Credit Derivatives and Structured Products

RMA Journal, The, Feb, 2001 by Andrew L. Kresse

Diversification Tools for Regional and Community Banks

This article looks at credit derivative applications for banks, particularly the credit default swap, and structured credit products such as collateralized debt obligations (CDOs), synthetic collateralized loan obligations, hybrid balance sheet CLOs, and synthetic portfolio trades. These financial tools have been used successfully by large financial institutions to diversify and reduce risk and can be used by regional and community banks to accomplish similar goals.

The mantra of large financial institutions in the late 1990s is by necessity the overriding theme of regional and community banks today. Diversification is one of the main drivers of portfolio and risk management, allowing institutions to absorb a hard hit in one area through strength in other areas. While large institutions historically have had greater resources to explore, develop, and manage such diversification tools as credit derivatives and structured credit products, smaller institutions have not. The current fierce competitive environment, in which customers and shareholders expect a large amount of sophistication from a financial institution, no matter its size, triggers a growing need for all institutions to explore and use these tools.

Credit Derivatives

Credit derivatives are unfunded or funded contracts that transfer credit risk between two parties without actually transferring the underlying asset. Three of the most common credit derivatives are credit default swaps, credit-linked notes, and total return swaps. According to the Office of the Comptroller of Currency, in the past three years, the domestic bank credit derivative market has grown 37% annually. In total, global year-end 1999 estimates for this market were about $1 trillion and year-end 2000 estimates were $1.5 trillion. Large institutions now offer and use a variety of credit derivatives and structured credit products across high-yield and high-grade asset classes.

Credit default swap. Credit default swaps synthetically transfer credit risk between two parties. The protection buyer makes periodic payments (the premium) to the protection seller in exchange for the right, in the case of a credit event, to sell defaulted debt instruments of the reference entity to the protection seller at face value (the credit event payment). The protection buyer purchases credit protection and is short the credit exposure. The protection seller sells credit protection and is long the credit exposure. The transaction schematic may be seen in Figure 1. A credit event, as defined in 1999 ISDA Credit Derivatives Definitions (International Swaps & Derivatives Association, Inc.; www.isda.org), may include Bankruptcy, Failure to Pay, Obligation Acceleration, Restructuring, or Repudiation/Moratorium. Why would a financial institution participate in a credit default swap transaction? There are five primary reasons for the buyer of protection:

1. Gains credit default protection/risk transfer.

2. Creates opportunity for increased credit capacity.

3. No client disclosure.

4. Asset remains on the balance sheet.

5. Regulatory capital reduction (when seller is OECD bank). Likewise, there are five primary reasons a seller of protection would choose to enter into a transaction:

1. Unfunded, off-balance sheet investment.

2. May offer higher return than the cash market.

3. Minimal transaction administration.

4. Maturity flexibility.

5. Seniority flexibility.

Additional considerations in credit default swaps include:

* Ease of execution. Standardized ISDA confirmation for credit default swaps provides industry-wide standards for ease of execution and administrative simplicity.

* Assumed funding rate. Generic credit default swap pricing assumes the buyers and sellers fund at Libor flat. As a result, buying protection can be attractive for sub-Libor funders and selling protection can be beneficial for above-Libor funders.

* Regulatory guidance. Purchase of protection from an OECD bank often leads to reduction in regulatory capital commitment. The growth of the market has encouraged greater guidance from the Federal Reserve, OCC, FDIC, and the European regulatory bodies on the use of credit derivatives by banks.

* Market liquidity. The current size of the U.S. credit derivatives market, as reported by the OCC in its 3Q2000 Call Report, exceeds $460 billion in notional outstanding. This reflects both the significant underlying credit markets and the liquidity of the default swap market.

* Risk management. Credit default swaps support active risk management and more rational credit pricing.

* Expanding base of underlying credits. The current market focus is aggressively expanding from investment-grade credits to high-yield and emerging-markets interests.

Structured Credit Products

Structured credit products are funded, unfunded, or hybrid transactions that use the 3 basic types of credit derivatives to allow investors to access a diversified portfolio of assets on a leveraged basis. There are six principal reasons that banks would participate in structured product applications: