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. Some of the more common derivatives include forwards, futures, options, swaps, and variations of these such as synthetic collateralized debt obligations and credit default swaps. Most derivatives are traded over-the-counter (off-exchange) or on an exchange such as the Chicago Mercantile Exchange, while most insurance contracts have developed into a separate industry. In the United States, after the financial crisis of 2007–2009, there has been increased pressure to move derivatives to trade on exchanges.
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. It is headquartered in New York City, and has created a standardized contract to enter into derivatives transactions. In addition to legal and policy activities, ISDA manages FpML, an XML message standard for the OTC Derivatives industry. ISDA has more than 925 members in 75 countries; its membership consists of derivatives dealers, service providers and end users.
Total return swap, or TRS, or total rate of return swap, or TRORS, or Cash Settled Equity Swap is a financial contract that transfers both the credit risk and market risk of an underlying asset.
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.
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.
Bonds securitizing mortgages are usually treated as a separate class, termed residential mortgage-backed security (RMBS). In that sense, making reference to the general package of financial agreements that typically represents cash yields that are paid to investors and that are supported by cash payments received from homeowners who pay interest and principal according to terms agreed to with their lenders; it is a funding instrument created by the "originator" or "sponsor" of the mortgage loan; without cross-collateralizing individual loans and mortgages, it is a funding instrument that pools the cash flow received from individuals and pays these cash receipts out with waterfall priorities that enable investors to become comfortable with the certainty of receipt of cash at any point in time.
The loan credit default swap index (LCDX) is a loan-only credit default swap index created by CDS Index Company (CDSIndexCo). The LCDX index is a tradeable index with 100 equally weighted underlying single-name loan-only credit default swaps (LCDS).
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 (CRAs)—firms which rate debt instruments/securities according to the debtor's ability to pay lenders back—played a significant role at various stages in the American subprime mortgage crisis of 2007–2008 that led to the great recession of 2008–2009. The new, complex securities of "structured finance" used to finance subprime mortgages could not have been sold without ratings by the "Big Three" rating agencies—Moody's Investors Service, Standard & Poor's, and Fitch Ratings. A large section of the debt securities market—many money markets and pension funds—were restricted in their bylaws to holding only the safest securities—i.e. securities the rating agencies designated "triple-A". The pools of debt the agencies gave their highest ratings to included over three trillion dollars of loans to homebuyers with bad credit and undocumented incomes through 2007. Hundreds of billions of dollars' worth of these triple-A securities were downgraded to "junk" status by 2010, and the writedowns and losses came to over half a trillion dollars. This led "to the collapse or disappearance" in 2008–09 of three major investment banks, and the federal governments buying of $700 billion of bad debt from distressed financial institutions.
Janet Tavakoli is the president of Tavakoli Structured Finance, Inc., a Chicago-based consulting firm. She has had three books published on credit derivatives, structured finance, and the 2008 global financial crisis.
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 insurance, derivatives, commercial banking, capital markets 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.
A bespoke portfolio is a table of reference securities. A bespoke portfolio may serve as the reference portfolio for a synthetic CDO arranged by an investment bank and selected by a particular investor or for that investor by an investment manager.
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