case of a credit event, but moratorium credit events can transfer legal or political risks with the credit as well. If an authorized company representative or a government authority declares a moratorium or repudiation of obligations and the company can still not serve its creditors within a certain timeframe (usually 60 days), the CDS contract is extended to avoid a triggering of the credit event from the protection buyer. In 2002, there was a huge public discussion about such a moratorium credit event leading to the Argentina crisis. 5. Restructuring Restructuring comprises changes in the terms of the reference obligations: •

Ranking of the debtors (Who is served first in case of a workout)

•

Change in the currency of payment (normally CDS contracts are

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denominated in currencies with a long-term debt rating of AAA, a currency with a weaker ranking and high inflation could cause serious trouble) •

Reduction of interest or principal payable

•

Change in the date of payment or amount of interest

Even if restructuring is listed under the main range of credit events, it causes some confusion. Most of the time, credit restructuring processes do not impact the credit worthiness of a company and there is no reason why the protection seller should cover an additional payment 27

Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

if the reference entity is still liquid. A clear definition of this event depends on specific contract characteristics set by the two counterparts. To sum up, it is important to note that the timing of a credit event notice can become crucial to the counterparts, especially to the protection seller who is interested in a quick settlement of duties since a quick liquidation of the underlying credit limits losses. Furthermore, the investors will not have to cover any offsetting hedge. This could even affect the protection buyer who may not find a replacement for the contract and may suffer losses in excess of those covered by a triggered CDS. In general, credit event notices are given in agreement of both counterparts. A. No “Credit Event” In this case, the only cash flow during the life of the contract will be the fixed rate including the risk premium. There is no transfer of the underlying principal. The amount of the premium is specified at the beginning of the contract and normally calculated by probability of default systems based on liquidity or historical, empirical values. B. “Credit Event” takes place The protection seller has to serve the protection buyer. Normally, the buyer delivers the underlying obligation to the seller so that the seller can make funding claims directly to the underlying reference entity of the CDS contract. In return, the protection seller has to settle immediately the outstanding full notional amount of the credit to the buyer in cash or physically. All rate payments stop at this point and the contract is finished. The net loss of the protection seller corresponds to the full notional amount of the credit less the recovery value on the delivered obligation. C. The transaction is hedged prior to maturity Copyright © 2008. Diplomica Verlag. All rights reserved.

If spreads of the credit widen and the protection buyer wants to take the credit risk back from the protection seller, the protection buyer can hedge by paying a higher fixed rate to the former protection seller. The hedging cost exceeds the original risk premium. The profitability of such a transaction depends on other factors such as default probabilities and expected recovery rates after default.

28

Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Illustration 6: Cash Flows without a Credit Event32 Floating rate

Protection Seller

Fixed rate

Protection Buyer

Illustration 7: Cash Flows with Credit Event (Physical Settlement)33 Face value of Credit

Protection Seller

Deliverable Obligation

Protection Buyer

The protection seller loses the face value of the credit minus the recovery value of the deliverable obligation. 2.5.4. Recovery Rate The recovery rate can be defined as the percentage of par value of the security recovered by the investor when a default event happens. It is very important in establishing a loss given default. The loss suffered is equal to: 1 – recovery rate. In general terms, the recovery rate corresponds to the value of the defaulted bond four weeks after the credit event. During the four weeks, the auditors and the defaulted entity proceed to determine a valid workout value. Recovery rates are especially important for CDSs, because they determine the amount of the loss to the credit protection seller. In a CDO, due to different tranches with different risk profiles, no recovery rates are applied when a default happens but the order in which the contract gets settled and the investors are

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paid back is affected. In most cases, only investors from the equity and mezzanine tranche have to deal with different recovery rates of their invested assets. The senior tranche holders are nearly always on the safe side and get back at least their initial investment.

32 33

Graph created by the author Graph created by the author

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Recovery rates are affected by the following factors: •

Type of asset and seniority

The recovery rate depends on the place of the asset in the capital structure of the issuer. Senior secured bonds are always served with priority to the bondholders compared to high yield bonds which are affected most negatively by a default •

Industry

The industry of the issuer is decisive as well. There are major differences in the opportunities whether the issuer has the capacity to redeploy the assets in profitable ways or not. •

Jurisdiction

Key drivers in this field are differences in bankruptcy law of the country of issue which can influence the loss given default. •

Ratings

The purpose of ratings is to rank securities according to their relative expected loss rates. This is the product of the expected default rate and the expected loss severity in case of a default event. In general, ratings are a precursor of the severity of default. Studies have shown that A-rated securities always paid back more than 90% of their par value.34 •

Variability over economic cycles

Historical data has shown that recovery rates are linked to overall economic conditions.35 Recovery rates tend to be higher in economic boom times and longer when the economy slows down and reaches a possible recession. Over a twenty-one year period from 1982 to 2003, recovery rates have fluctuated from 20% (2001) to 50% (1986). The long-term average has established itself around 40%.36 •

Correlation between recovery rates and default rates

The two rates are generally negatively correlated. Concretely, this means that higher than

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average default rates go along with lower than average recovery rates.

34

See Hamilton, David T., and Varma, Praveen - Default and Recovery Rates of Corporate Bond Issues, New York (Moody’s Investors Service), 2004, Page 15 35 See Gupton, G.M. and R.M. Stein - LossCalculator: Moody’s Model for Predicting Loss Given Default (LGD), New York (Moody’s Investors Service), 2002 (http://www.defaultrisk.com/_pdf6j4/losscalc_methodology.pdf Consulted on 25/08/2007) 36 See Hamilton, David T., Cantor, Richard and Ou, Sharon - Default and Recovery Rates of Corporate Bond Issues, New York (Moody’s Investors Service), 2002, Pages 14 - 15 (http://www.moodyskmv.com/research/whitepaper/02defstudy.pdf Consulted on 14/06/2007)

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Harald Seemann - Applications of Credit Derivatives

Table 3: Average Recovery Rates by Industry37 Issuer weighted mean recovery rate 2003

2002

1982-2003

Utility - Gas

48.00%

54.60%

51.50%

Utility - Electric

5.30%

39.80%

41.40%

Hospitality

64.50%

60.00%

42.50%

Transport - Ocean

76.80%

31.00%

38.80%

Transport - Air

22.60%

24.90%

34.30%

Media

57.50%

39.50%

38.20%

Finance and Banking

18.80%

25.60%

36.30%

Automotive

39.00%

39.50%

33.40%

Healthcare

52.20%

47.00%

32.70%

Consumer Goods

54.00%

22.80%

32.50%

Construction

22.50%

23.00%

31.90%

Technology

9.40%

36.70%

29.50%

Telecommunications

45.90%

21.40%

23.20%

Table 3 shows some illustrative data about recovery rates. In the recession year 2003 after the burst of the technology bubble and the Enron scandal, Utility - Electric, Air Transport, Finance and Banking and Technology were the business sectors that suffered the most severe losses. Businesses like Healthcare, Telecommunications, Consumer Goods and Media had much better recovery rates in 2003. It is evident, that the essential sectors of the economy

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were not hit as severely as the upcoming and very cyclical businesses.

37

See Hamilton, David T., and Varma, Praveen - Default and Recovery Rates of Corporate Bond Issues, New York (Moody’s Investors Service), 2004, Page 14

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2.5.5. Forms of Default Payment If a credit event occurs, the default payment will be made through one of the following forms: 2.5.5.1. Cash Settlement In this case, the seller of credit protection has to pay the buyer an amount based on the price change of the reference asset.38 If the reference asset is valued on a daily basis, there will surely be an indication of its value after the credit event. The underlying credit stays with the protection buyer; the seller pays the difference of reference value at the beginning of the contract (face value) compared to the current value. In most cases, there are workout values determined shortly after the credit event takes place. Example: Assume after the announcement of a credit event a bond trades at 25% face value. This is the amount the market is willing to pay for the company currently, pricing into the bond the actual loss due to bankruptcy and liabilities, but also the opportunity of a turnaround after a possible restructuring or discovery of hidden assets. People who are dedicated to the search of such opportunities are the so-called distressed debt traders. They bet on higher recovery rates after the bankruptcy courts have taken place. If the owner of the bond has bought protection on the CDS contract, the protection seller will settle the remaining 75% to face value in cash in order to fulfil contract duties. The investor may also decide to keep the bond and bet like a distressed debt trader or sell it right away in the market. In the worst case, if no bids are in the market, the price of the bond would be set to zero and the protection seller would have to cash settle the whole face value of the contract. 2.5.5.2. Physical Settlement To facilitate the fair pricing of recovery rates, traders and counterparts use the physical settlement option.39 The protection buyer delivers an agreed asset (bond or loan) of the reference entity to the protection seller. Such a transaction can be compared to the seller of a Copyright © 2008. Diplomica Verlag. All rights reserved.

put option on any underlying asset. The payable amount from the protection seller to the protection buyer is fixed in advance (face value of a CDS, e.g. 10 million US-Dollars); the protection seller receives the defaulted asset and can sell it directly in the market or wait until

38

See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 87 - 89 39 See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Pages 89 - 95

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

the fundamental situation of the reference entity improves. This is the most common form used in practice. A delivery basket is defined in advance for situations in which the bonds cannot be delivered. This means that several bonds that fit the criteria of the CDS contract can be delivered instead of the reference entity. 3. Fixed payment Such a settlement includes an estimation of the loss given default at the compilation of the contract. In case of a credit event, the seller pays a pre-agreed fixed amount, which is not always equal to the workout value of the credit. This offers advantages to buyers and sellers of credit protection, since the recovery rate is determined in advance. The so-called “Binary Default Swaps”40 have identical payouts for all credit events, from total bankruptcy to minor restructuring deficits of the underlying reference entity. A fixed recovery rate enables buyers and sellers to plan more efficiently and to make enough provisions for such events in their balance sheets. Such a deal can become critical if the protection buyer triggers a credit event. 2.6. Standardized Documentation In Europe until 1999, only regulators in France, Germany and the United Kingdom had implemented a framework for credit derivative transactions. One major problem is the issue of documentation. Standardized and generally accepted documentation is useful and important in various ways: it can reduce legal risk, especially in cross-border transactions, i.e. by providing clear and precise terminology and definitions and reducing risk of incompatibility of laws of different legal systems and enhancing market transparency by reducing a confusing variety of documentation. 2.6.1. International Swaps and Derivatives Association When credit derivatives emerged in the 1990s, there was not enough documentation provided. Copyright © 2008. Diplomica Verlag. All rights reserved.

Dealers had to hire derivative lawyers to draft the contract. Due to this development, the International Swaps and Derivatives Association (ISDA) was founded to solve the problem.41 A successful system of standard derivative documentation was first implemented in 1998 and updated on a regular basis, along with the innovation speed of the issuers and the new

40

See Berd, Arthur and Kapoor, Vivek - Journal of Derivatives, Spring 2003, Pages 66 – 76 ISDA, which represents participants in the privately negotiated derivatives industry, is the largest global financial trade association, by number of member firms. ISDA was chartered in 1985, and today has over 815 member institutions from 56 countries on six continents. (http://www.isda.org/ Consulted on 17/09/2007)

41

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

intricacies of the products. Contracts are documented under ISDA swap documentation and the 1999 ISDA Credit Derivative Definitions as amended by various supplements. On 6 May 2006, the revised 2003 definitions42 came into effect. The International Swaps and Derivatives Association has been considered a trendsetter in the derivatives arena by developing master agreements and standard documentation for some types of credit derivatives. With eight different definitions of credit events that could have an impact on the transaction – bankruptcy, credit event upon merger, cross acceleration, cross default, downgrade, failure to pay, repudiation and restructuring, the documentation provides a detailed framework for future transactions. One of the principal aims of ISDA in developing the definitions was to promote legal certainty in the market for credit default products. Nevertheless it has to be recognized that credit involves more variables than interest rates and consequently, the credit derivatives market will never be as straightforward as the interest rate derivatives market. The ISDA is lead by several committees dealing with accounting, documentation, different varieties of derivatives, risk management, market practices and taxation issues. One of the most powerful ones is the “Credit Derivatives Market Practice Committee”. It includes market practitioners who address issues affecting the business and practice of trading in credit derivatives. Taking in the views of dealers, end-user/hedgers and portfolio managers, the committee aims to find consensus on the most efficient, effective and appropriate means of conducting OTC credit derivatives transactions.

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The current committee is composed by the following members43: •

European Chairman: Bryon Lancaster (UBS)

•

North American Chairman: William Roberts (Goldman Sachs)

•

Japan Co-Chairman: Kazuyasu Makabe (J.P. Morgan Securities Asia Ltd.)

•

Japan Co-Chairman: Nobukazu Saeki (Mitsubishi Securities Co., Ltd.)

•

Japan Co-Chairman: Tatsuya Nakatsuka (Sompo Japan Financial Guarantee)

•

Regional Support (Europe): Richard Metcalfe (employed by ISDA)

•

Global Staff Contact: Karel Engelen (employed by ISDA)

42

2003 ISDA Credit Derivatives Definitions (http://www.isda.org/publications/isdacredit-deri-def-sup-comm.html Consulted on 11/09/2007) 43 2003 ISDA Credit Derivatives Definitions (http://www.isda.org/publications/isdacredit-deri-def-sup-comm.html Consulted on 28/03/2007)

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Furthermore, the “Risk Management Committee” performs an important role. It functions as a forum for the purpose of discussing the prudential treatment of ISDA member firms and advances in risk management techniques. The committee itself does not meet. Its members are invited to join working groups, the size of which enables interaction and facilitates the production of research documents, surveys, or recommendations to regulators. The risk management committee receives quarterly updates on the activities of the working groups, together with ad-hoc information bulletins on topical issues. To date, there have been three standard CDS contracts: the 1998, 1999 and 2003 versions. Supplements and guidance notes are issued continuously to clarify transactions. 2.7. Succession of CDS Reference Entities A CDS contract always refers to a reference entity whose risk is traded for a certain premium, corresponding to its economic situation. Global companies often have more than one entity for fiscal reasons. Consequently, it is not always clear whether a holding company or its affiliate entity is defined in the CDS contract and whether the holding company supports the affiliate company in times of financial trouble – this could avoid a credit event. When the Russian currency defaulted in 1998, the CDS contracts were backed by various sub-entities of the Russian government and its Ministry of Finance. Most CDS contracts became worthless due to an imprecise definition of the reference entity. In a CDS neither party necessarily has a direct relationship with the borrower. The CDS contract references the borrower, but if this reference entity mutates unexpectedly, the CDS counterparts are not always informed about the new status. They do not have permission power as the lender has with the borrower. The standard ISDA CDS documentation44 specifies that the credit protection should be transferred to the entity assuming all or substantially all of the payment obligations of the former reference entity. The ISDA decided to define four cases of the “new” reference entity

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in every scenario: •

An entity that assumes 75% of the existing obligations of the original reference entity

•

If no entity is able to assume 75% of the debt, the new reference entity is defined as all entities that assume between 25% and 75% of the obligations, with the original CDS being split evenly among these entities

•

If no entity assumes 25% or more, then the original legal entity is also defined as the new successor

44

See 2003 ISDA Credit Derivatives Definitions (http://www.isda.org/publications/isdacredit-deri-def-sup-comm.html Consulted on 28/03/2007)

35

Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

•

If no legal entity survives and no entity assumes more than 25% of the obligations, then the entity which assumes the greatest percentage of obligations becomes the reference entity for the CDS

But also in the case of mergers through e.g. leveraged buyouts (LBO) of private equity investors, succession in CDS contracts has to be regulated. In the case of a merger, a new entity must assume the relevant debt, such as a bond or a loan of the existing corporate entity underlying the CDS. There are two major scenarios: 1. New entity assumes existing debt directly 2. Bond exchange: A new bond is issued by the combined group (The risk of the issuing guarantee is transferred) A current example45 of a succession issue follows: •

Axel Springer tries to acquire ProSieben through an LBO; a new acquisition company (SPV) is founded by Axel Springer to take over the credit risk

•

Now ProSieben redeems any pre-existing bond or loan debt and injects it into the acquisition company

•

Axel Springer raises debt to finance the deal and takes over the majority of the shares

•

The problem in this financing of debt is that there is no clear definition of bond exchange or debt transfer (no succession event), meaning that the CDS contract between ProSieben and its counterparts might become worthless

•

In this case the deal failed because of intervention by the German competition agency46 (“Bundeskartellamt”) Illustration 8: Example for Succession of CDS Reference Entities47

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PRO SIEBEN

AXEL SPRINGER ACQUISITION COMPANY (SPV)

45

See Wolcott, Rachel – “Special report about event risk: Puzzled by Succession”, Risk Trade Magazine May 2006, Pages 26 - 27 46 See “Springer provoziert Veto des Kartellamts“ – Frankfurter Allgemeine Zeitung 16/01/2006 (http://www.faz.net/s/Rub8A25A66CA9514B9892E0074EDE4E5AFA/Doc~E40F4582D6FFD4984BAA25F53 3080CBEA~ATpl~Ecommon~Scontent.html Consulted on 12/09/2007) and “Anti-Cartel Office Rejects Springer's ProSieben Takeover“ – Deutsche Welle Business 07/01/2006 (http://www.dw-world.de/dw/article/0,2144,1849617,00.html Consulted on 12/09/2007) 47 Graph created by the author

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

3. Applications of Credit Derivatives Credit derivatives are used throughout economic sectors. The main users are banks, insurance companies and hedge funds. It is interesting to note that the most active sellers of credit protection are reinsurance and insurance companies. This is probably because synthetic CDO portfolios offer a lower risk/return profile and are considered as relatively safe over their maturity. On the other hand, banks can be found on the buy-side of credit protection. Currently, the focus is shifting from portfolio transactions to single name transactions, because the premium in this field is higher and probabilities of default can be calculated easier. 3.1. Portfolio Diversification Ironically, credit investing took off in 2000 with high growth rates when all other asset classes went down. The shifting of capital from equity and bond markets into credit as a new asset class had begun. Credit offers investors diversification because it does not correlate with other asset classes. Return is an important aspect. Compared to government bonds, credit risk is more attractive – it offers higher returns. But risk margins fluctuate as well – with more and more investors getting access to this market, liquidity and volatility increases. Ford Motor for example had credit spreads in a trading range from 1 to 6% in 2005. Credit derivatives allow access to previously illiquid credits. They can be used to diversify across a large range of borrowers in different regions to gain exposure to an asset without actually owning it. From a risk management perspective, the optimal portfolio is welldiversified according to Harry Markowitz’s findings.48 Credit derivatives as a new asset class enable investors to broaden diversity and to minimize risk by choosing the instrument adapted to their risk/return profile. 3.2. Short Positioning Credit derivatives allow investors to wager on negative economic developments. Indicators Copyright © 2008. Diplomica Verlag. All rights reserved.

for short strategies are: rating downgrades, declining equity markets, rising inflation and interest rates and macroeconomic events. When credit defaults rise, credit spreads widen and transactions on the protection sell-side become more attractive if credit risks are calculated adequately. Short positioning is very often an actively managed investment strategy which is mainly applied by hedge funds. They seek absolute return and a benefit from all market movements. 48

See Brealey, Richard A. and Myers, Stewart C. – Principles of Corporate Finance, 8th edition New York (McGraw-Hill/Irwin) 2005, Page 149

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

Therefore, the investment horizon in short positions is shorter than in longer-dated CDSs or other credit-linked products. In general, short positioning is used by asset managers who seek to minimize concentration risk or apply a long/short investment approach, i.e. to buy undervalued securities and to sell overvalued securities. 3.3. Concentration Risk CDSs have emerged from the need of banks to avoid concentration risk.49 Let us assume a bank gives loans to a specific client over several years. At the current stage, the internal risk management division notices that the amount exposed to this particular company has crossed a certain rate and the loan portfolio of the bank is not well diversified anymore. Due to possible uncertainties with this particular client, the industry or the country, the bank is afraid of having too much concentration risk on its balance sheet. The bank has had profitable business relationships with this client so far and does not want to neglect future demand for more credit. Due to its diversification policies, it sells the credit risk on the loan to make sure it does get its money back, even if little risk premium fees apply. The client of the bank is not aware of this transaction and keeps a positive image of the bank. CDS markets have become very liquid nowadays; there is always a counterpart who wants to buy or sell credit risk on major corporations with a market capitalization of 1 billion US-Dollars. The smaller the companies are, the harder it is to find a counterpart. Consequently, the risk premium is much more expensive on credit risks of small companies. On the 30 November 2006, the Basel Committee on Banking Supervision (BCBS) released a working paper50 entitled “Studies on credit risk concentration: an overview of the issues and a synopsis of the results from the Research Task Force project”. Historical experience shows that concentration of credit risk in asset portfolios has been one of the major causes of bank distress. This is valid for individual institutions as well as banking systems as a whole. The recent failures of large borrowers like Enron, Worldcom and Copyright © 2008. Diplomica Verlag. All rights reserved.

Parmalat were the source of sizeable losses in a number of banks. Large exposure to debt of the less-developed countries was one of the reasons for tremendous weakness in major US banks in the 1980s demonstrating that the stability of entire systems can be undermined by the excessive exposure to a single asset class. 49

See Das, Satyajit, Traders, Guns & Money – Knowns and Unknowns in the Dazzling World of Derivatives, Dorchester (Financial Times Prentice Hall) 2006, Page 270 50 See Bank for International Settlements - Quarterly Review: International Banking and Financial Market Developments, March 2007 (http://www.bis.org/publ/qtrpdf/r_qt0703.pdf Consulted on 11/04/2007)

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

It is therefore important to measure the concentration risk in the credit portfolios of banks arising from two sources: systematic and idiosyncratic.51 •

Systematic risk represents the effect of unexpected changes in macroeconomic and financial market conditions on the performance of borrowers (in credit derivatives contracts the reference entity). Borrowers may differ in their degree of sensitivity to systematic risk, but few firms are completely indifferent to the wider economic conditions in which they operate. Therefore, the systematic component of portfolio risk is unavoidable and only partly diversifiable.

•

Idiosyncratic risk represents the effects of risks that are specific to individual borrowers. As a portfolio includes more companies in the sense that the largest individual exposures account for a smaller share of total portfolio exposure, idiosyncratic risk is diversified at the portfolio level. This risk is totally eliminated in a portfolio with a very large number of exposures.

The concentration risk group of the Research Task Force of the BCBS conducted an analytical project with the following objectives: 1. To provide an overview of the issues and current practice in a sample of the more advanced banks as well as to highlight the main policy issues that arise in this context. This first work stream collected information about the current “state of the art” both in terms of industry best practice and relevant academic literature in development. It is important to point out that banks and supervisors often do not have the same understanding about concentration risk, and in particular about its relation to the Basel II framework. Supervisors interpret concentration risk as a positive or negative deviation from the Pillar 1 minimum capital requirements derived by a framework that does not account explicitly for concentration risk. Banks perceive that sector concentration (often referred to, with a positive connotation, as “diversification”) enables capital relief relative to pillar 1, Copyright © 2008. Diplomica Verlag. All rights reserved.

which they take as the non-diversified benchmark. Overall, business-sector concentration has traditionally received less attention by banks as a source of concentration risk than exposure concentration in geographic regions.

51

See Basel Committee on Banking Supervision – Working Paper No. 15 “Studies on credit risk concentration”, November 2006, Pages 4 - 5

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

In general, banks have different measures in place to capture and manage concentration risk: 1. Exposure limit systems, which also depend on the strategic goals of the bank 2. Internal economic capital models that measure the risk contribution of exposures 3. “Pricing tools” that allow banks to account for concentration risk in the pricing of a new exposure. Whereas limit systems and internal models are commonly applied across best practice banks, incorporating concentration risk in the pricing of new loans is practiced by less than half of the banks.52 There is also a disparity across the best practice banks in the methodological treatment of concentration risk. The more sophisticated banks employ internal economic capital models that can in principle adequately measure concentration risk but they are often constrained by data problems, for example, by grouping exposures to risk entities. The less sophisticated institutions surveyed employ simpler concentration measures. Banks use a mix of standard models and in-house built models to capture concentration risk in their economic capital calculations. Standard models are also used as a benchmark for internal models. Typically these are multi-factor asset value models. Sensitivity to industry and geographical factors is measured through asset correlations. These correlations are in turn typically estimated on the basis of either equity correlations, or correlation estimates derived from rating migrations or default events. The number of employed factors can vary from as few as 7 to as many as 110. Stability of the estimated correlations is an issue that banks often have to be concerned about. Measuring concentration risk relative to pillar 1 capital charges of Basel II will remain a challenge even for the most sophisticated, best-practice banks. The availability of data is always an important issue. In emerging markets, risk estimation is more difficult and possibly less reliable since markets are often less liquid. Apart from data constraints, the growing complexity of banks, in particular the increasing use of credit risk transfer instruments, limits Copyright © 2008. Diplomica Verlag. All rights reserved.

the accuracy of simple tools. 2. To assess the extent to which “real world” deviations from the “stylised world” behind the assumptions of the IRB model can result in important deviations of economic capital from Basel II capital charges in the IRB approach. This second work stream examined various methodologies that can help to bridge the gap between underlying risk and risk measured by 52

See Basel Committee on Banking Supervision – Working Paper No. 15 “Studies on credit risk concentration”, November 2006, Page 7

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Harald Seemann - Applications of Credit Derivatives

the specific model. The work stream has two sub-themes that focus on name concentration risk and sector concentration risk. Table 4 illustrates name concentration and shows how economic capital varies over a sequence of loan portfolios. The portfolios all contain a number of exposures to similar credits which are all of the same size with the exception of one that is ten times that size. The following table shows the simulated loss distribution for seven such portfolios of different sizes ranging from 10 to 3000 credits. As the number of credits increases, the importance in the portfolio of the single large exposure declines and the economic capital gets more and more diversified. In a portfolio of more than 500 credits, the possible loss of economic capital according to Value-at-Risk (VaR) is below 10%. Table 4: An example of the effect of diversification on portfolio credit risk53 Number of loans

10

50

100

500

1000

2000

3000

VaR (95%)

0.0526

0.0508

0.0459

0.0393

0.0386

0.0378

0.0389

VaR (99%)

0.5263

0.1695

0.1009

0.0786

0.0773

0.0762

0.0758

VaR (99.9%)

0.5263

0.1864

0.1284

0.0982

0.0971

0.0950

0.0947

Note: Credit VaR at the specified level of confidence is expressed as a fraction of total portfolio exposure. The calculations assume probability of default=1% and asset correlation of 20%. The effect of name concentration is clearly more pronounced for smaller portfolios. An indicative calculation of the contribution of idiosyncratic risk to economic capital can be shown by reference to a portfolio having the maximum permissible concentration under the EU large exposure rules.54

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Such calculations give estimates of 13% to 21% higher portfolio Value-at-Risk for this highly concentrated portfolio versus a perfectly diversified one as the ones in the table from 500 credits or more onwards. For portfolios in modern banks, the impact of name concentration is lower. The two academic researchers Gordy and Lütkebohmert (2006)55 use characteristics of 53

See Basel Committee on Banking Supervision – Working Paper No. 15 “Studies on credit risk concentration”, November 2006, Page 9 54 Directive 93/6/EEC from 15/03/1993 55 See Gordy, Michael B. and Lütkebohmert, Eva – Deutsche Bundesbank Eurosystem: Granularity adjustment for Basel II, 2007 (http://217.110.182.54/download/bankenaufsicht/dkp/200701dkp_b.pdf Consulted on 17/05/2007), Page 23

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Harald Seemann - Applications of Credit Derivatives

loans from the German credit register (including probabilities of default) to compare the impact of name concentration on loan portfolios of the size that can be found in modern banks. For large credit portfolios of more than 4.000 exposures, they found that name concentration can contribute about 1.5% to 4% of portfolio Value-at-Risk. For smaller portfolios (with around 1.000 to 4.000 loans) a range between 4 and 8% is closer to reality. The various methodologies proposed by practitioners and researchers for dealing with name concentration risk can be generally classified into those that are more innovative measures of risk concentration, and those that are based on more rigorous and rational models of risk with standardized approaches. Model-based approaches are strictly preferable, as long as they are feasible to implement. The precise definition of a “sector” and its constituencies is a key question for the implementation of many of the techniques discussed in current research papers. It is still not entirely clear if exposures belong to the same sector because of their similar characteristics or because of their close correlation of asset returns. In an ideal situation, the modeller has already identified a fixed set of sector-specific factors and the classification of individual credits is based on the degree of similarity between the exposure and each of the chosen factors. In practice, however, the identification of the set of systematic sector factors is not entirely clear. It is typically based either on pure statistical criteria or follows the industrial sector classification of the borrower. 3. To examine and further develop fit-for-purpose tools that can be used in the quantification of concentration risk. This third work stream deals mostly with the ability of stress tests to detect excessive concentration and to provide estimates of economic capital in stress scenarios.

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There are two types of stress tests56: regular stress tests in which stress is incorporated in the model without changing its structure and stress tests to analyse “model stress”. As long as one does not want to fundamentally question the model, it is advisable to choose stress scenarios which are consistent with the existing credit portfolio model. Otherwise stress testing results will have little relevance for risk management, or might even be misleading. This does not

56

See Basel Committee on Banking Supervision – Working Paper No. 15 “Studies on credit risk concentration”, November 2006, Pages 13 - 16

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

mean that “model stress” does not make any sense. But users should make up their mind if they believe in the portfolio risk model or if they question the risk model. 3.4. Hedging CDSs are used more and more to securitize investment portfolios. Hedge funds benefit from CDSs in a very profitable way. An example assumes that a hedge fund is long on certain equity like the German car producer Volkswagen. Its overall estimation of the company is positive, but certain risks within internal divisions in specific countries where Volkswagen operates (e.g. Volkswagen in Mexico) show instability and negative developments. To minimize the downside risk in Volkswagen, the hedge fund shorts the credit on this particular entity, it sells off credit protection that it does not own in the hope that the credit rating of Volkswagen Mexico will decline so that it can buy back its credit protection at a lower price. Ironically, this hedging strategy allows market participants to benefit from a decline in the fortunes of a company. Especially from a company’s point of view, credit derivatives offer tremendous advantages to hedge contracts and transactions of their core business. Some concrete examples57 will be outlined on the following pages. They show how credit derivatives are used in these cases – the opposite from trading opportunities which are practised by hedge funds. 3.4.1. Distressed Buyer The following example deals with companies from the automotive industry. Delphi, a large company in the automotive supply industry, has strong business relationships to General Motors and sells a significant amount of its products to them. Today, General Motors has major difficulties in repaying its debt due to the loss of market share to Japanese car producers. Delphi is exposed to high credit risk on its receivables. This is a common customer problem with which many monopolies are confronted. Delphi can use the CDS market to

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hedge as follows: •

Delphi buys credit protection on its receivables to General Motors

•

Now its maximum loss is limited to the risk premium paid

•

Even if spreads are wide, this is much better than the loss of all its receivables

57

The following fictional hedging examples are taken from: Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Pages 432 - 452

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

3.4.2. Vendor Financing Nokia wants to sell mobile phone equipment to an Algerian phone operator for a contract size of 400 Million Euros. Since the Algerian operator does not have as many liquid assets currently, it can only repay the amount in arrears for the next 5 years.

Table 5: 5-year Funding Levels Euro Swap Rate

5.00%

Nokia CDS spread

2.00%

Algeria Sovereign CDS Spread

3.50%

Illustration 9: Nokia raises funds and hedges credit risk of the Algerian operator58

Dealer CDS Algeria, 5 y: 3.50%

Possible default payment

Phone Equipment

Nokia

Algerian Operator 7% interest annually + principal after 5 years

Funds

Swap rate + CDS Nokia: 5%+2%=7%

Market Nokia is able to hedge credit risk through the purchase of credit protection while maintaining

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its client relationship to the Algerian phone operator. It can fund the necessary volume to process the transaction over the market through a bond, loan or structured note issue and only has to pay the additional risk premium of 3.50% to the dealer in order to be hedged. If Nokia’s profit margins are much higher, this transaction (even if it is with an emerging country where there is always increased default risk) is very cost-efficient.

58

Source: Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Pages 432 - 452

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

In vendor financing transactions, other factors such as the discounting of future cash flows have to be taken into account as well. It is obvious, that the 400 Million Euros principal in 5 year’s time will be worth much less if the net present value at the beginning of the contract is calculated. An efficient amortization rate including adequate cost of capital is necessary to calculate profit margins. Furthermore, Nokia does not own a bond or any similar instrument of the Algerian operator. Therefore, the settlement mechanism in terms of a credit event has to be clearly defined in the contract between the two parties. 3.4.3. Leasing Exposure In the commercial real estate business, many rentals are on a triple net lease basis. This means that the lessee is responsible for rent, maintenance, taxes and insurance of the rental object. Long-term lease prices are highly driven by lessee credit risk. Let us take a look at a concrete example: Elad Properties has built a condominium building in London. They have entered into a 30-year triple net lease with Rite Aid. The net present value of the commercial lease is slightly higher than the construction cost. Elad Properties wants to monetize the lease value and get rid of the credit risk of Rite Aid. A possible solution is structured as follows: Illustration 10: Elad Properties monetizes the lease - sale of its credit risk on Rite Aid59 CDS Premium

Dealer

Market Possible Default Payment

Cash

Lease Assignment Lease

Elad Properties

Rite Aid Triple Net Payments

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Cash

Commercial Mortgage

Market

59

Source: Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Pages 432 - 452

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Harald Seemann - Applications of Credit Derivatives

This graph shows clearly, that Elad Properties can benefit from its hidden asset, the illiquid credit risk on Rite Aid. Illiquid credit risk corresponds to the lease. The dealer (this can be an investment bank or a hedge fund) buys the relatively cheap credit risk and distributes the basis risk to the CDS market participants. For Elad Properties, this is a profitable way to generate risk-free income and to maintain client relationships with Rite Aid. 3.4.4. Managing Funding Cost Risk Continental expects to raise 5-year debt in 2008. Because of the good financial shape of the company and the overall economy, credit spreads have tightened recently. Table 6: Credit spread structure of Continental for different maturities Maturity in years for debt

Credit Spread in basis points (bps)

1

25

5

50

6

50

The company believes that within the next year credit spreads will widen above the implied forwards in the range of 75-100 basis points on 5-year debt. Swap rates should remain on the same level. Continental wants to lock in the 5-year debt spread of 50 basis points in 2007, even if it can only issue the debt in 2008. A hedge for such a future financing offers two solutions: Solution 1 to manage credit spread risk Continental could issue a bond with 6 years maturity today and invest the proceeds in the capital markets for one year until it needs the money for its own operations. This explanation looks very easy, but it implies several problems:

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•

Balance sheet impacts

Continental has to state borrowing and investing on the same balance sheet. This does not look very credible to its shareholders who want the money to be invested in the corporate strategy. •

Earnings impact

Continental has to search safe investment opportunities in the fixed income market. The spread between borrowing and investment will be negative.

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

•

Maturity of borrowing

This may affect the corporate debt planning in other areas and lead to restrictions in certain divisions. Solution 2 to manage credit spread risk In order to lock in the 5-year credit spread of 50 basis points in 2007, Continental can sell a one-year CDS on itself and buy a 6-year CDS on its own entity. With this strategy, Continental can beat the expected market movements. If credit spreads widen, the value of the CDS hedge will rise, due to an increased receipt of risk premium – this will lower the cost of borrowing. On the other hand, if credit spreads tighten, the Mark to Market (MTM) value of the CDS hedge declines and the cost of borrowing goes up. Since swap spreads are not expected to move, this would neither affect the CDS hedge nor the cost of borrowing. Difficulties involved in this transaction The two CDSs that Continental trades are self-referencing. This is contradictory to bankruptcy law. In terms of a default, Continental would not be able to meet the requirements of the CDS contract, because self-referencing CDSs may not be enforceable in a bankruptcy. Furthermore, Continental would have to deal with disclosure concerns. Financial transactions which involve market risks have to be communicated to shareholders and other regulatory institutions. Solutions for these difficulties Continental could hedge itself against rising credit spreads through the sale of a CDS on a similar corporation which correlates with Continental. Furthermore, Continental could hedge itself using a sectoral basket from the automotive supply industry. Another modern way is the

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hedge of this systematic risk with a publicly traded index from the iTraxx60 product range.

60

See International Index Company Limited - iTraxx Credit Derivative Indices, CDS Indices from all kinds of Continents and Industries (http://www.indexco.com Consulted on 09/05/2007)

47

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3.4.5. Synthetic Debt Repurchase Wal-Mart has a significant amount of long-term debt which it does not need for its operating activities. Therefore, Wal-Mart plans to retire a bond with 7 years remaining maturity. When the bond was issued, Wal-Mart credit spreads and swap levels were much higher. The synthetic debt repurchase will help Wal-Mart to achieve net present value (NPV) savings. There are two ways to repurchase the debt: Solution 1: Wal-Mart could make a tender offer to the bondholders. This would be expensive because most bondholders would exit prematurely if they received a premium to the current value of the bond. Even at a premium, not all bondholders would tender. Long-term debt is very often also used for long-term investments such as pension plans. Furthermore, most bonds have clean-up costs. Solution 2: Wal-Mart could synthetically retire the bonds through the CDS market. The company would receive the synthetic bonds including a risk premium. The only responsibility of Wal-Mart would be to perform the default payment in case of a credit event. This would bring up the self-referencing trade issue again as described in the hedging strategy “Managing Funding Cost Risk”. A self-referencing trade can only be authorized by legal authorities if sufficient funds are available to serve CDS counterparts in case of a default event.

Illustration 11: Example of Synthetic Debt Repurchase from Wal-Mart61

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CDS

Risk premium

Dealer

Coupons

Wal-Mart

Bondholders

Default payment

61

Source: Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Pages 432 - 452

48

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Harald Seemann - Applications of Credit Derivatives

3.5. Basics of Target Profiles A major advantage of credit derivatives to companies is that they are off balance sheet.62 That means they do not appear on any public statements unless a credit event affects the cash flow of the company. This may seem useful to companies, as they do not have to justify their way of speculating to their stakeholders. Credit linked notes can be used to gain exposure to reference entities with different currencies, maturities and coupon structures.63 This exposure may not be available in the cash market. As described earlier, equity and mezzanine tranches may also be used to gain greater leverage to credit risk. Since the protection period is not regulated by the ISDA, it is possible to create synthetically a maturity that is different from existing debt issues by the reference entity. This enables investors to shorten the maturity with a CLN if lines for the credit are shorter than outstanding debt issues. Investing in a CLN does not contribute to counterparty credit limits (see chapter 3.3 about concentration risk) relating to the sale of protection or the interest rate swap. This feature is very helpful for lower-rated investors, but also for those who are already strongly correlated to the reference credit. The sale of credit protection through a funded purchase of a CLN helps to avoid the need for infrastructure and pricing systems necessary for default swap trading. CLNs can be listed easily in over-the-counter-markets and are transferable in the same way as other bond issues. In contrast to the advantages mentioned so far, the CLN originator has to consider the legal costs associated with the creation of an SPV. These fixed costs do not depend on notional size or maturity, and have to be implemented in the pricing tools of a CLN. Summing up, it is evident that CLNs are much better for investors with a medium-term investment horizon rather than for short-term trading purposes such as the underlying single credit default swaps. 3.5.1. Cash Bonds versus Synthetic Securitization Copyright © 2008. Diplomica Verlag. All rights reserved.

Investing in a synthetic securitization (selling default protection) allows an investor to achieve a higher return than investing in cash bonds64, due to both the higher asset spreads (equal to the risk premium) paid on CDSs and the efficiency in placing senior tranches synthetically.

62

See Das, Satyajit, Traders, Guns & Money – Knowns and Unknowns in the Dazzling World of Derivatives, Dorchester (Financial Times Prentice Hall) 2006, Page 32 63 See Chris Francis, Atish Kakodkar, Barnaby Martin - Merill Lynch Credit Derivative Handbook, London 2003, Pages 46 - 47 64 See Chris Francis, Atish Kakodkar, Barnaby Martin - Merill Lynch Credit Derivative Handbook, London 2003, Page 96

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As capital markets are not efficient, default swap spreads are generally wider than comparable cash par floater spreads. Wider CDS spreads over the cash equivalents provide a major advantage of investing in synthetic structures. Furthermore, credit-linked notes with super senior notes also provide several efficiencies. With super senior notes, the risk of a synthetic CDO is reduced considerably and the cost of this tranche can be priced at tight spreads. This is not the case in the capital markets where further reduction in credit risk beyond an AAA level does not reduce credit spreads. The reason for this is the fixed “opportunity cost” of investing cash. An unfunded super senior tranche in a CDO reduces the cost of the senior liabilities and leaves more spread or subordination for the benefit of lower tranche investors. 3.6. Regulatory Arbitrage Banks always seek maximum return on capital. This is consistent with minimizing regulatory capital for a given level of credit risk, because regulatory capital is very expensive for financial institutions. Balance sheet CDOs allow banks to avoid the full capital requirements of BASEL II. These transactions aim to release regulatory capital and to re-invest it in more profitable ways. Normally, a bank would have to hold 8% against a loan of a corporation. After structuring a CDO, the bank would only have to securitize the equity tranche. In most cases, the equity tranche is much less than 8%. The difference in capital is the released capital which the bank can invest at the most favourable market conditions to achieve a considerable return. A CDO is very useful in this case. Table 7 gives a detailed example65 to illustrate this transaction. Table 7: Balance sheet CDO introduction

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•

The example assumes the following:

Bank’s annual cost of capital

15%

Maturity of portfolio

5 years

Portfolio Size

1 Billion Euros

Portfolio Net Interest Income

0.75%

Loan Entities

Corporations

Risk Weighting

100%

Initial Regulatory Capital

80 Million Euros (8%)

65

See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Page 360

50

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•

The bank decides to securitize this portfolio and has the choice between two possible transaction structures: 1. Fully funded cash flow CDO 2. Synthetic securitization (synthetic CDO) Table 8: CDO Capital Structure

Structure Tranche

CDO Notional

Spread

Super Senior

Synthetic CDO Notional

Spread

92.00%

0.10%

AAA

95.00%

0.30%

3.00%

0.30%

A

1.50%

0.80%

1.50%

0.80%

BBB

1.50%

1.50%

1.50%

1.50%

Equity

2.00% 100.00%

2.00% 0.3195%

100.00%

0.1355%

The given capital structure is representative, but will be driven by ratings breakpoints. Table 9: Regulatory Capital Position before CDO Transaction Origin

Capital

Explanation

Portfolio

80 Million Euros

8% from 1 billion

Table 10: Regulatory Capital Position in a Traditional CDO Origin

Capital

Explanation

First Loss

20 Million Euros

100% Capital against 2% Equity tranche

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Table 11: Regulatory Capital Position in a Synthetic CDO Origin

Capital

Explanation

First Loss

20 Million Euros

100% Capital against 2% Equity tranche

Super Senior

14.72 Million Euros

1 billion x 92% x 20% x 8%

Net

34.72 Million Euros

Note: The synthetic structure assumes that the super senior notes are hedged with an OECD counterparty. 51

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Table 12: Balance sheet CDO Net Capital Savings After Traditional CDO

After Synthetic CDO

Initial Capital

80 Million

8%

80 Million

8%

Post Transaction

20 Million

2%

34.72 Million

3.47%

Saving

60 Million

6%

45.28 Million

4.53%

Table 13: Ongoing Benefit each year from Traditional and Synthetic CDOs After Traditional CDO

After Synthetic CDO

Capital Released

60 Million

45.28 Million

Cost of Capital

15%

15%

Capital Benefit

9 Million

6.79 Million

CDO Cost (Spread)

3.2 Million

1.36 Million

Net Benefit

5.8 Million

5.44 Million

=> The net savings for the bank are more than 5 Million Euros per year Table 14: Balance Sheet CDO Return on Capital Traditional CDO

Synthetic CDO

%

Million

RoC

%

Million

RoC

Pre-CDO

0.75

7.5

9.375%

0.75%

7.5

9.375%

CDO Cost

0.32

3.2

0.136%

1.36

Net Earnings

0.43

4.3

0.614%

6.14

•

21.5%

17.68%

Return on Capital (RoC) is enhanced in either CDO transaction

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RoC is calculated as follows 7.5*100/80=9.375% 4.3*100/20= 21.5% 6.14*100/34.72=17.68% •

The bank increases its Return on Capital to approximately 20% from around 10%

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Harald Seemann - Applications of Credit Derivatives

4. Pricing of Credit Derivatives The pricing and management of credit derivatives require sophisticated credit risk models. With the advent of the market-based models the mathematical modelling of the pure interestrate risk in the bond market is coming closer to a generally accepted benchmark. Of the remaining risk components in the bond market, credit risk is the largest unresolved modelling problem. The valuation of credit derivatives has changed the focus of many credit risk models.66 Instead of developing a pricing framework which yields fair prices for defaultable bonds, these bonds can be taken as input to derive prices for more innovative derivative instruments. Therefore, models have been developed which have this degree of flexibility. Since there is no generally accepted valuation principle for credit derivatives, a lot of different tools exist among counterparts. Innovative derivative structures need to be broken down into their characteristics in order to find a fair market price and to allow trading in such instruments. Most of the time credit derivatives are valued similar to asset swap levels. Investors are satisfied with the same spread as they would receive through investing in the asset. From the point of view of a protection buyer, essential factors that have to be taken into account for a risk setup for internal rating based and standardized pricing approaches of credit derivatives are the following: •

Probability of default of the reference entity and the protection seller (based on empirical, historical figures, sector average, liquidity situation…)

•

Correlation between the reference entity and the protection seller (Rating, cash flows and amount of equity)

•

Joint probability of default of the reference entity and the protection seller

•

Maturity of the swap

•

Expected recovery value of the reference asset (based on workout process, ranking

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of debt)

66

See Phillip J. Schönbucher - Credit Derivatives Pricing Models: Models, Pricing and Implementation Singapore (Wiley Finance Series) 2003, Pages 51 and 111

53

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4.1. Firm Value Model The Moody’s KMV67 model, which was first developed by Robert Merton68 in 1974, is based on the structural approach to calculate expected default frequency (EDF) over a period of 1 to 5 years and is based on the assumption that credit risk is driven by the firm value process. EDF is a dynamic forward looking measure of actual probability of default. The model determines the default risk of the firm as the risk that the market value of assets trades below the book value of liabilities.69 These are the assumptions and key features for the model: •

It is best when applied to publicly traded companies in which the value of equity is determined by the stock market and sometimes part of the debt is directly traded in the form of corporate bonds

•

It works best under highly efficient liquid market conditions

•

The market information contained in the firm’s stock price (e.g. expectation about future cash flows) and balance sheet are translated into an implied risk of default

•

According to KMV’s empirical studies, asset returns correspond quite well to a

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normal distribution, and the value of the firm stays relatively constant

67

“KMV” stands for the first letter of the last names of the three founders of the company. The KMV Company was established in 1990 and was acquired by Moody’s rating agency in 2003. Source: Deutsche Bundesbank (http://www.bundesbank.de/download/volkswirtschaft/mba/2005/200510mba_en_transparency.pdf Consulted on 27/04/2007) 68 In 1997, Merton was awarded the Nobel Memorial Prize in Economics for his work on stock options 69 See Das, Satyajit, Credit Derivatives – CDOs & Structured Credit Products, 3rd Edition Singapore (Wiley Finance Series) 2005, Page 559

54

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4.1.1. Valuation Approach The distance to default ratio determines the level of default risk. This key ratio compares the firm’s net worth to its asset volatility (derived daily from the stock price), which drives the risk of default.70 There are three steps to calculate the EDF: 1. Estimation of the market value and volatility (standard deviation) of the firm asset value 2. Calculation of the distance to default from the asset value: An index measure of default risk Default point = short-term debt + (0.5 x long-term debt), where Short-term debt = contractual liabilities payable within one year Long-term debt = contractual liabilities payable in more than one year (Both derived from the current book value of liabilities) 3. Scaling of the distance to default to actual probabilities of default using a default

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database in order to determine the expected default frequency (EDF).

70

See Altman, Edward I. - Bankruptcy, Credit Risk and High Yield Junk Bonds, New York (Blackwell Publishers Inc.) Stern School of Business, New York University, 2002, Page 193

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Table 15: Simplified Example71 of Firm Value Model Federal Express (in billions of US-Dollars) November 1997

February 1998

7.9

7.3

Book liabilities72

4.7

4.9

Market value of assets

12.6

12.2

Monthly asset volatility

15 %

17 %

3.4

3.5

(12.6 – 3.4)/(12.6 x 0.15)

(12.2. – 3.5)/(12.2 x 0.17)

= 4.86

= 4.20

0.06 % (6 basis points)

0.11 % (11 basis points)

Rating = AA-

Rating = A-

Market capitalization of equity (share price x shares outstanding)

Default point Distance to default EDF for one year

The EDF is determined through empirical mapping between distance to default and default frequency (historical data of Federal Express collected by Moody’s). Moody’s KMV uses large databases with historical default frequencies and bankruptcies of different companies, industries and countries.

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Table 16: EDF versus Ratings agency default measures73 EDF in basis points

Standard & Poor’s (S&P)

Moody’s

2 to 4

AA or better

Aa2 or better

4 to 10

AA/A

A1

10 to 19

A/BBB+

Baa1

19 to 40

BBB+/BBB-

Baa3

40 to 72

BBB-/BB

Ba1

72 to 101

BB/BB-

Ba3

101 to 143

BB-/B+

B1

143 to 202

B+/B

B2

202 to 345

B/B-

B3

71

See The Hong Kong University of Science and Technology, Department of Mathematics (http://www.math.ust.hk/~maykwok/courses/MATH690/Spring_05/MATH685R_05_2_4.pdf Consulted on 23/04/2007) 72 For simplification reasons, the indicated figure includes the average coupon payments on the long-term debt 73 Table extracted from: Crouhy, Michel, Galai, Dan, and Mark, Robert - Risk Management; New York (McGraw-Hill) 2001, Page 379

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The distance to default means that in November 1997, Federal Express for example would have to loose 4.86 billion US-Dollars in market capitalization in order to default on its debt. If this is expressed in stock performance, the stock price would have to decline as follows: 4.86/7.9*100 = 61.52 % If the stock decreases more than 61.52 %, the firm is likely to default due to its deteriorated firm value. The current expected default frequency is 0.06 %, which means that it is comparatively low. In order to find a significant interpretation of this figure, it has to be compared to competitors from the same sector and historical EDF values of Federal Express. If someone would trade a CDS on a Federal Express loan, the credit spread would be 6 basis points (Assumption: risk neutral EDF corresponds to 6 basis points as well, explanation below). In February 1998, Federal Express would have to loose an additional 4.20 billion US-Dollars in market capitalization in order to default on its debt. If this is expressed in stock performance, the stock price would have to decline as follows: 4.2/7.3*100 = 57.53 % If the stock decreases more than 57.53 %, the firm is likely to default due to its reduced value. The current expected default frequency is 0.11 %, which means that it is not that low and has increased tremendously since November 1997. To analyse this figure, it should be compared to the results from competitors from the same sector and historical EDF values of Federal Express. If an investor would trade a CDS on a Federal Express loan today, the credit spread would be 11 basis points (Assumption: risk neutral EDF corresponds to 11 basis points as well, explanation below) The reasons for changes in the EDF are due to variations in the stock price, the debt level and the asset volatility. In order to price credit derivatives, information is needed on the risk neutral probabilities of Copyright © 2008. Diplomica Verlag. All rights reserved.

default and that is why the actual EDF has to be converted into a risk neutral EDF. This happens with the Capital Asset Pricing Model and the Sharpe Ratio.

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Harald Seemann - Applications of Credit Derivatives

Illustration 12: Distribution of terminal firm value at maturity of debt74

•

The graph illustrates on the x-axis factor time and the y-axis the firm value. With growing companies, the firm value increases steadily over time.

•

The waves mark the volatility of the stock. The liabilities are a linear line which runs parallel to the x-axis. In this particular case, the company is very healthy, because the firm value grows continuously.

•

At maturity of debt, the firm value exceeds the liabilities by far. This means that there is no default risk for the presented company. The default region lies far below the current firm value.

•

Empirical studies of Moody’s KMV for several hundred companies show that firms default when the asset value reaches a level somewhere between the total book value of liabilities and the value of the short-term debt. The explanation is

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that long term liabilities are not immediately due and payable.

74

Source: The Hong Kong University of Science and Technology, Department of Mathematics: (http://www.math.ust.hk/~maykwok/courses/MATH690/Spring_05/MATH685R_05_2_4.pdf Consulted on 23/04/2007)

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4.1.2. Advantages and Disadvantages of the Firm Value Model The firm value model is definitely an advanced and easily comprehensible indicator of default risk for a company. It involves some major advantages due to market efficiency, but also the disadvantages for certain businesses should not be overlooked. An evaluation of the model according to its flexibility of implementation for companies with different sizes follows. It includes the main advantages and disadvantages of the firm value model: Advantages •

Accurate and timely information from the equity market provides a continuous credit monitoring process that is difficult and expensive to duplicate using traditional credit analysis

•

Annual reviews and other traditional credit processes cannot maintain the same degree of control that EDF calculates on a monthly or a daily basis

•

The approach offers the possibility to adjust to the credit cycle and the ability to quickly reflect any deterioration in credit quality

•

Changes in EDF tend to anticipate at least one year earlier than the downgrading of the issuer by rating agencies like Moody’s and Standard & Poor’s

•

Since the net worth is based on values from the equity market, it is both a timely and superior estimate of the firm value (it adjusts automatically as equity prices and volatility changes; this drives credit spreads to move)

Disadvantages •

The firm value model requires some subjective estimation of the input parameters, there is for example a difficulty in valuing intangible assets

•

The asset value distribution is based on normal distribution although the default point itself is variable

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•

Private firms EDFs can be calculated only by using some comparable analysis based on accounting data because most of the time there are no liquid secondary markets

•

Reliance on accounting data can be misleading due to different accounting principles (US-Generally Accepted Accounting Principles versus International Accounting Standards)

•

It does not distinguish among different types of long-term bonds (maturity issue) according to their seniority, collateral, convertibility and other credit conditions

59

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4.1.3. Moody’s KMV Risk Management Tools75 today Moody’s KMV Corporation distributes the “Credit Monitor” to apply the described EDF calculation to companies and make efficient credit measures. The calculation of asset volatility needs more input parameters than the daily standard deviation. The Credit Monitor software uses a complex iterative procedure to solve the asset volatility. The processed asset volatility is combined with country, industry and size averages to produce a more precise and meaningful estimate of the asset volatility. The Risk Advisor and Risk Analyst76 allow institutions to create and deploy internal rating models based on both quantitative and qualitative criteria. The Moody’s KMV internal rating platform can accommodate a wide variety of risk rating models. Specifically, it is used to deploy risk models across local and global lending networks of banks and to manage the data requirements of the credit rating process. Banks around the world are making the platform a critical component of their credit risk process as they have to fulfil Basel II compliance. Basel II is divided into three compliance approaches: a standardized approach and two variations of the Internal Ratings-Based (IRB) approach, known as foundation and advanced. The core of the IRB approach is to encourage banks to differentiate borrowers based on risk. Under this approach, banks categorize their borrowers into corporations, sovereigns, retail, specialized lending, and equity. The method is based on an internal estimation of probabilities of default (PD) for each borrower. For banks pursuing advanced IRB compliance, it will also include estimation of loss given default (LGD) and exposure at default (EAD) for each transaction. In addition, there are standards for treating risk mitigation vehicles, especially guarantees and credit derivatives. The Moody's KMV internal rating platform creates borrower ratings, which are relative measures of creditworthiness that can be mapped by a bank to a risk grade and then to a PD

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with internal data. A bank is able to use the mapping approach that best meets its needs.

75

See Moody’s Investors Service (http://www.moodyskmv.com/products/standAlone_creditRisk.html Consulted on 27/04/2007) 76 See Moody’s Investors Service KMV - Moody’s KMV Internal Rating Platform and the Basel II IRB Approaches, Addressing Issues raised by the New Basel Capital Accord’s Internal Ratings-Based Approach, 31/03/2005 (http://www.moodyskmv.com/products/files/MKMV_IR_Platform_and_Basel_II.pdf Consulted on 17/08/2007)

60

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4.1.4. Equity Prices and Bankruptcy In many cases of corporate default it is obvious that the equity price of a company anticipates anything related to financial trouble that can possibly end in bankruptcy. Bad news, rating downgrades and other factors lead to declining equity prices. If an equity price declines sharply, it tends to be a precursor of default. Therefore, banks have created the so-called equity default swap77 (EDS). Equity default swaps have been developed to take account of the correlation between credit spreads and equity prices. In general, an EDS is like an out-of-the-money put option repackaged to look like a CDS contract. It has a binary payoff if the equity price declines substantially. In this case, the EDS buyer receives a fixed recovery rate from the EDS seller. If the equity price stays above a certain strike level, the seller of the EDS receives a periodic premium. It is interesting to compare EDS and CDS pricings. Ideally, they should converge, but in reality this is not always the case. Historically, there is little linkage between equity options and CDSs. This offers potential for relative mispricings. The following table illustrates the intricacies of each product. Table 17: Comparison of Credit Default Swap and Equity Default Swap Credit Default Swap

Equity Default Swap

Trigger Event

Credit Event

Stock reaches strike price

Documentation

ISDA Credit Documentation

ISDA Equity Documentation

Rating

Easy to create

Possible to create

Settlement

Physical or Cash

Cash

Recovery Rate

Market situation

Pre-set percentage

It is definitely questionable why an investor should buy an EDS instead of a put option or to purchase credit protection on a CDS. For a strike price above zero, an EDS should definitely Copyright © 2008. Diplomica Verlag. All rights reserved.

trade at a premium. Taking risk in EDS form may then make sense if the premium is sufficient. Furthermore, the EDS does not have complicated definitions such as the “credit event” in a CDS; the crucial factor of an EDS is the underlying equity price. CDS and EDS are ways of taking extreme event risk. Due to its simplified structure, an EDS offers clear advantages compared to a CDS.

77

See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA), 2007, Pages 397 - 402

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4.2. Market Pricing Model for Credit Correlation Products This simplified model78 can only be applied to a portfolio of credits like a credit-linked-note. It examines the correlation between one credit and another and tries to understand their behaviour in terms of default dependency and the impact on the overall credit portfolio. The ultimate goal is to generate a portfolio loss distribution function in order to •

Calculate directly the expected loss of any tranche by integration

•

Determine easily derivative prices linked to that expected loss Illustration 13: Global Loan Defaults from 1996 to 200579

Illustration 14: Global Bond Defaults from 1996 to 200580

These two graphs illustrate the connection between strong economic growth and corporate

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defaults. In 2001 and 2002, shortly after the burst of the technology bubble, global bond and

78

See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA) 2007, Pages 226 - 239 79 Source: Moody’s Investors Service - Syndicated Bank Loans: 2005 Global Default Review and Outlook, Special Comment from February 2006, Page 2 (http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20 Research/documents/current/2005200000427884.pdf Consulted on 07/05/2007) 80 Source: Moody’s Investors Service - Syndicated Bank Loans: 2005 Global Default Review and Outlook, Special Comment from February 2006, Page 4 (http://www.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20 Research/documents/current/2005200000427884.pdf Consulted on 07/05/2007)

62

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loan defaults reached their peak. In 2004 and 2005, when economic growth started to pick up .

again, global bond and loan defaults came back down to the level of the mid 1990s. Examples of default clustering81 •

Oil: 22 companies defaulted from 1982 – 1986

•

Railroad: 1 default each year from 1970 – 1977

•

Airlines: 3 defaults between 1970 and 1971; 5 defaults between 1989 and 1990

•

Thrifts: 19 defaults between 1989 and 1990

•

Casinos: 10 defaults in 1990

•

Retail chains: over 20 defaults from 1990 – 1992

•

Real Estate: 4 defaults in 1992

This data shows that many defaults do not happen independently. They show serial dependence. A high default rate year is likely followed by another high default rate year. This comes in line with a default model that is driven by a common macroeconomic factor.

For credit correlation products, there are two major categories: The Nth-to-default basket and a synthetic CDO. Here are the main characteristics of the two products: Table 18: Nth-to-default basket vs. Synthetic CDO

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Nth-to-default basket Loss is linked to the default of the nth name in a basket Underlying risk is to a CDS on each of the basket reference entity names Tends to be a small portfolio of names with around 5 holdings

Synthetic CDO Loss is determined by the performance of a certain tranche (Equity, Mezzanine….) Underlying risk is to a CDS on each of the portfolio names Tends to be a large portfolio of names with around 30 holdings

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See Read, Jonathan P. – Advanced Applications of Credit Derivatives, New York (Lecture Notes from Columbia Business School, USA) 2007, Page 211

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Applications of Credit Derivatives : Opportunities and Risks involved in Credit Derivatives, Diplomica Verlag, 2008. ProQuest Ebook Central,

Harald Seemann - Applications of Credit Derivatives

An efficient pricing framework should describe how the basket names interact in terms of defaults. The following basket composition is projected as an illustration: Table 19: Sample Basket for a Credit Correlation Product Name Lufthansa Adidas Romania General Motors

5-year CDS spread in basis points 200 150 50 800

At the beginning, there is real uncertainty over which name will default first. The credit spreads indicate the probability of default; General Motors especially is at high risk. If one name like General Motors dominates the basket, the first-to-default level will obviously be trading close to the widest spread name, i.e. General Motors. The dominance is technically based on hazard rate. To illustrate the correlation mechanics in a default an example is offered. •

There are three CDSs on three different reference entities in the basket: A, B and C

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Default probabilities (p) are as follows: pA < pB