1. Chapter 15 Credit Derivatives

2. Saunders & Allen Chapter 152 BIS Capital Requirements for Credit Derivatives Interest rate derivatives total $65 trillion FX derivatives exceed $16 trillion Equity derivatives $2 trillion As of 6/01: credit derivatives = $1 trillion. Insurance cos. are net suppliers of credit risk protection. Banks and securities firms are net buyers. Figure 15.1. BIS II proposes harmonization of treatment of credit derivatives. w factor adjusts risk weight.

3. Saunders & Allen Chapter 153

4. 4 Credit Spread Call Option Payoff increases as the credit spread (CS) on a benchmark bond increases above some exercise spread S T. Payoff on option = Modified duration x FV of option x (current CS – S T ) Basis risk if CS on benchmark bond is not closely related to borrowers nontraded credit risk. Figure 15.3 shows the payoff structure.

5. Saunders & Allen Chapter 155

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7. 7 Default Option Pays a stated amount in the event of default. Usually specifies physical delivery in the event of default. Figure 15.4 shows the payoff structure. Variation: barrier option – if CS fall below some amount, then the option ceases to exist. Lowers the option premium.

8. Saunders & Allen Chapter 158

9. 9 Breakdown of Credit Derivatives: Rule (2001) British Bankers Assoc Survey 50% of notional value are credit swaps 23% are Collateralized Loan Obligations (CLOs) 8% are baskets (credit derivatives based on a small portfolio of loans each listed individually. A first- to-default basket credit default swap is triggered by the default of any security in the portfolio). 6% are credit spread options

10. Saunders & Allen Chapter 1510 The Total Return Swap Swaps fixed loan payment plus the change in the market value of the loan for a variable rate interest payment (tied to LIBOR). Figure 15.5 shows the structure. Table 15.1 shows the cash flows if the fixed loan rate=12%, LIBOR=11%, and the loan depreciates 10% in value over the year (at swap maturity). Buyer of credit protection (the bank lender) receives 11% and pays out (12% - 10%) = 2% for a net cash inflow of 9%.

11. Saunders & Allen Chapter 1511

12. Saunders & Allen Chapter 1512 Credit Default Swaps (CDS) CDS specifies: –Identity of reference loan –Definition of credit event (default, restructuring, etc.) –Payoff upon credit event. –Specification of physical or cash settlement. July 1999: master agreement for CDS by ISDA Swap premium = CS Figure 15.6 shows the cash flows on the CDS.

13. Saunders & Allen Chapter 1513

14. Saunders & Allen Chapter 1514 Pricing the CDS: Promoting Price Discovery in the Debt Market Premium on CDS = PD x LGD = CS on reference loan Decomposition of risky debt prices to obtain PD (see chapter 5): Basis in swap market (CDS premium CS) because: –Noise and embedded options in risky debt prices. –Liquidity premium in debt market. –Default risk premiums in CDS market for counterparty default risk. Increase as correlations increase and credit ratings deteriorate. Table 15.2. –High cost of arbitrage between CDS and debt markets.

15. Saunders & Allen Chapter 1515 Table 15.2 CDS Spreads for Different Counterparties

16. Saunders & Allen Chapter 1516 Hedging Credit Risk with Credit Risk Forwards Credit forward hedges against an increase in default risk on a loan. Benchmark bond CS F. MD=modified duration. Actual CS T on forward maturity date. Figure 15.8: Hedging loan default risk by selling a credit forward contract. Even if CS F > CS T, then there is a maximum cash outflow since CS T > 0

17. Saunders & Allen Chapter 1517

18. Saunders & Allen Chapter 1518 Credit Securitiizations CLO, CLN, CDO Since assets remain on the balance sheet, then there is no reduction in capital requirements, except under 1/2002 regulations for securities with recourse, direct credit substitutes, and residual interests supervised by US bank regulators. Sets risk weights from 20% (for AAA and AA rated) to 200% (for BB), but no change for unrated. High spreads in ABS market makes cost of financing high for banks. Might need borrowers consent to transfer loan to a SPV. Reputational effects: ex. In July 2001, American Express took a $1 billion charge because default rates on its CDOs were 8% rather than the expected 2%.

19. Saunders & Allen Chapter 1519 Synthetic Securitization BISTRO (Broad Index Secured Trust Offering) $10 billion loan portfolio backed by $850 million: Originating bank buys credit protection with a CDS that absorbs all credit losses after the threshold is met (eg., 1.5% so bank absorbs the first $150 million of losses). The BISTRO SPV is securitized with $700 million in US Treasury securities. So: holders of the BISTRO do not take credit losses unless the defaults exceed $850 million. Can use diversified portfolio (including loan commitments, letters of credit, and trade receivables) not eligible for inclusion in CLOs, CLNs or CDOs.

20. Saunders & Allen Chapter 1520

21. Saunders & Allen Chapter 1521 Pricing a Credit Linked Note (CLN) $100 million 5 year coupon CLN guarantees payment of principal at maturity, but all coupon payments end if a default event occurs. R f = 5% and CS = 7% PV of principal = $100/1.05 5 = $78.35 million. If selling at par, then PV of coupon payments = $100 – 78.35 = $21.65 million.

22. Saunders & Allen Chapter 1522 Appendix 15.1 In this replication, the investor (swap risk seller): –Purchases a cash bond with a spread of T + S c for par –Pays fixed on a swap (T + S c ) with the maturity of the cash bond and receives LIBOR (L) –Finances the position in the repo market at a rate quoted at a spread to LIBOR (L - x) –Pledges the bond as collateral and is charged a haircut by the repo counterparty. First 2 transactions hedge the interest rate risk. The last 2 transactions reflect the cost of financing the purchase of the risky bond. Fig. 15.10 The credit risk exposure of the swap seller = S c – S s + x which is the spread between the risky bond premium and the swap spread in the fixed-floating market plus the cost of setting up the arbitrage using repos.

23. Saunders & Allen Chapter 1523

24. Saunders & Allen Chapter 1524 Appendix 15.2 BIS II Capital Regulations for ABS Assets can be removed from balance sheet only if there is a clean break such that the transferred assets are: –Legally separated from the bank, and –Placed into a SPV, and –Not under the direct or indirect control of the originating bank. If there is implicit recourse then the bank may not be able to remove assets from balance sheet. If the ABS has an early wind down provision, then the originating bank must apply a minimum 10% conversion factor. Banks investing in ABS have risk weights ranging from 20% (AAA and AA) to 50% (A+ to A-) to 100% (BBB+ to BBB-) to 150% (BB+ to BB-) to 1250% or a 1-for-1 capital charge if ABS is rated B+ and below

25. Saunders & Allen Chapter 1525 ABS Regulatory Arbitrage under BIS I and BIS II $100 million of BBB loans with capital charge of $8 million. Place loans into SPV and sell 2 tranches of ABS. –Tranche 1: $80 m rated AA since only absorb default losses up to 0.3%. Sold to outside investors. –Tranche 2: Residual $20m absorb all other credit losses – rated B. Retained by bank. Under BIS I, the banks capital requirement would be $20m x 8% = $1.6 m, a reduction of $6.4 million. Under BIS II, the capital charge on the $20 million tranche would be $20 million (1-for-1), thereby eliminating any arbitrage incentives.

26. Saunders & Allen Chapter 1526