In finance, a credit derivative refers to any one of "various instruments and techniques designed to separate and then transfer the credit risk"[1] or the risk of an event of default of a corporate or sovereign borrower, transferring it to an entity other than the lender[2] or debtholder.
An unfunded credit derivative is one where credit protection is bought and sold between bilateral counterparties without the protection seller having to put up money upfront or at any given time during the life of the deal unless an event of default occurs. Usually these contracts are traded pursuant to an International Swaps and Derivatives Association (ISDA) master agreement. Most credit derivatives of this sort are credit default swaps. If the credit derivative is entered into by a financial institution or a special purpose vehicle (SPV) and payments under the credit derivative are funded using securitization techniques, such that a debt obligation is issued by the financial institution or SPV to support these obligations, this is known as a funded credit derivative.
This synthetic securitization process has become increasingly popular over the last decade, with the simple versions of these structures being known as synthetic collateralized debt obligations (CDOs), credit-linked notes or single-tranche CDOs. In funded credit derivatives, transactions are often rated by rating agencies, which allows investors to take different slices of credit risk according to their risk appetite.[3]
The market in credit derivatives as defined in today's terms started from nothing in 1993 after having been pioneered by J.P. Morgan's Peter Hancock.[4] By 1996 there was around $40 billion of outstanding transactions, half of which involved the debt of developing countries.[1]
Credit default products are the most commonly traded credit derivative product[5] and include unfunded products such as credit default swaps and funded products such as collateralized debt obligations (see further discussion below).
On May 15, 2007, in a speech concerning credit derivatives and liquidity risk, Timothy Geithner, then President of the Federal Reserve Bank of New York, stated: “Financial innovation has improved the capacity to measure and manage risk.” [6] Credit market participants, regulators, and courts are increasingly using credit derivative pricing to help inform decisions about loan pricing, risk management, capital requirements, and legal liability. The ISDA[7] reported in April 2007 that total notional amount on outstanding credit derivatives was $35.1 trillion with a gross market value of $948 billion (ISDA's Website). As reported in The Times on September 15, 2008, the "Worldwide credit derivatives market is valued at $62 trillion".[8]
Although the credit derivatives market is a global one, London has a market share of about 40%, with the rest of Europe having about 10%.[5]
The main market participants are banks, hedge funds, insurance companies, pension funds, and other corporates.[5]
Types
Credit derivatives are fundamentally divided into two categories: funded credit derivatives and unfunded credit derivatives.
An unfunded credit derivative is a bilateral contract between two counterparties, where each party is responsible for making its payments under the contract (i.e., payments of premiums and any cash or physical settlement amount) itself without recourse to other assets.
A funded credit derivative involves the protection seller (the party that assumes the credit risk) making an initial payment that is used to settle any potential credit events. (The protection buyer, however, still may be exposed to the credit risk of the protection seller itself. This is known as counterparty risk.)
Unfunded credit derivative products include the following products:
The credit default swap or CDS has become the cornerstone product of the credit derivatives market. This product represents over thirty percent of the credit derivatives market.[5]
The product has many variations, including where there is a basket or portfolio of reference entities, although fundamentally, the principles remain the same. A powerful recent variation has been gathering market share of late: credit default swaps which relate to asset-backed securities.[9]
In this example coupons from the bank's portfolio of loans are passed to the SPV which uses the cash flow to service the credit linked notes.
A credit linked note is a note whose cash flow depends upon an event, which may be a default, change in credit spread, or rating change. The definition of the relevant credit events must be negotiated by the parties to the note.
A CLN in effect combines a credit-default swap with a regular note (with coupon, maturity, redemption). Given its note-like features, a CLN is an on-balance-sheet asset, in contrast to a CDS.
Typically, an investment fund manager will purchase such a note to hedge against possible down grades, or loan defaults.
Numerous different types of credit linked notes (CLNs) have been structured and placed in the past few years. Here we are going to provide an overview rather than a detailed account of these instruments.
The most basic CLN consists of a bond, issued by a well-rated borrower, packaged with a credit default swap on a less creditworthy risk.
For example, a bank may sell some of its exposure to a particular emerging country by issuing a bond linked to that country's default or convertibility risk. From the bank's point of view, this achieves the purpose of reducing its exposure to that risk, as it will not need to reimburse all or part of the note if a credit event occurs. However, from the point of view of investors, the risk profile is different from that of the bonds issued by the country. If the bank runs into difficulty, their investments will suffer even if the country is still performing well.
The credit rating is improved by using a proportion of government bonds, which means the CLN investor receives an enhanced coupon.
Through the use of a credit default swap, the bank receives some recompense if the reference credit defaults.
There are several different types of securitized product, which have a credit dimension.
Credit-linked notes (CLN): Credit-linked note is a generic name related to any bond whose value is linked to the performance of a reference asset, or assets. This link may be through the use of a credit derivative, but does not have to be.
Collateralized debt obligation (CDO): Generic term for a bond issued against a mixed pool of assets—there also exists CDO-Squared (CDO^2) where the underlying assets are CDO tranches.
Collateralized bond obligations (CBO): Bond issued against a pool of bond assets or other securities. It is referred to in a generic sense as a CDO
Collateralized loan obligations (CLO): Bond issued against a pool of bank loan. It is referred to in a generic sense as a CDO
CDO refers either to the pool of assets used to support the CLNs or the CLNs themselves.
Not all collateralized debt obligations (CDOs) are credit derivatives. For example, a CDO made up of loans is merely a securitizing of loans that is then tranched based on its credit rating. This particular securitization is known as a collateralized loan obligation (CLO) and the investor receives the cash flow that accompanies the paying of the debtor to the creditor. Essentially, a CDO is held up by a pool of assets that generate cash. A CDO only becomes a derivative when it is used in conjunction with credit default swaps (CDS), in which case it becomes a Synthetic CDO. The main difference between CDOs and derivatives is that a derivative is essentially a bilateral agreement in which the payout occurs during a specific event which is tied to the underlying asset.
Other more complicated CDOs have been developed where each underlying credit risk is itself a CDO tranche. These CDOs are commonly known as CDOs-squared.
Pricing
Pricing of credit derivative is not an easy process. This is because:
The complexity in monitoring the market price of the underlying credit obligation.
Understanding the creditworthiness of a debtor is often a cumbersome task as it is not easily quantifiable.
The incidence of default is not a frequent phenomenon and makes it difficult for the investors to find the empirical data of a solvent company with respect to default.
Even though one can take help of different ratings published by ranking agencies but often these ratings will be different.
Risks
Risks involving credit derivatives are a concern among regulators of financial markets. The US Federal Reserve issued several statements in the Fall of 2005 about these risks, and highlighted the growing backlog of confirmations for credit derivatives trades. These backlogs pose risks to the market (both in theory and in all likelihood), and they exacerbate other risks in the financial system. One challenge in regulating these and other derivatives is that the people who know most about them also typically have a vested incentive in encouraging their growth and lack of regulation. Incentive may be indirect, e.g., academics have not only consulting incentives, but also incentives in keeping open doors for research.
In finance, a derivative is a contract that derives its value from the performance of an underlying entity. This underlying entity can be an asset, index, or interest rate, and is often simply called the underlying. Derivatives can be used for a number of purposes, including insuring against price movements (hedging), increasing exposure to price movements for speculation, or getting access to otherwise hard-to-trade assets or markets.
A credit default swap (CDS) is a financial swap agreement that the seller of the CDS will compensate the buyer in the event of a debt default or other credit event. That is, the seller of the CDS insures the buyer against some reference asset defaulting. The buyer of the CDS makes a series of payments to the seller and, in exchange, may expect to receive a payoff if the asset defaults.
The International Swaps and Derivatives Association is a trade organization of participants in the market for over-the-counter derivatives.
Structured finance is a sector of finance — specifically financial law — that manages leverage and risk. Strategies may involve legal and corporate restructuring, off balance sheet accounting, or the use of financial instruments.
A collateralized debt obligation (CDO) is a type of structured asset-backed security (ABS). Originally developed as instruments for the corporate debt markets, after 2002 CDOs became vehicles for refinancing mortgage-backed securities (MBS). Like other private label securities backed by assets, a CDO can be thought of as a promise to pay investors in a prescribed sequence, based on the cash flow the CDO collects from the pool of bonds or other assets it owns. Distinctively, CDO credit risk is typically assessed based on a probability of default (PD) derived from ratings on those bonds or assets.
An asset-backed security (ABS) is a security whose income payments, and hence value, are derived from and collateralized by a specified pool of underlying assets.
A credit-linked note (CLN) is a form of funded credit derivative. It is structured as a security with an embedded credit default swap allowing the issuer to transfer a specific credit risk to credit investors. The issuer is not obligated to repay the debt if a specified event occurs. This eliminates a third-party insurance provider.
A structured product, also known as a market-linked investment, is a pre-packaged structured finance investment strategy based on a single security, a basket of securities, options, indices, commodities, debt issuance or foreign currencies, and to a lesser extent, derivatives. Structured products are not homogeneous — there are numerous varieties of derivatives and underlying assets — but they can be classified under the aside categories. Typically, a desk will employ a specialized "structurer" to design and manage its structured-product offering.
Single-tranche CDO or bespoke CDO is an extension of full capital structure synthetic CDO deals, which are a form of collateralized debt obligation. These are bespoke transactions where the bank and the investor work closely to achieve a specific target.
An asset-backed securities index is a curated list of asset-backed security exposures that is used for performance bench-marking or trading.
Residential mortgage-backed security (RMBS) are a type of mortgage-backed security backed by residential real estate mortgages.
Collateralized loan obligations (CLOs) are a form of securitization where payments from multiple middle sized and large business loans are pooled together and passed on to different classes of owners in various tranches. A CLO is a type of collateralized debt obligation, or CDO.
A synthetic CDO is a variation of a CDO that generally uses credit default swaps and other derivatives to obtain its investment goals. As such, it is a complex derivative financial security sometimes described as a bet on the performance of other mortgage products, rather than a real mortgage security. The value and payment stream of a synthetic CDO is derived not from cash assets, like mortgages or credit card payments – as in the case of a regular or "cash" CDO—but from premiums paying for credit default swap "insurance" on the possibility of default of some defined set of "reference" securities—based on cash assets. The insurance-buying "counterparties" may own the "reference" securities and be managing the risk of their default, or may be speculators who've calculated that the securities will default.
This article provides background information regarding the subprime mortgage crisis. It discusses subprime lending, foreclosures, risk types, and mechanisms through which various entities involved were affected by the crisis.
Credit rating agencies and the subprime crisis is the impact of credit rating agencies (CRAs) in the American subprime mortgage crisis of 2007–2008 that led to the financial crisis of 2007–2008.
Minibond are not bonds, but financial derivatives based on credit default swaps (CDS), which are high-risk financial investment products. They were a brand name for a series of structured financial notes issued in Hong Kong and Singapore under control of Lehman Brothers. The name was also used for other likewise structured Notes, namely Constellation Notes and Octave Notes, respectively issued in Hong Kong under the direction of DBS Bank and Morgan Stanley.
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Securitization is the financial practice of pooling various types of contractual debt such as residential mortgages, commercial mortgages, auto loans or credit card debt obligations and selling their related cash flows to third party investors as securities, which may be described as bonds, pass-through securities, or collateralized debt obligations (CDOs). Investors are repaid from the principal and interest cash flows collected from the underlying debt and redistributed through the capital structure of the new financing. Securities backed by mortgage receivables are called mortgage-backed securities (MBS), while those backed by other types of receivables are asset-backed securities (ABS).
Financial law is the law and regulation of the commercial banking, capital markets, insurance, derivatives and investment management sectors. Understanding financial law is crucial to appreciating the creation and formation of banking and financial regulation, as well as the legal framework for finance generally. Financial law forms a substantial portion of commercial law, and notably a substantial proportion of the global economy, and legal billables are dependent on sound and clear legal policy pertaining to financial transactions. Therefore financial law as the law for financial industries involves public and private law matters. Understanding the legal implications of transactions and structures such as an indemnity, or overdraft is crucial to appreciating their effect in financial transactions. This is the core of financial law. Thus, financial law draws a narrower distinction than commercial or corporate law by focusing primarily on financial transactions, the financial market, and its participants; for example, the sale of goods may be part of commercial law but is not financial law. Financial law may be understood as being formed of three overarching methods, or pillars of law formation and categorised into five transaction silos which form the various financial positions prevalent in finance.
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