A Credit Derivatives Primer

While it’s short on mathiness, it’s long on financespeak.  Another one of those speechie things I have given to people confused by what’s been going on in the financial markets.  Don’t worry, I’ll quit posting academic things later this week!  Meanwhile, don’t fall asleep!

Credit derivatives are a relatively recent financial innovation.  They were first introduced in 1992 but not broadly traded until 1999 when documentation was standardized.  The market for these securities is huge.  Since 2000, it has increased from $900 billion to more than $45.5 trillion.  This is roughly twice the size of the entire United States Equity Markets. Hedge funds are very active in this market and there is much concentration of the volume trade.  Four large broker-dealers are responsible for the majority of transactions. JP Morgan Chase, Citibank and Bank of America have been the largest players. Most credit derivatives are credit default swaps (CDS).  These are contractual agreements that transfer the default risk of one or more reference entities from one party to the other.  It is designed to shift credit risk from one party to another.  It is basically a bet on the health of a company or another set of assets like mortgages.

These instruments serve a role similar to insurance and appear to inject moral hazard into the banking community by leading to lax lending practices as witnessed by the current crises triggered by mortgage markets.  Many traditional bank assets have been packaged and sold recently.  This appears to be a side effect of the changing role of banks after GLBA.  Credit derivatives were developed as an attempt to manage credit risk.

There is also risk stemming from problems in the market itself.  Some of the biggest concerns come from the size of the notional outstanding.  It is believed that the total size of credit default swap universe is about 10 times bigger than the underlying pool of cash bonds.  This underlying mismatch has proved to be a problem as the market has recently become thin and less liquid.  Deliverables have become an issue.  This is probably one of the reasons that the government has proposed to buy “troubled assets” as part of the financial crisis rescue.

There is a clear and present danger, since the hedge funds have taken similarly losing positions and they may  play a role in further destabilizing the market as they unwind these assets.  This is one reason that the Fed is taking some of these assets onto their balance sheet as a strategy of their quantitative easing policy.  They’d prefer to slowly unwind this market.

Who are the players in this market?

Commercial  Banks use credit derivatives to shed risk in several areas of their credit portfolio, including large corporate loans, loans to smaller companies, and counterparty credit risk on over-the-counter (OTC) derivatives.  Banks use single-name credit default swaps (CDS) to shed the credit risk of issuers to whom they have a large exposure.  However, the pattern of shedding credit risk is no longer limited to large corporate loans but also loans to small and medium-sized enterprises, loans to emerging markets, and counterparty exposure on derivatives.  The reasons for this is because:  (1) credit spreads are at low levels, reducing the cost of hedging, (2) accounting changes in Europe allowing banks to carry loans at fair value, reducing the conflict between the accounting treatment of credit derivatives and their use in risk management, and (3) the Basel 2 capital accord aligns regulatory capital charges more closely with actual credit risks and will allow greater recognition of hedging.

Investment banks use credit derivatives to manage the risk they acquire when underwriting securities.  Prior to the financial meltdown, the fastest growing market for securities underwriting was in residential mortgage-backed securities (RMBS).  To cope with the potential increase in credit risk, underwriters have turned to credit default swaps on asset-backed securities (ABS CDS) to buy credit protection on an RMBS, creating an index called the ABX.HE.   This index is used to trade credit risk of a pool of twenty RMBS deals. The drawback of this hedging technique is noticeable  when sellers of credit protection become scarce because of a weaker-than-expected housing market. The ABS CDS and ABX.HE markets could see much of their recent liquidity dry up, and underwriters would lose a useful tool for credit risk management.

Investors can use credit derivatives to align credit risk exposure with their desired credit risk profile.  Insurers are an important class of investors that use credit derivatives.  It is believed that of the three groups, demand from investors is most responsible for spurring the growth of the credit derivatives market.  There are two types of investors in the credit derivatives market:  (1) buy-and-holder investors and (2) active traders.

Buy-and-hold investors seek to earn a return from a broad exposure to issuers of fixed-income securities.  Without credit derivatives, investors balance their portfolio by selling some of the holding bonds, but they may have to incur high transaction costs.  To replacing the foregone bond, they can buy newly issued bonds, but those bonds influenced by the market trend may not be what investors want.  With credit derivatives, investors can shift their exposures by buying credit protection using credit default swap and replace their exposures by selling credit protection on other bonds or credit default swap index.

Active traders seek to earn a return by predicting short-term price movements better than other market participants.  They usually pay particular attention to credit spread risk.  They take advantage of the flexibility of credit derivatives by taking a customized exposure to certain components of credit risk, such as spread risk, default risk, recovery risk, or correlation risk.

Oddly enough, the riskiness of credit derivatives has been a concern in both academic and regulator circles for some time.  The Fed issued a series of statements in 2005 that listed their concerns.  Chief among them was a backlog of confirmations for credit derivative trades.  The nonstandard nature of the contract led to this backlog and has consequently has made identification of owners of contracts difficult.  Additionally, studies showed a downward migration of average rating of underlying assets as early as 2006.  None of these concerns translated into changes in law or precautionary regulatory action.

Severe misjudgment of risk of default led to overinvestment by many institutions.  As defaults mounted, capital drawdown for these institutions approached regulatory minimums leading to threats of insolvency.  Since the volume in the credit markets has reduced liquidity, markets have yet to completely price various instruments.  Additionally, capitalization of FI’s by the Treasury keeps many of these assets off the market.  Future challenges to the financial system and the economy may result as these assets come to market.

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