Question

3. (a) What is meant by the term ‘credit risk’? What are the key inputs into, and how do they impact, a model that attempts to quantify credit risk? (b) Describe how a Collateralized Debt Obligation (CDO) is formed and how it distributes income to its investors? What is the risk borne by the investor? (c) A 2-year Credit Default Swap (CDS) with a notional principal of €80 million and a credit default spread of 140 basis points is initiated today. The reference entity is a firm called NCM. Premium payments are made semi-annually in arrears. (i) What is the purpose of a CDS? (ii) Describe the risk facing the writer of the CDS (the holder of the short side of the contract). (iii) Show the cashflows between the purchaser and seller of the contract written on NCM if the firm does not default during the life of the contract. (iv) Show the cashflows between the purchaser and the seller of the contract written on NCM if the firm defaults after 1 year and 10 months.

Answer 1

a.Credit risk is the possibility of a loss resulting from a borrower's failure to repay a loan or meet contractual obligations. Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. Excess cash flows may be written to provide additional cover for credit risk.

Traditionally, it refers to the risk that a lender may not receive the owed principal and interest, which results in an interruption of cash flows and increased costs for collection. When a lender faces heightened credit risk, it can be mitigated via a higher coupon rate, which provides for greater cash flows.

When lenders offer mortgages, credit cards, or other types of loans, there is a risk that the borrower may not repay the loan. Similarly, if a company offers credit to a customer, there is a risk that the customer may not pay their invoices. Credit risk also describes the risk that a bond issuer may fail to make payment when requested or that an insurance company will be unable to pay a claim.

Credit risks are calculated based on the borrower's overall ability to repay a loan according to its original terms. To assess credit risk on a consumer loan, lenders look at the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.

Some companies have established departments solely responsible for assessing the credit risks of their current and potential customers. Technology has afforded businesses the ability to quickly analyze data used to assess a customer's risk profile.

• Different factors are used to quantify credit risk, and three are considered to have the strongest relationship: probability of default, loss given default, and exposure at default.

b.A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors. A CDO is a particular type of derivative because, as its name implies, its value is derived from another underlying asset. These assets become the collateral if the loan defaults.

To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches based on the level of credit risk assumed by the investor.

The tranches of CDOs are named to reflect their risk profiles; for example, senior debt, mezzanine debt, and junior debt—pictured in the sample below along with their Standard and Poor's (S&P) credit ratings. But the actual structure varies depending on the individual product.

The senior tranches are generally safest because they have the first claim on the collateral. Although the senior debt is usually rated higher than the junior tranches, it offers lower coupon rates. Conversely, the junior debt offers higher coupons (more interest) to compensate for their greater risk of default; but because they are riskier, they generally come with lower credit ratings.

Collateralized debt obligations are complicated, and numerous professionals have a hand in creating them:

• Securities firms, who approve the selection of collateral, structure the notes into tranches and sell them to investors
• CDO managers, who select the collateral and often manage the CDO portfolios
• Rating agencies, who assess the CDOs and assign them credit ratings
• Financial guarantors, who promise to reimburse investors for any losses on the CDO tranches in exchange for premium payments
• Investors such as pension funds and hedge funds

  The earliest CDOs were constructed in 1987 by the former investment bank, Drexel Burnham Lambert—where Michael Milken, then called the "junk bond king," reigned. The Drexel bankers created these early CDOs by assembling portfolios of junk bonds, issued by different companies. Ultimately, other securities firms launched CDOs containing other assets that had more predictable income streams, such as automobile loans, student loans, credit card receivables, and aircraft leases. However, CDOs remained a niche product until 2003–04, when the U.S. housing boom led CDO issuers to turn their attention to subprime mortgage-backed securities as a new source of collateral for CDOs.

  Collateralized debt obligations exploded in popularity, with CDO sales rising almost tenfold from $30 billion in 2003 to $225 billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw CDOs become one of the worst-performing instruments in the subprime meltdown, which began in 2007 and peaked in 2009. The bursting of the CDO bubble inflicted losses running into hundreds of billions of dollars for some of the largest financial services institutions. These losses resulted in the investment banks either going bankrupt or being bailed out via government intervention and helped to escalate the global financial crisis, the Great Recession, during this period.

  Despite their role in the financial crisis, collateralized debt obligations are still an active area of structured-finance investing. CDOs and the even more infamous synthetic CDOs are still in use, as ultimately they are a tool for shifting risk and freeing up capital—two of the very outcomes that investors depend on Wall Street to accomplish, and for which Wall Street has always had an appetite.

c.A credit default swap (CDS) is a financial derivative or contract that allows an investor to "swap" or offset his or her credit risk with that of another investor. For example, if a lender is worried that a borrower is going to default on a loan, the lender could use a CDS to offset or swap that risk. To swap the risk of default, the lender buys a CDS from another investor who agrees to reimburse the lender in the case the borrower defaults. Most CDS will require an ongoing premium payment to maintain the contract, which is like an insurance policy.

A credit default swap is the most common form of credit derivative and may involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate bonds.

A credit default swap is, in effect, insurance against non-payment. Through a CDS, the buyer can avoid the consequences of a borrower's default by shifting some or all that risk onto an insurance company or other CDS seller in exchange for a fee. In this way, the buyer of a credit default swap receives credit protection, while the seller of the swap guarantees the creditworthiness of the debt security. For example, the buyer of a credit default swap will be entitled to the par value of the contract by the seller of the swap, along with any unpaid interest, should the issuer default on payments.

It is important to note that the credit risk isn't eliminated – it has been shifted to the CDS seller. The risk is that the CDS seller defaults at the same time the borrower defaults. This was one of the primary causes of the 2008 credit crisis: CDS sellers like Lehman Brothers, Bear Stearns and AIG defaulted on their CDS obligations.

While credit risk hasn't been eliminated through a CDS, risk has been reduced. For example, if Lender A has made a loan to Borrower B with a mid-range credit rating, Lender A can increase the quality of the loan by buying a CDS from a seller with a better credit rating and financial backing than Borrower B. The risk hasn't gone away, but it has been reduced through the CDS.

If the debt issuer does not default and if all goes well, the CDS buyer will end up losing money through the payments on the CDS, but the buyer stands to lose a much greater proportion of its investment if the issuer defaults and if it had not bought a CDS. As such, the more the holder of a security thinks its issuer is likely to default, the more desirable a CDS is and the more it will cost.

Any situation involving a credit default swap will have a minimum of three parties. The first party involved is the institution that issued the debt security (borrower). The debt may be bonds or other kinds of securities and are essentially a loan that the debt issuer has received from the lender. If a company sells a bond with a $100 face value and a 10-year maturity to a buyer, the company is agreeing to pay back the $100 to the buyer at the end of the 10-year period as well as regular interest payments over the course of the bond's life. Yet, because the debt issuer cannot guarantee that it will be able repay the premium, the debt buyer has taken on risk.

Alternatively, imagine an investor who believes that Company A is likely to default on its bonds. The investor can buy a CDS from a bank that will pay out the value of that debt if Company A defaults. A CDS can be purchased even if the buyer does not own the debt itself. This is a bit like a neighbor buying a CDS on another home in her neighborhood because she knows that the owner is out of work and may default on the mortgage.

Though credit default swaps can insure the payments of a bond through maturity, they do not necessarily need to cover the entirety of the bond's life. For example, imagine an investor is two years into a 10-year security and thinks that the issuer is in credit trouble. The bond owner may choose to buy a credit default swap with a five-year term that would protect the investment until the seventh year, when the bondholder believes the risks will have faded.

It is even possible for investors to effectively switch sides on a credit default swap to which they are already a party. For example, if a CDS seller believes that the borrower is likely to default, the CDS seller can buy its own CDS from another institution or sell the contract to another bank in order to offset the risks. The chain of ownership of a CDS can become very long and convoluted, which makes tracking the size of this market difficult.

c.i.A CDS contract involves the transfer of the credit risk of municipal bonds, emerging market bonds, mortgage-backed securities (MBS), or corporate debt between two parties. It is similar to insurance because it provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative "credit event."

The seller of the contract assumes the credit risk that the buyer does not wish to shoulder in exchange for a periodic protection fee similar to an insurance premium, and is obligated to pay only if a negative credit event occurs. It is important to note that the CDS contract is not actually tied to a bond, but instead references it. For this reason, the bond involved in the transaction is called the "reference obligation." A contract can reference a single credit or multiple credits.

As mentioned above, the buyer of a CDS will gain protection or earn a profit, depending on the purpose of the transaction, when the reference entity (the issuer) has a negative credit event. If such an event occurs, the party that sold the credit protection, and who has assumed the credit risk, must deliver the value of principal and interest payments that the reference bond would have paid to the protection buyer.

With the reference bonds still having some depressed residual value, the protection buyer must, in turn, deliver either the current cash value of the referenced bonds or the actual bonds to the protection seller, depending on the terms agreed upon at the onset of the contract. If there is no credit event, the seller of protection receives the periodic fee from the buyer, and profits if the reference entity's debt remains good through the life of the contract and no payoff takes place. However, the contract seller is taking the risk of big losses if a credit event occurs.

c.ii.The market for CDS is OTC and unregulated, and the contracts often get traded so much that it is hard to know who stands at each end of a transaction. There is the possibility that the risk buyer may not have the financial strength to abide by the contract's provisions, making it difficult to value the contracts.

The leverage involved in many CDS transactions, and the possibility that a widespread downturn in the market could cause massive defaults and challenge the ability of risk buyers to pay their obligations, adds to the uncertainty.

c.iii.