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«WP/06/139 The Credit Risk Transfer Market and Stability Implications for U.K. Financial Institutions Jorge A. Chan-Lau and Li Lian Ong © 2006 ...»

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The demand for synthetic CDOs has grown exponentially (see figure), and is displacing the regular CDO instruments. The introduction of single-tranche CDOs (also known as “bespoke tranches”) has been an important innovation in synthetic CDO structures. This instrument was created in 2003 as a more flexible alternative to traditional CDOs. With single-tranche CDOs, only one tranche of the structure—usually a mezzanine tranche—is sold to the investor, while the arranger becomes the direct counterparty of the investor since there is no SPV in the structure. This specialized structure allows the seller to meet specific needs of the investor, and in a more timely and cost effective manner compared to traditional CDOs, which require that all the different classes of tranches (equity, mezzanine, senior)—usually to different investors—be sold to do the deal.35 Since synthetic CDOs could be created without holding any actual bonds as an underlying asset, the supply of these instruments appears limitless. However, this causes problems in the event of a default if contracts specify physical settlement because there may not be enough Synthetic CDO tranches could be either “funded” or “unfunded.” If a tranche is funded, the CDO investor pays the notional amount of the tranche at the beginning of the transaction—the funds are put into a collateral account and invested in low-risk securities—and any default would result in a write-down of the principal. In return, the investor receives LIBOR plus a spread that reflects the riskiness of the investment. If a tranche is unfunded, no money changes hands at the initiation of the transaction. Rather, the investor (protection seller) receives a spread and pays out in the event that a default in the reference portfolio affects the investor’s particular tranche. Since unfunded tranches depend on the investor’s future ability and willingness to pay, they create counterparty credit risk for the protection buyer. A credit default swap is an unfunded credit derivative.

See Cousseran and Rahmouni (2005) for a detailed description of the structure of a single-tranche CDO and the risks attached to this instrument.


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Market risk largely affects sellers of single tranche CDOs (buyers of protection). Hedging the short credit risk positions requires selling protection periodically on the names referred in the CDO in credit markets. The originator/seller of the CDO is exposed to risk associated with changes in the credit spreads of names in the underlying portfolio of the tranche. However, any dynamic hedging techniques entered into by the seller would only be effective if the instruments used (CDSs, corporate bonds, CDS indices) are sufficiently liquid. Thus, the seller is often exposed to liquidity risk as well, which could exacerbate losses in the event of market stress.

Liquidity risk arises from the difficulty of selling an asset quickly in an insufficiently liquid secondary market. This risk tends to be higher for new or rapidly growing markets, compared to well-established, mature ones. The secondary market for customized CDOs is nonexistent. One potential concern is that some participants in credit derivatives markets may overestimate the liquidity of these products in constructing and hedging their correlationbased portfolios. The issue is not whether occasional losses are sustained by well-diversified large investors, but rather that one of the key player’s portfolios may be too highly concentrated in these instruments. While CDS indices have a certain level of liquidity due to their standard nature, they are not perfect hedges, and thus give rise to basis risk.

Basis risk arises when the hedging instruments available are not perfectly matched to the risks that are to be transferred. Indeed, most hedges are imperfect. For example, standardized tranches on credit derivatives indices are increasingly being used by arrangers to hedge their exposure to single (or “bespoke”) tranches.36 Given that the attachment points of the tranches of a substantial number of CDO structures, which determine the potential losses faced by CDO investors and arrangers, are different from the attachment points of standardized tranches, these market participants would be exposed to basis risk. This risk is particularly high at the more subordinated end of the capital structure, namely, equity and lower-rated mezzanine tranches, where idiosyncratic factors tend to be important.37 Furthermore, arrangers may not be able to hedge unanticipated event risk arising from a sudden default as experienced in the Delphi and Collins & Aikman bankruptcies.

Counterparty risk arises from the possibility that the risk buyer (seller of protection) may default in settling a claim. A fully-funded CDO structure incurs higher costs but is less

–  –  –

exposed to counterparty risk.38 The concentration of counterparty risk may be unavoidable during periods of rising credit risk; in some large CDO transactions, it may become prohibitively expensive to fund the credit risk transfer beyond a certain point (Rule, 2001).

Thus, buyers of unfunded protection must assess whether the protection seller would be able to pay up during an extreme credit event, that is, determine the correlation between the realization of credit events and the creditworthiness of the protection seller.

Market imperfections also work against fully realizing the benefits from credit risk transfer.

In particular, the lack of comprehensive legal and supervisory frameworks, the stilldeveloping trading infrastructure, and rating arbitrage could contribute to financial instability in the event of an adverse shock in the credit markets.

Legal risk in the relatively new CRT market has largely arisen from imperfect documentation, although the maturing of the market has resulted in the setting of precedents over time. Legal risk is fundamentally important since legal and documentary issues are key considerations in defining the roles of the different parties involved in a CDO structure, and ensuring the efficiency and validity of the risk transfer itself (Cousseran and Rahmouni, 2005). Unsound market practices such as incomplete documentation of trades in the credit derivatives market are key examples of legal risk. In the United Kingdom, the FSA recently asked banks for an update on delays and errors that are occurring in processing credit derivatives trades. The authorities have expressed concern about the apparent high levels of unsigned trade confirmations between credit derivatives counterparties in transactions conducted outside of exchanges.39 The inadequacy of the trading infrastructure is evident by the substantial backlog for processing trades. However, a number of private sector initiatives have been advanced to deal with this problem. Recently, 14 leading investment banks pledged to U.S. and European regulators to address the issue backlogs in trade processing and to improve operational practices. These initiatives include commitments to (i) reduce backlogs; (ii) provide regulators with information on the progress; and (iii) use a new procedure for or transferring trades according to the ISDA protocol produced in September, which requires consent before trading. Additionally, there are plans to increase automation of trade processing via the Depository Trust and Clearing Corporation, and a proposal that cash settlement become the standard and that offsetting trades between the same parties are cancelled.

Ratings risk arises from the fact that the structured nature of CDOs limits the usefulness of their ratings, since ratings only reflect certain aspects of their credit risk. Ratings reflect the average risk of a security and merely represent an opinion on the probability of default and Counterparty exposure is usually greater for synthetic CDOs, where the risk transfer is usually unfunded.

Further, these exposures could potentially increase very sharply if the creditworthiness of the counterparty deteriorates quickly.

When assignments of trades are effected without the correct notifications and/or consents, this could result in institutions having out-of-date or inaccurate information on their exposures to individual counterparties.

Tracking down these assignments has contributed to the existing confirmations backlog.


- 23 expected loss. They do not factor in the dispersion of risk around its mean (Cousseran and Rahmouni, 2005), nor can they convey the complexity of a structure or its sensitivity to embedded assumptions, for example, default correlations and recoveries post-default (Miles, 2005). In cases where investors rely on ratings for their CDO investments, model risk is also related to the specific model the rating agency uses to size the credit enhancement for a given tranche and rating (Fender and Kiff, 2004).40 Different methodological approaches used by to rate CDOs could result in “ratings shopping” activity. For instance, Moody’s ratings are based on the concept of expected loss, while Standard and Poor’s and Fitch base their ratings on probabilities of default, which could result in clear differences in the ratings assigned by the agencies to certain tranche structures (Peretyatkin and Perraudin, 2002). Thus, CDO issuers may be tempted to choose rating agencies based on which one assigns the highest rating to their particular issue or tranche, in order to minimize funding costs.41 One possible solution is to encourage investors to require more than one rating as part of their internal control procedures.

Model risk arises in the valuation of CDOs using myriad complex models that continue to evolve. A major shortcoming of existing models is that they do not adequately capture the co-movements of credit spreads and default correlations, leading to some simplifications in modeling the correlation structure. These simplifications, however, may be incorrect (Appendix I). Essentially, model-based prices cannot replicate observed market prices and the associated correlation skew, and hence, may be misleading for assessing risks. Moreover, since market prices are only available for tranches of CDS indices, these cannot be used for valuing synthetic CDOs with nonstandard underlying portfolios.

The asset pool for a CDO may sometimes need to be enhanced by one or more types of credit in order to attain the desired credit risk profile for the security being issued. Such enhancements are usually derived from internal sources, that is, they may be generated from the assets themselves or supplied by a third party.

See Fender and Kiff (2004) for a detailed discussion on the practice of ratings arbitrage.

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British Bankers’ Association (BBA), 2004, Credit Derivatives Report 2003/04 (London, September).

Carhill, Michael, 2005, “Supervising Securitizations,” presented at the High-Level Seminar on Asset Securitization and Structured Finance: Benefits, Risks and Regulatory Implications, International Monetary Fund (Washington, April).

Clementi, David, 2001, “Recent Developments in Securities Markets and the Implications for Financial Stability,” presented at the Euromoney International Bond Congress, London.

Cousseran, Olivier, and Imene Rahmouni, 2005, “The CDO Market: Functioning and

Implications in Terms of Financial Stability,” in Financial Stability Review (Paris:

Banque de France).

Duffie, D., and N. Garleanu, 2001, “Risk and Valuation of Collateralized Debt Obligations,” Financial Analysts Journal, vol. 57, No. 1, pp. 41–59.

European Central Bank (ECB), 2004, “Features of CRT Markets,” in Credit Risk Transfer by EU Banks: Activities, Risks and Risk Management (Frankfurt, May).

Fender, Ian, and John Kiff, 2004, “CDO Rating Methodology: Some Thoughts on Model Risk and Its Implications,” BIS Working Papers No. 163 (Basel: Bank for International Settlements).

Fitch Ratings, 2005, “Global Credit Derivatives Survey: Risk Dispersion Accelerates,” Financial Institutions Special Report (London and New York, November).

Gibson, Michael S., 2004, “Understanding the Risk of Synthetic CDOs,” Working Paper (Washington: Board of Governors of the Federal Reserve).

Hamilton, James D., 1994, Time Series Analysis (New Jersey: Princeton University Press).

Hasbrouck, Joel, 1991a, “Measuring the Information Content of Stock Trades,” Journal of Finance, Vol. 46, pp. 179–207.

_____, 1991b, “The Summary Informativeness of Stock Trades: An Econometric Analysis,” Review of Financial Studies, Vol. 4, pp. 571–95.

International Association of Insurance Supervisors (IAIS), 2003, “IAIS Paper on Credit Risk Transfer between Insurance, Banking and Other Financial Sector,” presented at the Financial Stability Forum, Bank for International Settlements (Berlin, March).

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Joint Forum, 2004, Credit Risk Transfer, Bank for International Settlements (Basel, October).

Memani, Krishna, 2005, “Asset Securitization and Structured Finance,” presented at the High-Level Seminar on Asset Securitization and Structured Finance: Benefits, Risks and Regulatory Implications, International Monetary Fund (Washington, April).

Miles, Colin, 2005, “Structured Finance,” presented at the High-Level Seminar on Asset Securitization and Structured Finance: Benefits, Risks and Regulatory Implications, International Monetary Fund (Washington, April).

Monks, Allan, and Marco Stringa, 2005, “Inter-Industry Linkages between U.K. Life

Insurers and U.K. Banks: An Event Study,” in Financial Stability Review (London:

Bank of England).

Peretyatkin, Vlad, and William Perraudin, 2002, “EL and DP Approaches to Rating CDOs and the Scope for ‘Ratings Shopping’,” in Credit Ratings—Methodologies, Rationale and Default Risk, ed. by M.K. Ong (London: Risk Books).

Risk, 2003, “Landesbanks and Life Insurers Counter Credit Critiques,” July.

Rule, David, 2001, “Risk Transfer between Banks, Insurance Companies and Capital Markets: An Overview,” in Financial Stability Review (London: Bank of England).

_____, Adrian Garratt, and Ole Rummel, 2004, “Structured Note Markets: Products, Participants and Links to Wholesale Derivatives Markets,” in Financial Stability Review (London: Bank of England, June).

Tett, Gillian, 2005, “CDOs Unwinding with a Whimper,” Financial Times, July 8.

Wagner, Wolf, and Ian W. Marsh, 2004, “Credit Risk Transfer and Financial Sector Performance,” Discussion Paper No. 4265 (London: Center for Economic Policy

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