Credit Risk

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Credit Risk Measurement and Management

Credit Risk Credit Risk Measurement Mortgages & Mortgage Market Securitization (MBS, ABS , Others) Collateral Debt Obligations (CDOs) Credit Derivatives (CDS, CLNs)
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Credit Risk The uncertainty in Lending

Credit Risk is the risk of loss arising from the non-payment of principal & interest (obligation) by the borrower (obligor) on time. Any amount of fund lent to a borrower is exposed to certain level of credit risk (unless lent to someone who is considered default risk free) Every debt-instrument, based on its level of credit risk, trade at a yield higher relative to one with less credit risk or vice versa. Investors demand an extra yield premium for carrying the extra burden of credit risk. The difference in yield between two securities due to different credit quality is called yield spread or credit spread. The credit spread is often quoted in relation to yield on a credit risk free benchmark security.
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Few Credit Events

Credit spreads tightened during 90s, blue chip companies like GE and BT were offered syndicated loans at 10-14 basis points above LIBOR. To maintain margin, or increased return on capital, banks increased lending to riskier (high default risk) Corporates, increasing their credit risk exposure. Rapid increase in high yield and emerging market sectors, riskier assets, increased the magnitude of credit risk for investors and banks that held and traded the assets. The growth in credit risk exposure, increasing corporate defaults and consequently more losses led to more sophisticated risk management techniques.
Corporate Defaults
Corporate defaults increased excessively after 1999. Excessive default levels demanded focus on credit risk management.
Credit Risk
There are 2 main types of risk that a portfolio of assets/ position in a single asset is exposed to: Credit Default Risk Issuer of debt (obligor) is unable to meet its financial obligations. This is known as DEFAULT. Post default, lender incur a loss equal to the amount owed by the obligor less any recovery amount as the result of foreclosure, liquidation or restructuring of the obligor. The recovery amount, expressed as % of the amount owed is called recovery rate. The measure of firms credit default risk is given by its credit rating.
Credit Spread Risk

Credit spread is the excess premium, over and above government or risk-free risk, required by market for taking additional risk exposure. Higher the credit rating, smaller the credit spread. Credit spread risk is the risk of financial loss arising from the changes in the level of credit spread used in the mark-to-market of the product. Changes in observed over credit spreads affect the value of the portfolio and can lead to losses.
Credit Ratings and Transition

Standard & Poors
AAA AA A BBB BB B CCC CC C D
Moodys
Aaa Aa A Baa Ba B Caa Ca C
Transition Matrices
probability of migrating to rating by year end (%) original rating AAA AA A BBB BB B CCC Default AAA
93.66 0.66 0.07 0.03 0.03 0.00 0.16 0.00
AA
5.83 91.72 2.25 0.25 0.07 0.10 0.00 0.00
A
0.40 6.94 91.76 4.83 0.44 0.33 0.31 0.00
BBB
0.08 0.49 5.19 89.26 6.67 0.46 0.93 0.00
BB
0.03 0.06 0.49 4.44 83.31 5.77 2.00 0.00
B
0.00 0.09 0.20 0.81 7.47 84.19 10.74 0.00
CCC
0.00 0.02 0.01 0.16 1.05 3.87 63.96 0.00
Default
0.00 0.01 0.04 0.22 0.98 5.30 21.94 100.00
One-year ratings migration probabilities based upon bond rating data from 1981-2000. Data is adjusted for rating withdrawals. Numbers in each row should sum to 100%. Due to round-off error, they may not do so exactly. Source: Standard & Poor's
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Credit Risk Measurement Risk Quantified

Credit risk is measured using value-at-risk (VaR) technique. It was first introduced as a market risk measurement tool, and subsequently applied to credit risk and is an accepted methodology. VAR represents the maximum loss which can occur with X% confidence over a holding period of n days. In simpler words, it is a number that indicates the expected loss of a portfolio over a specified time period for a set level of probability. eg. Daily VaR: $100M to a 95% level of confidence=> during the day there is only 5% chance that the loss the next day will be greater than $100M. VaR estimates the potential loss in the market value of a portfolio using estimated volatilities and correlation.
Visualizing VAR
V a lu e a t R is k
.0 2 2 .0 1 6 .0 1 1 .0 0 5 .0 0 0 1 .5 2 .9 4 .3 C e r t a in t y i s 9 5 . 0 0 % f r o m 5 .6 2 . 6 t o + I n f in i t y 7 .0 433 3 2 4 .7 2 1 6 .5 1 0 8 .2 0
The area under the normal curve for confidence value is:
Confidence (x%)
90% 95% 97.5% 99%
ZX %
1.28 1.65 1.96 2.32
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How to measure?
VaR (daily VaR) (in %) = ZX% *
ZX%: the normal distribution value for the given probability (x%) (normal distribution has mean as 0 and standard deviation as 1) : standard deviation (volatility) of the asset (or portfolio)
VaR (daily VaR) = VaR (in %) * asset value

Or, VaR (daily VaR) = Z X% * * asset value
VaR (n days) (in %) = VaR(daily VaR) (in %) * n VaR (n days) = ZX% * * asset value * n port = wa2 a2 + wb2 b2+2wawb* a* b* ab VaRport (daily VaR) (in %) = wa2 (%VaRa)2 + wb2 (%VaRb)2+2wawb* (%VaRa)* (%VaRb)* ab
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Credit Value at Risk (CVaR)

Credit VaR methodologies take portfolio approach to quantify benefits of diversification and risks of concentration:
Credit risk of each obligor across the portfolio is re-stated on an equivalent basis and aggregated in order to be treated consistently regardless of the underlying asset class. Correlations of credit quality movements across obligors are taken into account.
Portfolio risk of an exposure is determined by the following factors:

size of exposure Maturity of exposure Probability of default of the underlying obligor Systematic or concentration risk of the obligor
Credit VaR, like market VaR, considers (credit) risk in mark-to-market framework (arising from changes in value due to credit events defaults, upgrades and downgrades)
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CVaR
Credit risk is different in nature to market risk.
Market return distributions are assumed to be relatively symmetrical and approximated by normal distributions. In credit portfolios, value change are relatively small resulting from minor upgrades, downgrades but is substantial upon default.
The remote probability of default produces skewed distributions with heavy downside tails.
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CVaR
Credit VaR models look to a time horizon and construct a distribution of value given different estimated credit outcomes. Modeling credit risk would require two main risk measures:
Distribution of loss: obtain distribution of loss that may arise from the current portfolio (this considers the question of expected loss for given confidence level) Identifying extreme and catastrophic outcomes: addressed using scenario analysis and concentration limits
The choice of time horizon shouldnt be shorter than the time frame over which risk-mitigating actions can be taken.
Constant time horizon: suitable for trading desk Hold t0 maturity: used by insurance companies and similar fund managers
Data Inputs: Modeling credit risk would require certain data input such as Credit Exposures Obligor default rates Obligor default rate volatilities Recovery rates
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Credit Risk Measurement Models

CreditMetrics KMV CreditRisk +
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Credit risk models

Measurement credit risk Definition credit risk
Expected loss = default probability x exposure x (1 - recovery rate) Economic interpretation: Average business costs, first moment Unexpected loss = standard deviation of expected loss Economic interpretation: Business risks, second moment
Modelling credit risk

CreditMetrics (J.P. Morgan) KMV (Moodys) CreditRisk+ (Credit Suisse First Boston)
Common data disadvantage / restriction is availability of (public) information
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CreditMetrics (JP Morgan, 1997)

Introduced value at risk (VAR) framework for the valuation and risk of non-tradable assets such as loans and privately placed bonds. 2 main approaches for quantifying risk:
First approach- Consider only Default or No Default (Builds Binomial Tree). Second approach- Risk Adjusted Return on Capital (RAROC) which observes volatility of corporate bond values within rating catogory, maturity band and industry grouping.
CreditMetrics stands between the two approaches by estimating portfolio VaR at the risk horizon due to credit events (includes upgrades, downgrades and defaults). CreditMetrics assumes 1year risk horizon (Risk horizon shouldnt be shorter than time to adopt risk mitigating actions.
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Three Steps in CreditMetrics : Methodology

Step 1: Measure Exposure: Decompose portfolios by instruments their exposure( Instruments covered: bonds, loans, swaps, receivables, commitments and letters of credit. Step 2: Distribute default risk and evaluate volatility of each exposures : Assign credit rating to each instrument/Credit events are defined with rating transitions. Step 3: Calculate credit quality correlations : correlations are inferred from correlations in asset prices.
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CreditMetrics Anatomy
Source: CreditMetrics
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Step 1: Estimating Credit Risk Exposure Amounts

Future cash flows at risk are covered for products such as:
Bonds and Loans face value Loan commitments face value Receivables face amount Letters of credit full nominal amount
Market-driven instruments:
Swaps Forwards
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Step 2: Compute the Volatility in Value Caused by Credit Quality Changes

Level of likelihood are attached to each credit event of upgrade, downgrade and default. Probability of obligor moving to a different credit rating is calculated. Each transition will result in change in value (derived from credit spread date and in default, recovery rates) Each value is weighted by its likelihood to create a distribution across each credit state. The senior unsecured credit rating of the issuer indicates the probability of default or transition to any other possible credit quality state in the risk horizon.
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Step 2: Compute the Volatility in Value Caused by Credit Quality Changes (Cont)
Revaluation during the risk time horizon can done by the following:
Seniority of exposure (recovery rates in the event of default) Forward zero coupon curve (spot curve) for each rating category which determines the revaluation upon upgrades or downgrades.
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Step 2: Compute the Volatility in Value Caused by Credit Quality Changes (Cont)
Probabilities from the above two steps are combined to calculate volatility of value due to credit quality changes.
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Step 3: Correlations
Estimating Credit Quality Correlations Each credit is segregated based on its industry and geographic location Correlations are calculated using the database of 152 country industry indices, 28 country indices and 19 world wide industry indices.
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Step 3: Correlations (Cont)

Obtaining a distribution of values for a portfolio of many bonds A random sample of possible portfolio states is used to obtain the value distribution for a portfolio of many bonds
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Effects of concentration and correlation on credit risk
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Calculation of VaR
Table 3: VaR Calculations for the BBB Loan
Year-End Rating Prob. Of State 0.02% 0.33 5.95 86.93 5.30 1.17 0.12 0.18 New Loan Value Plus Coupon $109.37 109.19 108.66 107.55 102.02 98.10 83.64 51.13 Prob. Weighted Value Difference of Value from Mean $2.28 2.10 1.57 0.46 (5.06) (8.99) (23.45) (55.96) Prob. Weighted Difference Squared 0.0010 0.0046 0.1474 0.1853 1.3592 0.9446 0.6598 5.6538
AAA AA A BBB BB B CCC Default
$0.02 0.36 6.47 93.49 5.41 1.15 1.10 0.09 Mean = $107.09 Variance = $8.95 SD=$2.99
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Calculation of VaR (Cont)

Assuming Normal Distribution
5% VAR = 1.65 * = $4.93 1% VAR = 2.33 * = $6.97
Assuming Actual Distribution

5% VAR = 95% of actual distribution = $107.09- $102.02 = $5.07 1% VAR = 99% of actual distribution = $107.09- $98.10 = $8.99
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Portfolio Case
The major distinction between the single loan case and the portfolio case is the introduction of correlations across loans. CreditMetrics solves for correlations by first regressing equity returns on industry indices. The correlation between any pair of equity returns is calculated using the correlations across the industry indices. Once we obtain equity correlations, we can solve for joint migration probabilities to estimate the likelihood that the joint credit quality of the loans in the portfolio will be wither upgraded or downgraded. Finally, each loans value is obtained for each credit migration possibility. The first two moments (mean and standard deviation) of the portfolio value distribution are derived from the probability-weighted loan values to obtain the normally distributed portfolio value distribution.
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The KMV Approach

KMV approach uses market-based quantitative techniques to assess credit risk Bondholders are paid first, equity holders have a residual claim If market value of assets falls to lower than value of liabilities then share is worthless becomes bankrupt i.e. liabilities > assets AND declining share price => company is getting closer to bankruptcy THUS only need to monitor share prices
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EDF (Expected Default Frequency)

Market-driven measure of a companys default risk Probability that a firm will default within a given time frame Default = failure to make scheduled principal or interest payments Calculated on the basis of:
Market value of the firm Level of debt obligations Volatility of firms value
EDF is calculated on a day-to-day basis Supposed to be forward-looking and able to outperform agency ratings and credit scoring statistical models EDF of 2% = 2% probability of defaulting with 12 months
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Figure from KMV
Value
Distribution of asset value at horizon Asset Volatility (1 Std Dev)

Distance-to-Default = 3 Standard deviations
Asset Value
Default Point EDF
Today
1 Yr
Time
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KMV strength and weakness

Strength
1. 2. 3. 4. Responsive to changing conditions ,(EDF updated quarterly) Based on stock market data which is timely and contains a forward looking view Strong theoretical underpinnings Can be applied to any publicly-traded company
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KMV strength and weakness (Cont)

Weakness
1. 2. 3. 4. Difficult to diagnose a theoretical EDF (what is the distribution of asset return outcomes) Problems in applying model to private companies and thinly-traded companies Results sensitive to stock market movements (does the stock-market over-react to news?) Ad-hoc definition of anticipated liabilities (i.e.. 50% of long-term debt)
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CreditRisk+
Uses two stage modeling:
Considers the distribution of the number of default events in a time period such as a year (within a portfolio of obligors having a range of different annual probabilities of default) Annual probability of default of each obligor can be determined by its credit rating Incorporates the effects of default correlations by using default rate volatilities and sector analysis.
Step 1
What is the frequency Of the defaults?
What is the Severity of the losses?
Step 2
Distribution of default losses
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Credit risk models

Main difference in three models is the measurement of default probability
CreditMetrics: Based on transition matrix Default probability is historically determined, i.e. given Input: Ratings, yield spread, market-model (VaR), available-for-sale KMV: Based on market volatility Default probability is continuous determined, i.e. implied Input: Stock-prices (equity call-option total assets), default risk, arbitrage-model, arbitrage CreditRisk+: Based on Poisson-distribution Default probability is theoretically determined, i.e. estimated / given Input: Ratings, default risk, default-model (Markov), hold-to-maturity
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Credit risk models CreditMetrics:

Using ratings makes model less volatile but also less realistic Market-model (given time-horizon) usefull for solvency calculations
KMV: Based on market volatility

Using stock-prices makes model more volatile but also more realistic Market-model (chosen time-horizon) usefull for solvency calculations
CreditRisk+: Based on Poisson-distribution

Using ratings makes model less volatile but also less realistic Default-model (closed-form relation) usefull for cash-flow hedging
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Summary of credit portfolio models
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Mortgages and Securitization
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Mortgages Leveraged Life

"Give me a lever long enough and a place to stand, and I could lift the world." Archimedes (287-212 B.C.) Mortgage: A pledge of property to secure payment of a debt which can be repossessed on default. Typically, Home buyers do not have enough capital to fund outright purchase (particularly young individuals and households) Buyers finance the purchase (leverage through loan) The loan is secured by the real-estate being purchased Until the loan is repaid, the lender is a lien holder on the title of the property.
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Lien Status
Lien status indicates the seniority of loan in the event of forced liquidation of property owing to default by the obligor. Mostly mortgages have first lien status. Second lien would indicate access to the proceeds of liquidation only after first lien balance is extinguished. Second lien loans were used to liquefy the equity component in the home. Second lien can also be originated along with first lien to maintain the first lien loan-to-value (LTV) ratio below a stipulated level (typically 80%). This avoided need of mortgage insurance, which is required for loans with LTV more than 80%. Such transactions were often referred as a piggyback loan.
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Market Participants
Borrowers
Residential Real Estate (for family, households) Commercial Real Estate (for business)
Lenders/ Originators: operate in primary and secondary markets Primary mortgage markets
Originators of the loans : Loan Origination is the process of creating a new loan agreement between lender and a borrower. Mortgage Banking refers to the activity of originating mortgage loans.
Secondary mortgage markets

Participants buy, sell and securitize mortgages Government participants (Government Sponsored Enterprises) Institutional participants (Depository, insurance, Finance companies)
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Primary Mortgage Market

Primary market participants:
Depository Institutions Commercial banks Savings banks Non depository institutions Finance companies
Insurers
FHA: Federal Housing Administration VA: Veterans Administration Private insurers
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Primary Mortgage Market
Notice that GMAC, a finance company once chartered to finance car loans, is one of the largest participants in the mortgage markets.
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Secondary Mortgage Market

Secondary market participants:
Government sponsored enterprises Federal National Mortgage Association (FNMA Fannie Mae) Federal Home Loan Mortgage Association (FHLMC Freddie Mac) Government National Mortgage Association (GNMA Ginnie Mae) Other purchasers Life insurance companies Pension funds REITs Households By dollar volume, holders of mortgage securities Federally related mortgage pools = $3.4 Trillion Commercial banking = $1.5 Trillion ABS (asset backed securities) issuers = $1 Trillion Savings institutions = $800 Billion
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Mortgage underwriting process

Borrower seeks funds from originator (mortgage banker), who needs to address the adverse selection problem.
Decision (to determine type) is based on: credit history income history current financial situation Borrower needs to submit (to demonstrate type): Most recent pay stubs 2 yrs W-2 all financial accounts (assets retirement, bank accounts, real-estate, vehicles & liabilities outstanding loans, credit card) credit history (as a homeowner, renter) Originator evaluates credit and repayment capability using two primary ratios: IIR: Income to Installment ratio (PTI: Payment-to-income) LTV: Loan-to-value (Loan Amount/ Value of Real Estate) Larger down payments increases home equity hence reduces risk.
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Loan origination risk: Mortgage brokers make loan commitment well before the actual loan disbursements and hence are exposed to the following Price risk: If mortgage rates rise, the lender has pre-committed to a rate that is below the market rate. Fallout risk: If mortgage rates drop, borrowers may seek an alterative loan package at a lower rate
Once approved, lender sends commitment letter to borrower

Pre approval letter Usually valid for 30-60 days. realtors and home sellers may require pre approval before a bid can be submitted (solves the problem of adverse selection)
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Borrower selects financing option once a home is chosen, a price is agreed and all inspections are done
Fixed Rate: The loan interest rate is constant over the term of the mortgage Based on the market rate, adjusted for lender risk Fixed at time of loan application or approval (loan lock) Fixed at time of closing Terms are usually 30 years, 15 years (shorter tenor loans are motivated by desire to build home equity). Adjustable rate (ARMs): The loan interest rate may change over the term of the mortgage The contractual rate is based on both the movement of an underlying rate (the index) and the spread over the index (the margin). Fixed for 1, 3 5, 7 years and variable thereafter (1, 3, 5, 7 year ARMs)- Hybrid ARMs. Minimum (Floor) and Maximum (Cap) rates are generally set (eg. Rate may increase or decrease by a maximum of 1% per years, and no more than 5% over the life of the loan) cap & floor protects from payment shock ARMs typically adjust or reset annually. The initial rate is often less than the fully indexed rate and often referred as teaser rate.
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Mortgage Amortization
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Mortgage Amortization
Mortgage interest is front-end loaded Hence, tax benefit is greatest during the earlier years, when interest expense is tax deductible This is a self amortizing loan unlike a coupon paying bond Self-amortization is partly a solution to moral hazard, since the principal is paid over time with interest similar to a sinking fund provision
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Type of Mortgages
Mortgages are classified by interest rate type and loan size.
Fixed Rate Mortgage (FRM) : CPM,CAM,CIM Adjustable Rate Mortgage (ARM) Graduated Payment Mortgage (GPM) Shared Appreciation Mortgage (SAM) Reverse Annuity Mortgage (RAM)
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Government sponsored enterprises

The role of government in real-estate financing: The government has created a number of federal agencies to:
1. Promote home ownership 2. Create a flow of capital to facilitate this ownership.
Federal and private agencies keep funds flowing in markets regardless of interest rates. Loans are continuously reprised as the yield curve changes. Since loans are passed on to public markets, capital is free to originate new loans. 1934: Established Federal Housing Association (FHA) and Veterans Administration (VA) to restore confidence in the nations housing sector.
1. 2. 3. 4. 5. Developed lending standards to reduce lender risk exposure Loans that meet these standards are called conforming Standardized loan terms (long) and amortization schedules Established a (fee based) mortgage insurance program to cover lender losses Insurance allows securitization of the mortgages such that they can be packed into bond-like securities and sold in public markets
FHA insurance guarantees that 99% of principal is repaid. GNMA can enhance this as additional insurance. Cost is about 13 bp.
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Government sponsored enterprises

1938: Created Federal National Mortgage Association (Fannie Mae) to help facilitate a secondary market in mortgages.
1. Chartered to create a secondary market for loans insured by FHA/VA/FMHA mortgages, allowing originating institutions to underwrite new loans 2. Converted to private form in 1968, traded on the NYSE, but continues with original charter 3. FNMA sells securities backed by these mortgages to the public market (Mortgage backed securities) 4. FNMA also buys and securitizes conventional loans 5. FNMA issues public debt that it uses to buy, pool and package securities from loan originators and sell these backed securities in secondary markets. 6. Has a secured line of credit with the U.S. Treasury 7. Is perceived by many to have the full faith and credit of the U.S. government, but this not so. It might be implicit, but we will not know until the full faith and credit of the U.S. government is needed.
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Government Sponsored Enterprises

1968: Government split off Government National Mortgage Association (Ginnie Mae) from FNMA to provide subsidized loans to borrowers.
1. Wholly owned by the government U.S. Department of Housing and Urban Development (HUD) 2. Created to increase secondary market for mortgages as fewer VA originated loans were available to securitize, thus encouraging continued expansion of the housing market 3. Provides a government guaranteed secondary market backed by full faith and credit of the U.S. government, unlike all other GSEs. 4. Offers federally subsidized housing programs (HUD homes) 5. Provide a federal guarantee to FHA, VA and Farmers Home Administration (FMHA) mortgages that are pooled together in a mortgage backed security 6. Target mortgages are groups of borrowers that might otherwise be disadvataged low income.
Question: What is the difference between Fannie Mae and Ginnie Mae? Answer: FNMA purchases loans and issues new securities, GNMA is only issuing a guarantee on the loan, facilitating secondary market activity.
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Government Sponsored Enterprises

1970: Federal Home Loan Mortgage Corporation (FHMLC - Freddie Mac) created as a quasi publicprivate institution
1. It is 100% public owned and traded. 2. Plays a similar role as Fannie Mae, except that their major source of loans comes from Thrift institutions, rather than VA, FHA or FMHA. 3. Issues debt securities to buy conventional loans, those that are not federally insured by FHA or VA 4. Conventional loans are those backed by the credit of the borrower and the real estate being purchased. 5. Otherwise mimics Fannie Mae
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Securitization: Pool, Package, Sell

Securitization is a mechanism of packaging future cash flows associated with illiquid asset (or asset pool) inform of tradable securities and selling them for cash. The process starts when an originator, who originates/owns the assets (e.g., mortgages or accounts receivable) which has predictable cash flows. A SPV is created : new legal entity. Originator sells assets to SPV . The SPV aggregates assets, pools and repackages them into predictable cash flow streams. The SPV issues tradable securities to investors, which are backed by these cash flow streams. These securities are called pass through certificates (PTCs) Proceeds from the issue of securities are used to pay the seller of assets. A servicer continues to manage collections on behalf of the SPV. Collections from pool of assets used to repay securities Outright sale provides bankruptcy remoteness (look to assets, not originator)
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Generic deal diagram

Obligors
2 Collections 1 Original Loan Cash flows 10 Sale of asset 6 7 Purchase consideration
Credit Enhancement Providers

3 Credit enhancement 9 Issue of securities 11 Servicing of securities
Collection Agent Originator
SPV
4 Rating
Investors
8 Subscription to securities
Rating Agency
5
Arranger
Contracts Ongoing cash flows Initial cash flows
Structurer
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Securitisation PTCs vs. Bonds/Loans

Securitised Notes PTC holder specific charge on the assets Obligor (borrower) Bonds On the list of Official Liquidator Based on the strength of originator
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Key Players in Securitization

Sponsor: The sponsor of the securitisation program that initiates the securitisation process. Seller: Seller originates loans and receivables with predictable cash flows. Arranger: Originator/ seller appoints an arranger for the transaction (an investment bank).
Responsible for taking the transaction from deal origination to closure Determining transaction dynamics Appointing various transaction participants Coordinating with participants on data and other information Deal structuring, pricing and placement
Servicer:
Typically, the seller itself Responsible for primary collection, management and administration of receivables underlying pool
Auditor: Audit full or sample contracts from pool to determine whether selection criteria is adhered to.
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Key Players in Securitization (Cont)

Trustee: Fiduciary responsibility towards the investors
Manages the SPV trust from transaction opening to closing Responsible for taking various actions to protect the interest of the investors
Rating agency
Assesses the credit quality of the collateral to determine credit enhancement for the deal Assesses the counterparties to the transaction and their impact on the deal Evaluates the legal structure based on independent legal opinions
Independent legal counsel

Provides legal advise on transaction and final opinions on key issues such as bankruptcy remoteness etc Drafts proposed deal documents
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Credit Enhancement: Default Protection

Excess Spread of margins Over collateralization Cash collateral Bank Guarantee Letter of credit
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Securitization - Advantages
Resilient funding source eg. Chrysler
Profitability and Capital Adequacy
Accelerates earning
Attractive cost of funds
Liquidity :
Funding diversification
Credit Quality
Transfers catastrophic risk Benefits from multiple levels of due diligence
Capital
Reduces Regulatory capital requirement Faster turnaround of assets with limited capital
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Benefits to Financial System

Cleaner books due to expertise of originators Systemically solves the ALM problems in the sector Encourages an efficient market Results in substantial benefits to the end customer . Return on Equity
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Securitization - Disadvantages
Adverse selection Reduced operating flexibility May result in over-reliance: Potential for short term market disruptions Earnings distortion Results in strong growth pressure Securitization treadmill Moral risk: Risks in a way remain on balance sheet pressure to Save Securitization Reduces entry barriers for weaker originators
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Key Risks- Where can we loose money??

Credit Risk: Function of underlying obligors ability and willingness to pay (Default Risk). Dependent on the underlying asset and the origination quality. Prepayment Risk: Early payment of interest and principal by the obligors. Servicing Risk: The obligors may have the ability to pay but the servicer can be incapable to collect. Counterparty Risk: Funds collected from the collateral pool are held in different bank accounts before being transferred to the investor. In the event of insolvency of any of the party of the transaction, the funds can get commingled with the bankruptcy estate of the defaulted party (Commingling Risk). Various counterparties are involved in the Legal Risk:
Transferability of assets Bankruptcy remoteness of issuer Security interest over assets Transfer tax, stamp duty, withholding tax
Market Risk:
Macroeconomic Risks
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Securitization Classification
Off balance Sheet: sell the securities
pass-through certificates, there are different classes of bonds, investors receive cash flow based on the class of PTC they hold. Tranches: Senior / Subordinate
On Balance sheet: covered bonds

Covered bonds are full recourse debt obligations of the issuing financial institution, secured by a pool of performing eligible assets (cover pool) that remain on the balance sheet of the issuer.
With recourse credit risk retained by originator With out recourse credit risk is passed on to the investor An asset-backed security (ABS) is a security whose value and income payments are derived from and collateralized (or "backed") by a specified pool of underlying assets. The pools of underlying assets can include common payments from credit cards, auto loans, and mortgage loans, to cash flows from aircraft leases, royalty payments and hotel revenues.
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Mortgage Backed Securities (MBS)

A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from the underlying mortgage loans ,held by the SPV. All mortgage is composed of 2 parts:
Mortgage Deed or the Deed of Trust: Mortgage Deed describes the real estate to be used as a collateral against the repayment. In Deed of trust the borrower creates a trust and conveys the title of property to the trustee who holds it as security for the benefit of the lender Promissory note: Personal promise to repay the note even in absence of any real estate security
Legal relationship:
Title theory: Title is held by the mortgagee (lender) Lien Theory: Mortgagor (borrower) holds the tile and mortgagee has lien to the property.
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FNMA: Agency Pass-Through Security

Securitization process:
1. Mortgages are pooled by FNMA 2. Principal and Interest (P&I) from the underlying assets (mortgages) is the securitys cash inflow 3. Servicing fee for collecting and dispersing payments is removed (25-50 basis points) 4. Default fee paid to credit enhancer (like GNMA) is removed 5. Remaining cash is dispersed to investors.
This is an AGENCY PASSTHROUGH SECURITY
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GNMA Insurance
Ginnie Mae securitization process:
1. 2. 3. 4. 5. 6. A GNMA approved mortgage lender makes a commitment to a home buyer or refinancer Lender gets a guarantee from GNMA Mortgage is settled between lender and borrower Lender pools similar mortgages and delivers the package to GNMA The lender remains the servicer of the mortgage, or Lender can sell the right separate from delivery of the mortgage to GNMA Securities dealers sell the GNMA guaranteed pools of mortgages and advises GNMA of sale Lenders (mortgage servicer) forwards monthly payments to GNMA who then disburses payments to investors.
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Structure and Risk Associated with pass-through Securities

Risks associated with mortgages
1. 2. 3. 4. Price risk Default risk Liquidity risk Prepayment risk
Cash flow characteristics:

1. 2. 3. 4. Principal payments: Paying off the loan amount Interest payments: Interest on loan Prepayments: Early payments of principal Fees: Servicing Credit enhancement 5. Payment delay: although mortgage payments are due on the first day of the month, there is a delay in the payment of the cash outflow to security holders. This delay is an interest bearing fee.
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Contraction & Extension Risk

Prepayment occurs when:
1. 2. 3. 4. Owners sells home new owner finances with new mortgage Re-finance lower market rate Re-finance cashout equity Extra payments owner seeks early payoff decreasing interest rates increase the face value of a bond, but not necessarily for mortgage backed securities, because prepayment is likely
Contraction risk:
1. Probability of prepayment is higher as interest rates drop and homeowners choose to refinance. 2. Prepayment is done at par value, not current market rate, so no premium is paid. 3. Mortgage loan is essentially a callable bond.
The price sensitivity of a bond has negative convexity the price changes non-linearly as the market Extension risk: prepayment slows when interest rates rise
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Prepayment risk
The upside potential of a mortgage security is limited by prepayment since redemption is at par.
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Conditional Prepayment Rate (CPR)

Financial institutions, particular banks, are worried about duration matching, since they borrow short and lend long Knowing prepayment rates, and the extent of either extension risk or contraction risk of their mortgages, is particularly important Conditional Prepayment Rate (CPR): Some fraction of a pool of mortgages will be prepaid each year.
1. 2. 3. 4. Best predictor of CPR is past prepayment rates. Its called conditional since its conditional on the remaining mortgage balance. CPR = percent of remaining pool prepaid typically non linear Benchmark CPR = 100%PSA (public securities association prepayment benchmark)
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Conditional Prepayment Rate (CPR)

Prepayment is low for new mortgages, but speeds up until 30 months, remaining constant thereafter. < 30 months, CPR = 6%*month/30 >30 months, CPR = 6% If a mortgage pool has different prepayment characteristics, its typically quoted as a percentage of PSA (eg 150% PSA has a higher pre-payment rate. CPR is 50% greater than the average CPR) The percent PSA will increase as yield decreases (lower interest rate environment)
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Structuring: Slicing and Dicing

At all times, the total cash flows, value, and risk of the tranches must equal those of the collateral. If some tranches are less risky than the collateral, others must be more risky.
Senior/Subordinate IO/PO Floater/Inverse Floater
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I-O/P-O pass-through Securities

Interest only, principal only pass-through securities: investors chooses one of two cash flow streams.
This is a stripped MBS, first introduced by Fannie Mae in 1986 Separates interest rate risk into different classes of securities
I-O class
Receives all of the interest has no par value prepayment of a mortgage cancels all associated future interest payments
P-O class
Receives all of the principal Is sold at a discount to par value
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The price yield characteristic is different for each class yield depends on the speed of prepayment.
Unpredicted early prepayment (faster prepayment) increases the value of the PO tranche Lower than expected prepayment (slower prepayment) increases the value of the IO tranche.
If interest rates increase, then prepayment slows (homeowners limit refinance and selling)
IO tranche value increases Value increasing with interest rates is a unique feature most fixed income instruments have opposite relationship.
If interest rates drop, then prepayment increases (homeowners increasingly refinance)

PO tranche value increases
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What type of investor holds a PO or IO? IO Tranches are unique in that their value increases when interest rates rise (most other bond securities have the opposite relation) Mortgage servicers earn money on servicing mortgages, and protect themselves against early prepayment by purchasing PO tranches as a hedge. A financial institution holding a portfolio of loans may purchase an IO strip to hedge against interest rate risk and resulting maturity matching problems. (borrowing short lend long problem)
Investors purchase these securities to hedge against pre payment. These securities are popular during regimes of changing interest rates
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IO Stripped MBS
If the mortgages underlying a $100M, 7.5% MBS with PO and IO classes were paid off in the first year, then the IO MBS holders would receive a one-time cash flow of $7.5M:
$7.5M = (.075)($100M)
If $50M of the mortgages were prepaid in the first year and the remaining $50M in the second year, then the IO MBS investors would receive an annualized cash flow over two years totaling $11.25M:
$11.25M = (.075) ($100M) + (.075)($100M-$50M)
If the mortgage principal is paid down $25M per year, then the cash flow over four years would total $18.75M:
$18.75M = (.075)($100M) + (.075)($100M-$25M) + (.075)($75M-$25M) + (.075)($50M-$25M))
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Floater & Inverse Floaters

The collateral consists of a regular five-year, 6% coupon $100 million note. This can be split up into a floater, that pays LIBOR on a notional of $50 million and an inverse floater that pays 12% LIBOR on a notional of $50 million. CouponF = Min(LIBOR, 12%) CouponIF = Max(12% LIBOR, 0) $50 LIBOR + $50 (12% LIBOR) = $100 6% = $6 Assume a flat-term structure and say the duration of the original five-year note is D = 4.5 years. The portfolio dollar duration is: $50,000,000 DF + $50,000,000 DIF = $100,000,000 D Just before a reset, the duration of the floater is close to zero DF = 0. Hence, the duration of the inverse floater must be DIF = ($100,000,000/$50,000,000) D = 2 D, or nine years, which is twice that of the original note.
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Calculate
Suppose the coupon is tied to twice LIBORfor example 18% 2 LIBOR. x LIBOR + (100 x) (18% 2 LIBOR) = $6 [x 2(100 x)] LIBOR + (100 x) 18% = $6 Because LIBOR will change over time, this can only be satisfied if the term between brackets is always zero. This implies 3x 200 = 0, or x = $66.67 million. Thus, two-thirds of the notional must be allocated to the floater, and one-third to the inverse floater. The inverse floater now has three times the duration of the original note.
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Collateralized Mortgage Obligations (CMO)

Tranches are created from alternate methods of separating risk Class A: guaranteed interest, but not maturity length. Class A gets highest PSA speed, paying off this security first Class B: Structured like Class A, but paid off second, principal payment begin once Class A paid off Class C/D: Fixed periods and interest rate Residual: All residual cash flow goes here Make the RESIDUAL tranche just big ($3M) enough to assume all residual prepayment risk such that Class C and D are not at risk.
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Collateralized Mortgage Obligations (CMO)

Security Ratings for CMO:
1. Class A D are rated by CRA, which if structured properly, should have little risk and a high rating. 2. Residual is not rated all risk resides here.
Alternatively, a CMO could be structured entirely as Class A and B above, where each succeeding class doesnt receive any principal payment until all preceding classes are paid off.
1. Precise principal payments are known for each class, but timing of payments (or precise amount in each period) is not. 2. All securities collect stated interest until such time that principal payoffs reach that class. 3. The effect of this security is creating different maturities for different investors, both shorter and longer than the average life of the collateral
PSA100% -> average life of collateral 15.11 years. Tranche 1 = 4.90 yrs Tranche 2 = 10.86 yrs Tranche 3 = 15.78 yrs Tranche 4 = 24.58 yrs
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CDO: Debt Repackaged

Collateralized Debt Obligation (CDO) is an asset backed security structure backed by debt instrument collateral.
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Type of Collateral
CDOs are distinguished based on the type of collateral that backs the notes. CDO backed entirely by loans are called Collateralized Loan Obligations (CLOs) where as bond backed CDOs are called Collateralized Bond Obligations. Later, CDOs were backed by ABSs, CMBSs and RMBSs. (also known as structured finance CDOs)
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CDO
Asset pool of Bonds with face value: 1000 mn Transaction Waterfall : Determines how the cash generated from the asset will flow through the liabilities/notes. Rating enhancement for the senior classes is achieved through prioritizing the cash flows or through external credit support. Rating agencies have internal models to rate the senior tranches based on the probability of shortfalls due to defaults. Example:
Tranche A pays LIBOR + 45bp, Equity tranche, which is not rated, Due to leverage, the return can be very high if there is no default. The pricing of the equity tranche differs from others. He recives a running spread, and an up-front fee. This fee is quoted in percent and is typically around 40% for an investment-grade CDO. In this case, the investor would get 40% $30 = $12 million up front.
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CDO
The underlying and resulting securities, will have the same cash flows at each point in time, apart from transaction costs. As a result, this implies (1) the same total market value, and (2) the same risk profile, both for interest rate and default risk. The weighted duration of the final package must equal that of the underlying securities. The expected default rate, averaged by market values, must be the same. So, if some tranches are less risky, others must bear more risk. This is sometimes called toxic waste. The institution sponsoring the CDO will most of the time retain the most subordinate equity tranche.
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Types of CDOs : Economic Motivations

Balance Sheet
The primary goal of balance sheet CDOs is to move loans off the balance sheet of commercial banks to lower regulatory capital requirements.
Arbitrage CDOs
Arbitrage CDOs are designed to capture the spread between the portfolio of underlying securities and that of highly rated, overlying tranches.
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Cash Flow and Synthetic CDOs

Funded, cash-flow CDOs: The physical assets are sold to a SPV and the underlying cash flows are used to back payments to the issued notes. Synthetic CDOs is achieved with credit default swaps (CDSs). We know that a long position in a defaultable bond is equivalent to a long position in a default-free bond plus a short position in a CDS. Synthetic CDOs create higher yields by first funding, or placing the initial investment in default-free, or Treasury, securities, and second, selling a group of CDSs to replicate a cash flow CDO.
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Typical Cash CDO Structure
Collateral Manager
IR Hedge Counterparty
Class A Notes
Collateral Senior Secured Loans Senior Unsecured Loans Sub-Participations
Interest & Principal Collections
Issuer SPV
Interest & Principal on the Notes
Class B Notes Class C Notes Class D Notes Class E Sub Notes [unrated]
Trustee/ Collateral Administrator
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Typical Funded Synthetic CDO Structure
Reference Portfolio
Premium SPV
Libor + Premium Investor Note Proceeds
Arranging Bank buys Contingent Payment protection under Libor Portfolio Credit Default Swap Charged Asset
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Subprime Mortgage
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Subprime Loan
A type of loan that is offered at a rate above prime to individuals who do not qualify for prime rate loans. Quite often, subprime borrowers are often turned away from traditional lenders because of their low credit ratings or other factors that suggest that they have a reasonable chance of defaulting on the debt repayment. The amount of default in the pipeline for remaining loans in the next four months is constructed as follows: Pipeline default = 0.7 (60-day + 90-day + bankruptcy) + (foreclosure + real-estate owned) Total default = pipeline default (fraction of loans remaining) + (Cum loss)/(loss severity)
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Overview of subprime MBS

The typical subprime trust has the following structural features designed to protect investors from losses on the underlying mortgage loans:
Subordination Excess spread Shifting interest Performance triggers Interest rate swap
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Subordination
The distribution of losses on the mortgage pool is typically tranched into different classes. The most junior class of a securitization is referred to as the equity tranche. A small part of the capital structure of the trust is made up of the mezzanine class of debt securities, which are next in line to absorb losses. mezzanine class of securities typically has several tranches with credit ratings that vary between AA and B. The lions share of the capital structure is always funded by the senior class of debt securities, which are last in line to absorb losses.
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Excess spread
The weighted average coupon from the mortgage loan will typically be larger than fees to the servicers, net payments to the swap counterparty, and the weighted average coupon on debt securities issued by the trust. This difference is referred to as excess spread, which is used to absorb credit losses on the mortgage loans.
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Shifting interest
Senior investors are also protected by the practice of shifting interest, which requires that all principal payments to be applied to senior notes over a specified period of time (usually the first 36 months) before being paid to mezzanine bondholders. During this time, known as the lockout period, mezzanine bondholders receive only the coupon on their notes.
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Performance triggers
The trigger event is defined as a distribution date when one of the following two conditions is met:
The rolling three-month average of 60-days or more delinquent (including those in foreclosure, REO properties, or mortgage loans in bankruptcy) divided by the remaining principal balance of the mortgage loans is larger than 38.70% of the subordination of the senior class from the previous month; or, The amount of cumulative realized losses incurred over the life of the deal as a fraction of the original principal balance of the mortgage loans exceeds the thresholds.
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Interest rate swap

The trust is exposed to the risk that interest rates increase, so that the cost of funding increases faster than interest payments received on the mortgages. In order to mitigate this risk, the trust engages in an interest rate swap with a third-party named the swap counterparty.
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The subprime credit rating process

The rating process can be split into two steps:
Estimation of a loss distribution, and Simulation of the cash flows.
Credit enhancement (CE) is simply the amount of loss on underlying collateral that can be absorbed before the tranche absorbs any loss. When a credit rating is associated with the probability of default, the amount of credit enhancement is simply the level of loss CE such that the probability that loss is higher than CE is equal to the probability of default.
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Relationship between the credit ratings cycle and the housing cycle
Like corporate credit ratings, the agencies seek to make subprime ABS credit ratings through the housing cycle. Stability means that one should not see upgrades concentrated during a housing boom and downgrades concentrated during a housing bust. Rating agency must respond to shifts in the loss distribution by increasing the amount of needed credit enhancement to keep ratings stable as economic conditions deteriorate. stabilizing of ratings through the cycle is associated with pro-cyclical credit enhancement: as the housing market improves, credit enhancement falls; as the housing market slows down, credit enhancement increases. This phenomenon has two important implications:
Pro-cyclical credit enhancement has the potential to amplify the housing cycle, creating credit and asset price bubbles on the upside and contributing to severe credit crunches and on the downside. Investors in subprime ABS are vulnerable to the ability of the rating agency to predict turning points in the housing cycle and respond appropriately.
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Cash Flow Analytics for Excess Spread

The key inputs into the cash flow analysis involve:
the credit enhancement for given credit rating the timing of these losses prepayment rates interest rates and index mismatches trigger events weighted average loan rate decrease prepayment penalties pre-funding accounts swaps, caps, and other derivatives.
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Anatomy of Downgrade
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Predatory lending is defined by Morgan (2007) as the welfare-reducing provision of credit. In other words, the borrower would have been better off without the loan. The Center for Responsible Lending has identified seven signs of a predatory loan:
Excessive fees, defined as points and other fees of five percent or more of the loan Abusive prepayment penalties, defined as a penalty for more than three years or in an amount larger than six months interest Kickbacks to brokers, defined as compensation to a broker for selling a loan to a borrower at a higher interest rate than the minimum rate that the lender would be willing to charge Loan flipping, defined as the repeated refinancing of loans in order to generate fee income without any tangible benefit to the borrower
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Unnecessary products Mandatory arbitration requires a borrower to waive legal remedies in the event that loan terms are later determined to be abusive Steering and targeting borrowers into subprime products when they would qualify for prime products. Fannie Mae has estimated that up to half of borrowers with subprime mortgages could have qualified for loans with better terms
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Predatory Borrowing
Predatory borrowing is defined as the willful misrepresentation of material facts about a real estate transaction by a borrower to the ultimate purchaser of the loan. This financial fraud might also involve cooperation of other insiders realtors, mortgage brokers, appraisers, notaries, attorneys. The victims of this fraud include the ultimate purchaser of the loan (for example a public pension), but also include honest borrowers who have to pay higher interest rates for mortgage loans and prices for residential real estate.
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Four guiding principles of FAS140

The transferred assets have been isolated from the transferor-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership. Each transferee (or, if the transferee is a qualifying special-purpose entity (SPE), each holder of its beneficial interests) has the right to pledge or exchange the assets (or beneficial interests) it received, and no condition both constrains the transferee (or holder) from taking advantage of its right to pledge or exchange and provides more than a trivial benefit to the transferor. The originator must surrender effective control over the assets. Permissible activities of the SPE must be significantly limited.
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Enrons FAS140 Transactions
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FIN46R Anti-Enron Rule

It define certain types of SPVs as Variable interest entities if the SPE is nonpassive and requires subordinated financial support for its activity and beyond the equity issued by the entity. the rules govern whether or not a company must consolidate the results of entities that would not previously have been consolidated.
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Securitisation - Accounting
Financial Accounting Standard Board (FASB) USA (FAS 140), International Accounting Standards Committee (IAS), UK (IAS 39) and the Accounting Standards Board UKs Financial Reporting Standard 5 (FRS 5)
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Credit Derivatives Own the risk but not the asset!!

Credit Derivatives are bilateral financial contracts structured to eliminate credit risk exposure by providing insurance against losses suffered due to adverse credit events. Payout under a credit derivative is triggered by a credit event associated with the reference asset or reference entity. Almost insurance like but distinguished by principles of indemnity and insurable interest.
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Transferring Credit Risk

Credit Default swaps are most similar to credit insurance policies or financial guarantees among of all derivatives. Credit risk is transferred from the Seller to the Buyer for an amount called premium. Most popular form of credit derivatives transaction is the single name credit default swap.
Single name CDS Mechanics Periodic Premium

The protection buyer pays a running premium to the seller, in exchange for payment in the case of a Credit Event This premium is set by the market as the risk premium necessary for the seller to take risk
Protection Buyer
Credit Event (payment made)
Protection Seller
Contingent Payment
No Credit Event (no payment)
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CDS Cash Flows before a credit Event

The only cash flows (pre Credit Event) are the premium payments made by the Buyer of protection
Typical Single name CDS Mechanics (pre-credit event) Example Default Swap Spread Protection Buyer Zero
P&I
Example: 5 Yr CDS on Tata Steel is quoted at 75/85.
Protection Seller
Investor can buy protection (i.e. go short the credit) by paying the market maker 85bp credit spread Investor can sell protection on Tata Steel (i.e. go long the credit) an earn a spread of 75bps
Reference Asset
CDS premium is exchanged until the occurrence of a Credit Event, or the scheduled maturity of the CDS transaction
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CDS Cash Flows Post a credit Event

Post a credit event, protection buyer receives a payment equal to the full swap par/notional (100%) amount on the reference asset minus the expected recovery.
Physical Settlement Mechanics

Deliverable Obligation, Face equal to Swap Notional
Settlement Methods
Cash Settlement: Protection seller makes a single cash payment equal to par value minus the current price of the asset. Digital Settlement: A type of cash settlement with fixed cash payment from the seller to buyer. Physical Settlement: Protection buyer delivers the defaulted asset physically in lieu of fixed cash payment which is usually the par value. Majority of CDS contracts trade with Physical Settlement
Protection Buyer
Cash Payment equal to Swap Notional
Protection Seller
Reference Asset
Post the Credit Event, the CDS terminates and no further payments are made by either party
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CDS Cash Flows Post a credit Event (Cont)

Mechanics: What is the defaulted bond
Protection seller pays to the buyer an amount equal to the Swap Notional Example: USD 5 million Protection buyer delivers to the seller a qualifying debt instrument (the Deliverable Obligation) of the Reference Entity
The deliverable obligation can be any obligation meeting a specified list of criteria; the Reference Entity is the company that protection is being traded on
Cash Settlement
Two (netting) cash payments
The Swap Notional (i.e. USD 5m)
The value of the Deliverable Obligation (say 40% of USD 5 m) An auction mechanism (of the Reference Obligation) is utilized to determine 2), the recovery value
The valuation mechanism generally engages 3-5 dealers The cash payments are then netted, with Seller paying the net amount (in this case USD 3mio, from USD5mio less USD2 m) to the Buyer
The face amount of the security delivered (Deliverable Obligation) is equal to the notional of the swap.
The protection buyer stops paying the regular premium following the Credit Event and the CDS contract terminates
Unlike insurance, CDS owner need not own the underlying reference asset thus does not need to have an insurable interest. Right to recovery remains with the owner of the reference asset.
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CDS Components
CDS Components Reference Entity Details
The CDS contract is like a guarantee on the obligations issued (reference asset) by the company (the reference entity) Triggering a Credit Event will involve public information of a material event with respect to one of their Obligations Once credit event has occurred, any Obligation of the Reference Entity, which meets a range of criteria (seniority, currency, tenor, etc.) can be used as: The Deliverable Obligation (in a Physically Settled CDS), or The Reference Obligation (in a Cash Settled CDS)
Before Exercise
Which Credit Events Default on which Obligation(s) trigger an exercise
Upon Exercise
Physical Settlement: What Deliverable Obligations will be delivered?
Cash Settlement: Reference Obligation(s) will be key for determining market value
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Chronology of Default Swap
Protection Buyer
Credit Event?
Yes
No
No trigger on protection contract
- Bankruptcy - Failure to pay - Restructuring
Publicly Available Information?
Yes
Materiality?
Yes
No
No - Default - Payment No
Credit Event Notice?
Settlement
Fixed payment
Par less recovery value
Physical delivery for par
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Key Terms:
Reference Entity: The corporate, sovereign entity on whose credit the CDS contract is based. Single name CDSs are based on specific single reference asset. Instead of assets, CDSs are most often based on reference name,or the legal entity corresponding to specific issuer. Reference Obligation Reference Obligation is pre-specified obligation issued or guaranteed by the Reference Entity. A single name CDSs covers a default on any eligible obligations issued by the reference name based on the CDSs documentation.
It is used to position the CDS in the capital structure of the reference entity. The buyer however does not have to deliver this specific obligation. Any obligation that ranks pari passu with the Reference Obligation can be delivered by the Protection Buyer (or used as the final Reference Obligation in most cash settled CDS) If no Reference Obligation is specified, Senior Unsecured obligation is assumed
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Review of Key Terms

Right to recovery The right to recovery rests with the owner of the reference asset, whose current market price (post default) reflects the expected recovery. In cash settled CDS, the protection buyer receives par minus the expected recovery, but if it owns the asset, it can improve on the actual recovery. In the event, if the protection buyer doesnt own the underlying reference asset, the right to recovery is not relevant and carries the settlement risk. To mitigate settlement risk, physically settled CDSs often specify deliverable obligations that go beyond the reference asset. Deliverable Obligation The buyer of protection can deliver any qualifying obligation of the reference entity. The Reference Entity may have issued a great variety of bonds and protection sellers would like as tight a specification of the deliverable obligation as possible
The Deliverable Obligation must fit all the criteria specified in the Deliverable Obligation Characteristics. May be either a Bond or a Loan
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Review of Key Terms

Credit Events: Most market participants now rely on International Swaps and Derivatives Association (ISDA) credit derivatives confirm, which allow lot of flexibility to define the event of default. Defined Events that trigger performance by the Seller under the swap. Standard events are: 1. Bankruptcy is the occurrence of any one of certain events specified in the Credit Default Agreement related to the insolvency of the entity (including administration, winding up, dissolution, institution of insolvency proceedings 2. Failure to Pay: This covers non-payment by the reference entity of any amount due and payable under a specific obligation (default materiality criteria is USD 1 million). 3. Restructuring: Restructuring/rescheduling of payments in respect of any one or more Obligations of the entity (provided that the aggregate amount of the Obligations affected is at least equal to USD 10 million or equivalent). Restructuring: includes the following:
1. 2. 3. 4. Reduction in interest or principal payable Deferral/postponement of either the payment of interest or principal Change in the ranking of the debt Change in the currency of payment (other than into certain permitted currencies).
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Review of Key Terms (Cont)

4. Obligations default or obligations acceleration: These are rarely used in practice. Under obligation acceleration, creditors must take action to require immediate payment of amounts owed under the obligation. Under obligation default, creditors must have the right to take action but may or may not have done so. 5. Repudiation or debt moratorium: this relates to the position where the reference entity or the government repudiates or declares a moratorium on its obligations. 6. Important: Rating downgrades are not considered as credit events
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Financial Guarantees vs. CDSs

Reference Asset and Trigger events: Insurance tend to be more specific with respect to reference asset or reference name as opposed to CDSs, where the credit event is fairly broad. CDSs usually is triggered by an event of default declared publicly while insurance can be triggered by a non-disclosed event. Extent of coverage and exit option: CDSs terminates with the event of default but an insurance remains ongoing. An exit option (with consent from the buyer)is there for the protection seller in case of a CDS which is not the case for protection seller through insurance. Tax and Accounting: Financial guarantees is subject to accounting and tax rules for insurance where as a CDSs is a derivative contract which has to be marked to market.
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Portfolio Credit Default Swaps

Portfolio protection products, as the name suggests offers protection on multi-name basket of credits. Basket CDSs: Reference obligations covered are either all or specific obligations issued by the reference names. If a basket CDSs covers all potential defaults, then it would resemble a portfolio of single named CDSs. (This approach would be very expensive) Common basket CDSs products cover losses arising out of single default (or a specific group of defaults) in the portfolio of reference assets and then terminates. Which default can trigger the cash flow, describes the basket product. Nth to Default: The nth default in the portfolio triggers the CDSs pay off. Senior and Subordinated Basket CDSs: (Multiple asset basket product) Senior piece of reference assets form the senior basket while the subordinated piece of reference basket forms subordinated basket. A subordinated basket would pay in the event of default of any subordinated asset and senior basket would pay in case of default in the senior asset basket.
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First to Default CDSs

Investor takes the risk of the first name to default of a number of reference entities in a basket of credits After the first name defaults, the investor has no further exposure to other names in the basket Investor Risk is greater than the risk of buying a CLN linked to one name only Investor Return is (depending on correlation)
Greater than the widest spread in the basket (because even with perfect correlation, sellers exposure remains on the riskiest exposure) Less than the Sum of Spreads of the basket (correlation wouldnt be zero)
Pricing is dependent on
Individual Single Name Spreads Correlation between the Credits in the FTD Basket
Other variations Second to Default etc.
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First to Default (FtD): Correlation & Pricing

Basket CDS has a large correlation play. Defaults among uncorrelated names in the reference portfolio is unlikely than defaults on names which are highly correlated. Correlation of default is the main determinant of price. Buying n CDSs is more expensive than buying nth to default CDS. The degree to which nth to default would be cheaper would depend on the default correlation between reference entities. Eg, 4 reference entities covered by 1st to default and have default correlation of 100%. The fair price would be the same as premium of the most expensive single name CDS 5 Name Basket/ Sum of Spreads is 750 bps/ Tenor 5 years
Spread 680 630 580 530 480 430 30% 35% 40% 45% 50% 55% 60% 65% 70% 75% 80%
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Credit Indexes
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Credit Linked Notes

CLNs are funded credit derivatives (funded equivalent of CDSs) The entity purchasing credit protection on a reference asset issues a note/bond (issuer can be any financial or corporate entity or special purpose entity). Investor of the notes is the protection seller and makes an upfront payment to the protection buyer. Performance of the note including the maturity value is credit linked to the performance of the specified underlying asset. No credit event situation: The investor receives scheduled P&I. In the event of default: issuer can withhold interest or part of principal to cover prescribed loss. In return for bearing the risk, investors receive above market rate prior to default. CLN = Bond+ single name CDS
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Credit Linked Notes

Credit Linked Notes (CLNs) are on balance sheet securities: investment alternatives to standard cash bonds CLNs can be issued by financial institutions or by SPVs
CLN Mechanics
Explanation
CDS Counterparty (Protection Buyer)
150 bp pa Default swap premium
Special Purpose Vehicle
LIBOR
Coupon
Highly Rated Collateral
LIBOR +150 bp (pa)
Coupon
Investor (Protection Seller)
A typical SPV will have two assets securing its obligations: Highly rated collateral (e.g., AAA rated credit securities a credit default swap Coupon and Principal payments on the CLN are contingent on the occurrence of a Credit Event on the underlying credit default swap
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Credit Linked Notes (Cont)

CLN Mechanics Explained
CLN Investor buys the Note and pays [par] The SPV uses the Issue Proceeds to buy the collateral (typically highly liquid securities with minimal market risk e.g. AAA rated instruments) The SPV sells protection in the market and receives the premium The investor receives the coupon from the collateral plus the credit default premium If there is no Credit Event, then at maturity of the note the investor gets back par (from the redemption proceeds of the collateral) Following a Credit Event, the note holder will be delivered an obligation of the Reference Entity (or a cash amount equal in value to a Reference Obligation)
Comments
What is a CLN? What risk is created? A CLN creates, in essence, a synthetic bond CLNs are similar to funded CDS The investor takes both the risk of the collateral and the risk of the CDS Why CLNs? CLNs are interesting for investors looking to utilize CDS to create a customized bond (tenor, currency, cashflow profile, etc.) which is not available in the market Or for investors who do not have access to the repo or CDS markets, as it is an investment in a bond
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Analogy Between Bond market and the CDS Market

Bond Market
100 to invest Buy a 5 year 7% coupon bond at par i.e. 7% yield
CDS Market
100 to invest Put 100 on deposit of 4% for 5 years Sell a 5 year CDS on the credit and receive 300bp default swap spread
100
Investor
Investor
4%
Riskless Swap, or Deposit
100
7% Coupon for 5 Years
Risk on Referenc e Entity
300 bps for 5 Years
Bond
CDS
(protection buyer)
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The Bond market and the CDS Market

What happens in default In both cases, the investors is left holding a defaulted bond
Bond Market Investor left holding a defaulted bond
CDS Market
Investor left holding a defaulted bond
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Investor
Investor
Deposit
100
Defaulted Bond
Defaulted Bond
CDS
(protection buyer)
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The Replication Argument

Creating the Arbitrage Free Package
*S = Asset Swap Spread
IRS Market
Receive Floating L + S
Get Bond Coupons C Pay Repo Cost L + X
Get Money P (i.e. 100%) Pay Bond Coupons (and make upfront exchange for any premium /discount/accrued)
Funding
Investor
Receive Bond Cashflows (i.e. Coupons + Principal)
Bond
Lend Bond
Pay Full Price P (i.e. 100%)
Netting out the cash flows shows that the investor is paid (S - X) bps for taking on the bonds credit risk If Libor flat funding is assumed (i.e. X = 0), then the Asset Swap Spread is a close proxy for the Default Swap Spread
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Total Rate Of Return Swap (TROR)
Total economic performance of an asset is exchanged for another cash flow (L+/- spread) TR payer (protection buyer) pays to TR receiver (protection seller) total returns from the asset Libor + Z bps is the fee paid by TR receiver to TR payer for funding the exposure TR receiver thus acquires credit and market risk on the reference asset Both parties have counterparty exposures
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TR receiver and payer

TR receiver
Long risk-free bond (market risk) Short CDS (protection seller) Long risky bond
TR payer
Short risk-free bond Long CDS (protection buyer) Short risky asset
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Credit Spread Options

Option premium Option buyer Principal * Option Pay-off * Duration
Pay-off of credit spread put = max(Credit Spread Strike Spread, 0) Pay-off of credit spread call = max(Strike Spread - Credit Spread, 0)
Option seller
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Credit Spread forward

Investors take long/short position on credit spreads Long position pay-off: (Strike Spread Credit Spread) * Duration * Principal Short position pay-off: (Credit Spread - Strike Spread) * Duration * Principal Buying a credit spread call option plus selling a credit spread put option is equivalent to long position in credit spread forward
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Credit Spread Swaps

Fixed spread payer
Short position in underlying asset because he gains when credit spread widens A long position in underlying may be hedged using credit spread swap
Fixed spread receiver

Makes Libor linked payment
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TPDS, TBDS, CDO2

Tranched Portfolio Default Swap
Provides protection to specific tranches of a portfolio In CDO, full portfolio exposure is passed to investors by the SPV
Tranched Basket Default Swap

Hybrid of CDO and Nth-to-default Swap Attachment and detachment points are based on number of defaults rather than default amount
CDO2
Invests in tranches of other CDO
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BISTRO
An originating bank buys protection from JPM through portfolio credit swap subject to a threshold JPM purchases protection from SPV on a part of total portfolio
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Pricing of CDS
Value of protection leg Value of premium leg Using risk-free discount rate, compute the Using risk-free discount rate, compute the present value of the LGD at each possible present value of the premium paid on each default date date (typically each quarter) Transform into expected value multiplying Transform into expected value multiplying by risk neutral default probabilities by risk neutral survival probabilities Add up the expected value of the present Add up the expected value of the present value of the LGD at each possible default value of the premium paid over the full date maturity of the swap
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Arbitrage
Yield of 15% on a bond
CDS premium on the bond 8% Treasury yield is 5%
Buy the bond to earn 15%

Take credit protection for 8% Short treasury bond to hedge market risk (ignoring basis risk) and to finance your investment
Risky bond return = Risk-free bond return CDS premium
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Arbitrage: TROR
Cost of funding for ABC: L + 10 Cost of funding for XYZ: L + 60 Risky bond is paying L + 80
ABC should buy the bond and enter in a TROR as TR payer to earn a fixed spread XYZ might be willing to give a spread of L + 50 as TR receiver At L + 50, it would be making 30 bps as compared to 20 otherwise for same asset ABC would earn a risk-free return of 40 bps because market, credit risk is transferred (though counterparty risk remains)
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Capital requirement
Banking book hedge
RW asset = 15% RWu + 85% RW protecction seller
Trading book hedge

CDS, CLN: Rwasset TROR: 0% RW = 20% Rwu
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Applications of Credit Derivatives

Credit Risk and market risk protection Yield enhancement
Covered credit spread put strategy Long a bond, short a credit spread put option Upside if credit quality improves. High risk, high return Covered credit spread call strategy Long a bond and short a credit spread call option Hedged position with low risk Covered credit spread collar strategy Long bond, long spread put with high strike (inexpensive), short call with high strike (expensive) Net income earned on options Long bond and short call would offset each other Put would provide a hedge in case of sharp decline in prices of bond
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Applications of credit derivatives (Cont)

Cost reduction
ABC Bank: Cost of fund: 8%. Return on a bond: 10%. Net Income: 2% SBI: Cost of fund: 5%. Return on bond: 10%. Therefore, SBI may pay upto 5% for default protection to lock-in credit risk-free investment ABC sells protection to SBI for 2.5% ABC gains 0.50% additional income for same credit risk exposure SBI locks in credit-risk free investment and making 2.5% after funding costs
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Definitions: Counterparty Risk

Counterparty exposure is the larger of zero and the market value of the portfolio of derivative positions with a counterparty that would be lost if the counterparty were to default and there were zero recovery. Counterparty exposures created by OTC derivatives are usually only a small fraction of the total notional amount of trades with a counterparty. Current exposure (CE) is the current value of the exposure to a counterparty. Potential future exposure (PFE) is the maximum amount of exposure expected to occur on a future date with a high degree of statistical confidence.
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Expected exposure (EE) is the average exposure on a future date. The curve of EE(t), as t varies over future dates, provides the expected exposure profile. Expected positive exposure (EPE) is the average EE(t) for t in a certain interval (for example, for t during a given year). Right-way/wrong-way exposures are exposures that are positively/negatively correlated with the credit quality of the counterparty. Those exposures may have lower/higher expected credit losses associated with them than would be the case without correlation. Credit risk mitigants are designed to reduce credit exposures. They include netting rights, collateral agreements, and early settlement provisions.
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Monte Carlo simulation engine

1. Initiate a new, independently simulated scenario. 2. Simulate, for this scenario, date by date, the net exposure of Counterparty A to default by Counterparty B. At each date, this gives the market value that would be lost if B were to default at that date, with no recovery, with all applicable netting agreements in force, and net of all collateral. The enforceability of netting and the valuation of collateral can also be simulated if uncertain. 3. Simulate, date by date, whether or not B defaults at that date, and whether A defaults at that date. 4. If, at a given date, Counterparty B defaults and Counterparty A has not already defaulted, then simulate the fraction of the net exposure, as obtained in Step 2, that is lost. This determines the losses to A in this scenario. 5. Simulate the path of short-term interest rates. 6. Discount to present market value, using the compounded short-term interest rates for this scenario, the losses to Counterparty A. 7. Return to Step 1, unless a sufficiently large number of scenarios have been run to obtain the approximate effect of the law of large numbers. 8. Average the results of Step 6, over all independently generated scenarios. This average is the estimate of the market value of default losses to Counterparty A due to default by Counterparty B.
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Market valuation of credit exposures

The credit valuation adjustment (CVA) of an OTC derivatives portfolio with a given counterparty is the market value of the credit risk due to any failure to perform on agreements with that counterparty. This adjustment can be either positive or negative, depending on which of the two counterparties bears the larger burden to the other of exposure and of counterparty default likelihood. the market value of credit risk to a given counterparty incorporates the valuation of credit risk associated with all positions with that counterparty, including loans to, and inventories of securities issued by, that counterparty.
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Risk-neutral mean loss rate

The rate at which investor is risk neutral mean he is not bothered about risk attached with the instrument as he is getting the returns accordingly or the price quoted is less.
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Credit Risk

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Credit Risk

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Pristine Careers

Credit Risk Measurement and Management

Credit Risk The uncertainty in Lending

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Few Credit Events

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Credit Spread Risk

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Credit Ratings and Transition

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Credit Risk Measurement Risk Quantified

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VaR (daily VaR) = VaR (in %) * asset value

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Credit Value at Risk (CVaR)

Portfolio risk of an exposure is determined by the following factors:

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Credit Risk Measurement Models

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Credit risk models

Modelling credit risk

Common data disadvantage / restriction is availability of (public) information

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CreditMetrics (JP Morgan, 1997)

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Three Steps in CreditMetrics : Methodology

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Step 1: Estimating Credit Risk Exposure Amounts

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Step 2: Compute the Volatility in Value Caused by Credit Quality Changes

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Step 3: Correlations (Cont)

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Effects of concentration and correlation on credit risk

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AAA AA A BBB BB B CCC Default

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Calculation of VaR (Cont)

Assuming Actual Distribution

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The KMV Approach

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EDF (Expected Default Frequency)

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Figure from KMV

Distribution of asset value at horizon Asset Volatility (1 Std Dev)

Default Point EDF

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KMV strength and weakness

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KMV strength and weakness (Cont)

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