T1-FRM-4-Ch4-Transfer-Mech-v3.1 - Study Notes

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P1.T1. Foundations of Risk

Chapter 4. Credit Risk Transfer Mechanisms
Bionic Turtle FRM Study Notes
COMPARE DIFFERENT TYPES OF CREDIT DERIVATIVES, EXPLAIN HOW EACH ONE TRANSFERS CREDIT
RISK, AND DESCRIBE THEIR ADVANTAGES AND DISADVANTAGES. ................................................. 3
EXPLAIN DIFFERENT TRADITIONAL APPROACHES OR MECHANISMS THAT FIRMS CAN USE TO HELP
MITIGATE CREDIT RISK. ............................................................................................................11
EVALUATE THE ROLE OF CREDIT DERIVATIVES IN THE 2007 — 2009 FINANCIAL CRISIS AND EXPLAIN
CHANGES IN THE CREDIT DERIVATIVE MARKET THAT OCCURRED AS A RESULT OF THE CRISIS........12
EXPLAIN THE PROCESS OF SECURITIZATION, DESCRIBE A SPECIAL PURPOSE VEHICLE (SPV), AND
ASSESS THE RISK OF DIFFERENT BUSINESS MODELS THAT BANKS CAN USE FOR SECURITIZED
PRODUCTS. ............................................................................................................................15
2

 Compare different types of credit derivatives, explain how each one transfers credit
risk, and describe their advantages and disadvantages.
 Explain different traditional approaches or mechanisms that firms can use to help
mitigate credit risk.
 Evaluate the role of credit derivatives in the 2007 — 2009 financial crisis, and explain
changes in the credit derivative market that occurred as a result of the crisis.
 Explain the process of securitization, describe a special purpose vehicle (SPV), and
assess the risk of different business models that banks can use for securitized
products.
Compare different types of credit derivatives, explain how each one

transfers credit risk, and describe their advantages and
disadvantages.
Credit derivatives are contracts with payoffs contingent on changes in the credit performance or
credit quality of the specified issuer or assets (aka, reference) underlying the contracts. These
off-balance sheet instruments that facilitate the transfer of credit risk between two counterparties
are referred to as over-the-counter securities because the financial contracts do not trade on a
formal exchange. Rather, the over-the-counter contracts are traded through a dealer network.
Types of credit derivatives include credit default swaps (CDS), first-to-default put, total return
swaps, credit spread options and asset-backed credit-linked notes (CLN). One can refer to
these diverse group of securities as credit derivative securities.
Figure 4.1: Credit derivatives in the U.S.
3
Credit Default Swaps

Credit default swaps (CDS) are a form of insurance against default for an underlying asset or as
a put option on the underlying asset1. Although credit default swaps can differ in each instance
depending upon the buyer and seller, the general structure is depicted in Figure 4.2. Typically:
 The CDS protection buyer (see green box in Figure 4.2) makes periodic payments to the
protection seller (yellow box) for protection against default. The periodic payments are a
negotiated number of basis points multiplied by the underlying security’s notional .
o For instance, suppose the notional amount of the underlying loan is $1 billion and
the negotiated payment is 25 basis points. The buyer of the CDS would pay the
seller $2.5 million each year for the life of the loan (0.0025 x $1,000,000,000).
 The CDS seller makes no payment unless the issuer of the underlying security defaults
or experiences some measurable credit event. If this occurs, the protection seller pays
the protection buyer a default payment (e.g., based on notional and recovery factor).
 To avoid litigation, the counterparties should have a clear definition of what a credit
event. Generally, default swaps require validation by a third-party in the event of a
potential credit event, known as a “materiality clause”.
 The dollar value of the payment once a legitimate credit event has occurred is
negotiable. It is sometimes fixed, but it is more common to set the payment at par
minus the recovery rate because this approximates the net loss due to default.
o The recovery rate for bonds is usually determined by the market price of the
bond after default.
o The recovery rate for most standardized CDS is usually contractually determined
at 40% for a bond and 60% for a bank loan. Once the credit event occurs, the
protection buyer stops making the regular premium payments.
Figure 4.2: Structure of a Typical Credit Default Swap
1 Although the buyer of a credit default swap is not required to have an insurable interest in the underlying
asset, see https://en.wikipedia.org/wiki/Insurable_interest. In fact, there may be no direct relationship

between the CDS counterparties and the underlying reference (except for their “bet” on the credit
performance of the reference underlying derivative contract). For this reason, there can be many CDS
counterparties referencing the same asset; similarly, the total notional CDS may be many multiples of a
single common reference asset.
4
Credit Events
Typical credit events include:
 Payment default;
 Bankruptcy;
 Insolvency;
 A downgrade in the rating of the issuer or in the underlying asset;
 A pre-agreed upon trigger if the price of the underlying asset falls below a certain point;
 Restructuring, which tends to be the most controversial of the credit events because it
opens the door to a wide range of interpretations;
 Obligation acceleration, which addresses the situation where debt becomes due prior to
the formal maturity date. In general, the materiality threshold is $10 million.
 Repudiation/moratorium
o When bond (or loan) issuer refuses to meet its debt covenants or obligations; or
o A company is legally prohibited from making a payment because of a sovereign
debt moratorium, such as was the case with the City of Moscow in 1998.
Default Payment
Typical default payments include:
 Through a dealer poll, the par price of the asset minus the post-default price of the
underlying asset;
 The par price plus a recovery factor, which is the same as a pre-negotiated amount
(digital swap);
 Payment of par by the seller in exchange for the physical delivery of the defaulted
underlying asset.
Hedging against risk in bonds issued by corporations or sovereigns is quite common, known
naturally as single-name CDSs. A natural connection with the CDS hedging is arbitrage pricing
the differences in price between the CDS and underlying bond price by taking offsetting
positions. This type of trading is referred to as “basis trading.”
First-to-Default Put
A first-to-default approach to credit risk attempts to plan for risk exposure by purchasing a
hedge against the first loan in its portfolio defaulting.
 In the following example, a bank holds a portfolio of five high-yield loans rated B. All five
loans have a par value of $200 million, a maturity of 10 years, and an annual coupon of
LIBOR plus 400 basis points (bps). In a typical portfolio, the bank attempts to have a
diversified loan portfolio by choosing loans that have low correlations. What this means
is that banks choose loans that have a low chance of all five loans defaulting
simultaneously.
 The bank wishes to hedge its credit exposure by purchasing a first-to-default put.
Essentially, should one or more of the loans in its portfolio default at any time during the
negotiated period of potential default, the bank will be paid for the first loan to default.
The bank will only be compensated for the first loan.
5
 Presuming the default events are uncorrelated2, then the probability that the dealer will
need to compensate the bank for its first-to-default put credit derivative is the par value
multiplied by the default probabilities. Assuming a default probability for each loan of 1
percent, then the sum of the default probabilities for the five-loan portfolio is 1 percent
multiplied by $1 billion (5 x $200 million), or $10 million.
 Banks sometimes opt for a first-to-default put because insuring the five-loan portfolio is
less expensive than hedging its credit risk for each loan separately.
Figure 4.3: Structure of a Typical First-to-Default Put
First-to-default derivatives are pairwise correlation risk reduction strategies. The yield on
first-to-default derivatives is largely a function of (1) the number of loans in the portfolio and (2)
the specific, expected correlation between the loans (also called names in banking circles).
The actual spread on a first-to-default derivative will be somewhere between the loan with the
worst credit and the sum of the spreads for all the loans. The spread will be closer to the sum of
the spread for all loans if correlation is low and closer to the spread for the worst credit loan if
correlation is high.
The first-to-default derivative is a common version of the more general nth-to-default credit
swap.
2The math becomes more difficult when the assets are correlated. For research on the issue, see Jordan
Nickerson and John Griffin’s 2017 Journal of Financial Economics paper: “Debt correlations in the wake
of the financial crisis: What are the appropriate default correlations for structure products?”
6
Total Return Swaps

Total return swaps (TRS) mirror the performance of the underlying instrument. The instrument
may be a loan, a bond, or a portfolio of financial assets. In general, TRS have maturities that
are shorter than the underlying asset, such as having a maturity of 5 years for the TRS
compared to a maturity of 15 years for the underlying asset.
The typical TRS deal is depicted in the figure below:

 The buyer of the TRS makes payments of LIBOR plus negotiated basis point amounts.
 The seller of the TRF makes payments to the buyer in the form of some total return
measure on the underlying asset.
 In many cases (because TRS deals are not dealing with liquid market information), the
mark-to-market is unknown, making it often difficult to pass through at the maturity of the
TRS. Arriving at an agreed upon economic value of the loans may therefore be difficult,
even if the underlying asset is still far from maturity. This is the reason why most deals
have the buyer taking delivery of the underlying asset at the price, P0, which is its initial
value.
 When time T comes, the buyer gets paid PT-P0 if the amount is greater than zero and
pays P0-PT otherwise. When the buyer takes delivery of the assets at their market value,
PT, the buyer pays the seller the initial value of the assets, P0, in exchange for the assets.
Figure 4.4: Structure of a General Total Return Swap
7
Leveraged Total Return Swaps

Leveraged total return swaps (LTRS) are like TRS with the exception that an LTRS allows the
buyer the explicit option to walk away from the deal in the case that P0-PT is less than zero. In
this situation, the buyer of the swap abandons the collateral, and leaves the counterparty to
manage any loss greater than the value of the collateral, as depicted in the following figure.
Figure 4.5: Structure of a Leveraged Total Return Swap
A total return swap is generally the same thing as taking a synthetic long position in the
underlying asset. The buyer of the TRS gets the cash flow and benefits if the value of the
asset rises. Of course, the buyer is also on the hook if losses occur of the value of the asset
falls.
 Leverage is unlimited in a LTRS, offering unlimited downside and upside.
 No principal is exchanged, there is no change in ownership, and no voting rights change
hands.
What is the difference between a CDS and a TRS? In a TRS, both market and credit risk
change hands. In a CDS, only the credit risk is transferred from the seller to the buyer.
 In the case when the buyer collateralizes all the underlying instrument, then there is no
risk of default. In this case, the bank’s floating payment would equate to the bank’s
funding costs.
 If the buyer uses leverage, then the floating payment is the funding cost and a spread.
This compensates for the risk of not having the entire asset all collateralized.
8
Asset-Backed Credit-Linked Notes

An asset-backed credit-linked note (CLN) creates a security with a default swap embedded in a
product such as a medium-term note.
 A CLN is an obligation with a consistent coupon payment attached and a redemption
value that is tied to the performance of the loan or bond, or to government debt.
 The CLN is on-balance sheet with an exchange in principal but no change in ownership
of the underlying asset.
A CLN offers the ability for investors to avoid margin calls while also leveraging an asset. A
CLN offers unlimited upside and downside by creating a tangible asset with these
characteristics. Additionally, a CLN can obtain a rating from Standard & Poor’s, Moody’s, or
Fitch like other debt securities. The following is an example flow of funds in a CLN investment.
Figure 4.6: Structure of an Asset-Backed Credit-Linked Note3
 In the example, the bank (on the left) buys the financial asset and puts them into a trust.
The $105 million placed in the trust are purchased by the bank at a cost of LIBOR (the
funding rate for banks) and are assumed to yield LIBOR plus 250 bps.
3Michel Crouhy, Dan Galai, and Robert Mark, The Essentials of Risk Management, 2nd Edition (New
York: McGraw-Hill, 2014)
9
 An investor buys an asset-backed note from the trust for $15 million. This $15 million is
then invested in U.S. government securities, which provide a yield and are used as the
collateral for the basket of loans. In this example, the collateral is $15/$105 = 14.3%; put
another way, the leverage ratio is 7.0 = $105/$15.
 The bank sees cash flow of 100 bps. This is the result of the LIBOR plus 250 bps from
the assets in the trust less the cost of funding the assets (LIBOR) and the 150 bps paid
to the trust. The 100 bps is the bank’s compensation for retaining the risk of default for
anything above $15 million.
 Presuming a yield of 6.5% on the government securities, the investor gets a yield of
17%. The 17% is the sum of the 6.5% plus the 150 bps on the notional amount paid out
by the bank of the $105 million ($15 million notional amount from the investor
perspective). Additionally, the investor sees the gain from any increase in the value of
the loan portfolio.
 In this setup, the investor has a maximum downside of $15 million. If the loan portfolio
loses value more than $15 million, then the investor defaults and the bank is on the hook
for any loss above that $15 million.
Collateralized Loan Obligations

Collateralized loan obligations (CLO) is a single security backed by a group of loans. The
security is similar to a collateralized mortgage obligation (CMO) with the difference being that a
CLO has (typically) corporate loans as the pool of securities while a CMO has a pool of
mortgages undergirding the pool behind the single security.
In day to day operations of a CLO, the CLO manager is actively buying and selling loans. In
order to purchase new loans, the manager sells parts of the CLO to investors, commonly
referred to as traches. Each tranche has a different risk level associated with it, and as such,
pays a different interest rate to the different tranche investors. Typically, investors that get paid
first receive lower interest payments because their investment has a lower risk of default.
Investors purchasing downstream tranches generally have more risk in their investment, and
therefore typically receive higher interest payments.
Credit Derivatives Offer Price Discovery and Risk Evaluation

In addition to the advantage of being able to spread-out credit exposure, a healthy credit
derivatives market also offers price discovery and robust risk evaluation. The credit derivatives
market puts numbers on default risk and monitors risk in real time. Proponents of a healthy
credit derivatives market generally believe that credit derivates lead to higher liquidity and a
more transparent and efficient pricing of credit spreads.
10
Advantages of Credit Derivatives in Practice

Credit derivates are used by diverse group of entities for several advantages, including:
For Banks
 Ability to lower credit risk exposure.
 Ability to manage the risk profile of a portfolio.
For Investors
 Ability to eliminate credit or market risk or both.

 The potential to increase yield with or without leverage.
 Ability to reduce the amount of sovereign risk in asset portfolios.
 Ability to borrow the bank’s balance sheet without servicing loans.
 Access to new, previously untapped markets.
Explain different traditional approaches or mechanisms that firms can

use to help mitigate credit risk.
Traditionally, businesses (banks) have had several ways to address their exposure to credit risk.
Firms have been able to manage credit risk for individual issuances and on a broader basis.
Some of the strategies included:
 Accounting for counterparty risk: This situation occurs when parties to a transaction
account for the assets and liabilities each counterparty has with each other and agreeing
that the exposures can be netted. If this netting was not done, should a counterparty go
bankrupt, the obligation from one party would be eliminated while the other party would
still be liable for funds due to the other counterparty.
 Margining or mark-to-market pricing: This is like counterparty risk accounting with the
exception that the two counterparties revalue their position as often as the agreement
stipulates. The revaluing minimizes net exposure between the two firms. This method
has been most often used in the exchange-traded derivatives market.
 An option to terminate: When the initial contract is signed, the two firms agree on
situations when the position must be unwound using a predetermined methodology.
Events that could lead to the termination option include large changes to balance sheets
or income statements, defaults on other assets, downgrades, among others. When a
put option is in place, the lender has the power to force the unwinding at a pre-
determined price.
 Transferring credit risk to another firm in the case of an adverse event, such as a ratings
downgrade.
 Buying insurance from an underwriter, which is referred to as a guarantee. A very
common example of this type of risk hedging occurs within the U.S. municipal bond
market.
11
 Collateral: Banks often minimize credit risk by requiring collateral to be posted.

Collateral is, of course, not constant in value and may change depending upon the state
of the industry and the economy. For instance, the value of the collateral of say a
natural gas producer will likely depend upon the price of natural gas. If the price of
natural gas falls, so will the value of the collateral.
 Syndication: This is generally considered a new type of credit exposure minimization,
although in modern times it has been around since the 1980s. Syndication involves the
original bank loan originator arranging to distribute part of the loan transaction to other
banks and investors. By unloading most of the loan value, the originator bank is
distributing the risk associated with the loan. Additionally, the originator bank typically
earns a percentage fee for its efforts and often keeps a portion of the original loan value
on its book, perhaps around 20%. There are two types of syndicated loans: firm
commitment and best efforts. A firm commitment loan guarantees that the obligor will
receive a set amount for the loan. If the originator bank is unable to find additional
investors, the bank holds a larger portion of the loan on its own books. A best efforts
loan is one in which the originator bank does its due diligence in finding other investors
for the deal, but there is no guarantee on the amount of money that will be raised.
 Secondary market loans: These are loans that are purchased and sold after the original
loan has been created. This allows distributed risk sharing and for non-bank investors to
hold bank loans.
Evaluate the role of credit derivatives in the 2007 — 2009 financial

crisis and explain changes in the credit derivative market that
occurred as a result of the crisis.
Credit Derivatives Leading Up to the 2007 – 2009 Financial Crisis
Syndication and the secondary market expanded enormously leading up to the 2007 to 2009
global financial crisis. The previously mentioned strategies to manage risk may be effective but
come with a few drawbacks. First, they require agreements between the counterparties to
make the transaction happen. This can be time consuming and require legal advice and some
form of due diligence. Second, the strategies are limited in that they do not isolate credit risk
from the underlying positions for redistribution to a broader class of investors. Third, they do not
allow for a fine-tuning of the positions so that banks and/or investors can target specific
positions or a desired credit portfolio.
The creation of a wide scale credit derivatives market made this fine-tuning possible. Credit
derivatives allow for two counterparties to buy and sell credit risk without the need to sell the
underlying position. Credit derivatives also allow targeting of a specific type of credit risk (such
as a bond or a certain type of loan) and transfers that risk without client management issues or
funding requirements. Credit derivatives are also off-book.
Credit derivatives come with the just-mentioned set of advantages. They also come with
challenges. Parties to the transaction must understand the nature of the risk that is being
transferred, what events would cause a “credit event”, potential payment obligations, and
liabilities when a credit event occurs, among others considerations. Credit derivatives also have
systemic concentration risk, meaning that because there are a relatively small number of credit
derivative providers, the market could face trouble if even one of the providers experienced
distress.
12
In addition to enabling the transfer of credit risk and the ability to tailor pools of credit risk,
securitization is an important source for funding of consumer and corporate lending. The
International Monetary Fund reported that securitized loans increased from almost nothing in
the early 1990s to $5 trillion in 2006.
Perhaps the most important business model change leading up to the 2007 to 2009 financial
crisis was the originate-to-distribute (OTD) paradigm. Credit risk that traditionally would have
been held on a bank’s balance sheet was instead packaged and sold to investors in the form of
an asset backed security (ABS). One of the drivers behind this shift towards an OTD model
was the Basel Accord capital adequacy requirements. Banks got rid of capital-consuming loans
from their books through the OTD model.
The OTD seemed to be a socially beneficial transaction for all parties involved. It:
 Offered originators greater capital efficiency and higher and less volatile earnings while
simultaneously distributing credit and interest rate risk across market players.
 Offered investors a broader array of investments, allowing for diversification and
targeting of a risk/return portfolio.
 Offered greater availability of credit and funding options, in addition to potentially lower
borrowing costs.
Credit Derivatives During the 2007 – 2009 Crisis

When housing prices began to drop in 2007, the value of credit derivatives also began to drop.
Trading volumes in mortgage-backed CDOs and CLOs experienced large drops as interest
dried up over concern about consistent payments. Other types of loan-backed credit derivatives,
such as credit card receivables and auto loans continued to see interest and demand remained
relatively stable. The drop in credit derivative volume was exacerbated by banks that had
become investors rather than just intermediaries. Banks generally held considerable amount of
mortgage risk on their books, and when the value of the mortgage-backed securities began to
drop, the condition of banks deteriorated.
13
Figure 4.7: Total Private European and U.S. Securitization Issuance (billions $)4
Instead of risk being broadly dispersed under an OTD model, mortgage risk was largely
concentrated in (mostly) large banks. Banks’ effort to skirt mandatory capital requirements
ended up backfiring. In addition to the concentration of risk, banks misjudged the commitments
made to outside investors. Banks also incorrectly assumed that there would be ongoing,
consistent access to easy liquidity. These assumptions turned out to be false.
Overall, the factors that led to the financial crisis of 2007 to 2009 were bank leverage,
questionable origination practices, and the concentration of risk in the securities generated.
4Segoviano, M., Jones, B., Lindner, P., & Blankenheim, J. (2013, November). Securitization: Lessons
Learned and the Road Ahead(Rep.). Retrieved https://www.imf.org/external/pubs/ft/wp/2013/wp13255.pdf
14
Changes in the Credit Derivatives Market in Response to the 2007 – 2009 Crisis
The 2007 to 2009 financial crisis taught the financial industry a few “lessons”:
 The OTD model brought about the incentive to focus on short-term profits and weakened
incentives to make business decisions for the long-term.
 Investor oversight was weak.
 There was a lack of understanding of the complexity of credit derivatives.
 The risks of credit derivatives were not transparent, with some investors seemingly
unsure of the risks they were accepting.
 Risk management of the securitized products was relatively weak, with stress testing of
market, liquidity, concentration, and pipeline risks barely, if ever, considered.
 Investors placed too much weight on the ratings provided by credit ratings agencies,
which was problematic because the ratings agencies failed to provide adequate review
and grossly underestimated the risks of subprime CDO structures.
On the regulatory front, the U.S. Securities and Exchange Commission and federal banking
regulators addressed credit derivatives through Section 15G of the Securities and Exchange Act
of 2014. This bill requires originators of asset-backed securities to hold, without recourse to risk
mitigation, a minimum of 5% of the credit risk. This provision was an attempt to ensure that loan
originators also had “skin in the game”.
Explain the process of securitization, describe a special purpose

vehicle (SPV), and assess the risk of different business models that
banks can use for securitized products.
Securitization is the process of creating new securities from packaged loans or other assets.
Packaging loans or other assets means combining them into one group of loans or assets. In
theory, by securitizing loans or other assets, the risk of default is lower for the group.
The process of securitization starts with what is known as a special purpose vehicle (SPV).
When the SPV is created, it is empty. The SPV then purchases assets from banks, be they
loan portfolios or mortgages or some other assets. Funding for the SPVs is mainly through
classes of bonds and equity tranches. In general, the equity tranche will usually make up less
than 10% of the SPV’s funding.
Figure 4.8: Securitization of financial assets

Collateralized
Equity/Liabilities
Assets
• Asset poll • Equity tranches
• Corporate loans • Senior bonds
• Leveraged loans • Junior bonds
• Mortgages
• Asset-backed
securities
15
The Move Towards Securitization

The movement towards securitization began in 1968 with the creation of the Government
National Mortgage Association (known as Ginnie Mae with the acronym GNMA). In the 1980s,
asset-backed consumer loans (ABS) and residential mortgage-backed securities (RMBS) took
hold in the U.S. and the U.K. In the next decade commercial mortgage backed securities
(CMBS) appeared in the U.S. From 2000 to 2007, issuance of securitized assets ballooned,
and then eventually popped, leading to what is now known as the Great Recession.
Figure 4.8: The Historical Development of Securitized Markets8
8Segoviano, M., Jones, B., Lindner, P., & Blankenheim, J. (2013, November). Securitization: Lessons
Learned and the Road Ahead(Rep.). Retrieved https://www.imf.org/external/pubs/ft/wp/2013/wp13255.pdf
16

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P1.T1. Foundations of Risk

Chapter 4. Credit Risk Transfer Mechanisms

Chapter 4. Credit Risk Transfer Mechanisms

Compare different types of credit derivatives, explain how each one

Figure 4.1: Credit derivatives in the U.S.

Credit Default Swaps

Figure 4.2: Structure of a Typical Credit Default Swap

asset, see https://en.wikipedia.org/wiki/Insurable_interest. In fact, there may be no direct relationship

Figure 4.3: Structure of a Typical First-to-Default Put

Total Return Swaps

The typical TRS deal is depicted in the figure below:

Figure 4.4: Structure of a General Total Return Swap

Leveraged Total Return Swaps

Figure 4.5: Structure of a Leveraged Total Return Swap

Asset-Backed Credit-Linked Notes

Figure 4.6: Structure of an Asset-Backed Credit-Linked Note3

Collateralized Loan Obligations

Credit Derivatives Offer Price Discovery and Risk Evaluation

Advantages of Credit Derivatives in Practice

 Ability to eliminate credit or market risk or both.

Explain different traditional approaches or mechanisms that firms can

 Collateral: Banks often minimize credit risk by requiring collateral to be posted.

Evaluate the role of credit derivatives in the 2007 — 2009 financial

Credit Derivatives During the 2007 – 2009 Crisis

Explain the process of securitization, describe a special purpose

Figure 4.8: Securitization of financial assets

The Move Towards Securitization

Figure 4.8: The Historical Development of Securitized Markets8

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