CREDIT RISK TRANSFER MECHANISMS

 CREDIT RISK TRANSFER MECHANISMS

• Credit default swaps (CDSs) are financial derivatives that pay off when the issuer of a reference instrument (e.g., a corporate bond or a securitized fixed income instrument) defaults.
• This is a very direct way to measure and transfer credit risk. These derivatives function like an insurance contract in which a buyer makes regular (quarterly) premium payments, and in return, they receive a payment in the event of a default.
• Advantages of CDSs include:
• Spur innovation. This enables them to fund riskier opportunities 
• Cash-flow potential. CDS sellers create a stream of payments that could be a significant source of cash flow. Theoretically, they can diversify the CDS contracts  across industries and geographies such that defaults in one area should be offset by fees from CDSs that have not been triggered through default.
• Risk price discovery. The use of a CDS enables price discovery of a specific credit risk. A CDS is a pure play on pricing a given borrower’s credit risk.
• Disadvantages of CDSs include:
• Historically weak regulation. CDS contracts were unregulated until 2007–2009. 
• False sense of security. The presence of a CDS contract creates a false sense of security for fixed income buyers, who could support an issuer that is far riskier than they would support without the presence of credit risk transfer. This can be both an advantage (access to capital) and a disadvantage (excessive risk-taking behavior), depending upon one’s vantage point.  

Collateralized Debt Obligations 

• A collateralized debt obligation (CDO) is a structured product that banks can use to unburden themselves of credit risk. These financial assets are repacked loans which are then sold to investors on the secondary markets.
• A CDO could include some combination of asset-backed securities (ABSs) which could include mortgages (commercial or residential), auto loans, credit card debt, or some other loan product. Typically, the loans included in a CDO are heavily biased toward mortgage debt through a securitized basket of mortgages called a mortgage-backed security (MBS). 
• When a CDO consists only of mortgage loans, it is technically known as a collateralized mortgage obligation (CMO).
• A CDO may also contain securitized short-term corporate borrowings through a product called asset-backed commercial paper
• Sometimes, a CDO will contain repackaged portions of another collateralized debt obligation that could not be sold directly to investors. This product is then called a CDO-squared, and it enables riskier portions of loans to be bundled with lower-risk loans to attract investor interest.
• The most junior tranche offers a high interest rate but receives cash flows only after all other tranches have been paid. For this reason, this most junior tranche is sometimes referred to as the equity tranche or even toxic waste. 
• Above the equity tranche are the mezzanine tranches, which receive payment before the junior tranches. 
• The highest-rated tranche, called the super senior tranche (often rated AAA), is the safest tranche and the first tranche to be paid out; however, it pays investors a relatively low interest rate
• Advantages of CDOs include:
• Increased profit potential
• Direct risk transfer
• Loan access.
• Disadvantages of CDOs include: 
• Encourages increased risk taking
• Risk concentration potential
• High complexity

Collateralized Loan Obligations 

• Like a CDO, they are a bundle of repackaged loans that are organized into tranches. However, a CLO’s constituent loans are predominantly bank loans, which have typically been exposed to a rigorous underwriting process.

Mitigating Credit Risk 

• Purchase third-party insurance. If a single borrower is being insured, then this insurance overlay is technically called a guarantee. 
• Exposure netting. When a bank has multiple risk product exposures to the same counterparty, it is common to net those exposures in terms of their ultimate financial impact. 
• Marking-to-market. Counterparties will periodically revalue credit derivatives and immediately transfer any required payments to the winning counterparty. This prevents the risk of one party not having sufficient funds to make a balloon payment at the end of a credit derivative’s maturity. Marking-to-market is primarily used with exchange-traded derivatives. 
• Requiring collateral. The collateral may offset the lender’s credit risk exposure. However, there is the potential for wrong way risk, which occurs when the value of the collateral is negatively impacted by the same factors that cause the firm to potentially default on a loan
• Termination clause. A bank might include a clause in a credit risk transfer transaction that would cause the position to terminate if a given trigger event occurs. Examples of triggers could be a downgrade or missing financial metrics (e.g., gross profit levels or interest coverage).
•  Reassignment. A bank could have an agreement to automatically transfer credit risk to a third party in the event of a trigger (e.g., downgrade).
• Additionally, banks may decide to disperse credit risk for a given loan across a number of other lenders. This credit risk tool is known as syndication. This mechanism is only used for very large loans

Role of Credit Derivatives in the Financial Crisis

• CDSs hold counterparty risk. This reality came into full view when Lehman Brothers filed for bankruptcy in a surprise event.
• The Dodd-Frank Wall Street Reform Act of 2009 (Dodd-Frank) was created to address regulatory shortcomings that helped allow the storm to build leading up to the financial crisis. The embedded Volcker rule prohibited commercial (depository) banks from proprietary trading and from investing in derivatives (i.e., CDSs). It also required the Commodity Futures Trading Commission to regulate all swap contracts, including CDSs.
• More recently, the Securities and Exchange Commission (SEC) added a new rule—Section 15G—to the Securities and Exchange Act in 2014. This regulation requires that originators of securitized products (e.g., MBSs, CDOs, and CLOs) must retain at least 5% of the credit risk on their balance sheet.
• Section 15G was designed to force originators to be more concerned with the products that they repackage for sale to investors.

Securitization and Special Purpose Vehicles 

• Securitization is the general process of repackaging loans into a bundled new product that can be sold to investors on the secondary markets. This process involves four key steps:
• Create a special purpose vehicle (SPV), which is an off-balance sheet legal entity that functions as a semi-hidden subsidiary of the issuing parent company.
• The SPV will use borrowed funds to purchase loan assets from one bank or possibly several banks to create structured products (e.g., CMO, CDO, or CLO). 
• The SPV’s constituent loans will be arranged by either seniority or credit rating and structured into tranches to form risk layers within the SPV
• The various tranches are then sold to investors on the secondary markets.
• When sourcing loans, banks can choose between two high-level business models. The traditional model is referred to as the buy-and-hold strategy. In this approach, banks will source a loan and then retain it on their books. They enjoy periodic interest payments to compensate for holding credit risk
• The innovation enabled by securitization is the originate-to-distribute (OTD) model. The OTD model involves banks sourcing loans with the explicit intention to securitize them and sell the structured products to investors. With this model, banks do not retain credit risk and they are paid a fee for sourcing the loans that feed into the securitized products rather than receiving interest payments, which belong to the investors in the structured products. The incentive in the OTD model is to generate high loan volume, not high-quality loans, which is the incentive in the buyand-hold model.