Risk transfer has become the name of the game. The collapse of Enron Corp. made that exquisitely clear with Citigroup, in particular, using highly sophisticated risk transfer instruments to keep its nose clean despite the biggest bankruptcy ever.Enron is not an isolated case. Bond defaults and corporate bankruptcies are hitting all-time highs. Some 211 bond issuers defaulted on $115.4 billion in debt in 2001, a record both in the number of defaults and the dollar-value, according to Standard & Poors.
Bankruptcy filings by publicly traded companies in the U.S., according to the Federal Deposit Insurance Corp., rose to 257 in 2001, a 46% increase over the previous years record of 176 filings.
Clearly, banks can be in a precarious position, but there is a host of new instruments, most notably credit derivatives, that can help them hedge their bets.
And regulators are urging them on. The potential for the credit derivatives market is substantial because most banks and corporations have credit risks that need to be managed, says Michael Brosnan, deputy comptroller for risk evaluation at the Office of the Comptroller of Currency.
Until recently, credit derivatives have been the purview of only the biggest banks, here and overseas. In the U.S., the top seven commercial banks hold more than 96% of the outstanding credit derivatives, according to the Comptrollers office. (See chart on page 38.)
But change is underway. Sunjay Mithal, vice president of global credit derivatives strategy at Citigroup, and Janet Tavakoli, executive director of credit derivatives structuring and engineering at Westdeutsche Landesbank Girozentrale (WestLB) in London, say they have seen a significant number of small banks entering the credit derivatives market in the past year. And they are both taking and selling risk through the credit derivatives market.
Some experts ask, however, whether smaller banks and other less sophisticated institutions are ready or able to play in this market. Risk management instruments come with inherent risks of their own, such as the credit quality of the counter parties or the legal risk in case of a disagreement over the terms.
Its important that whoever starts with a new product understands what they are trying to do, understands the product, understands the legal nuances, and is sure that counter parties are both credit worthy and have a good amount of integrity, warns Brosnan of the OCC. You just dont jump in and do it.
Some experts acknowledge there are sales-driven dealers who may take advantage of new players who know little about credit derivatives. A dealer might package some of his very risky assets with higher grade assets into a synthetic structure, such as a highly complex collateralized debt obligation, and sell it to an investor without disclosing the dangers in the asset pool, says a fund manager in London. Its not a common practice, but Ive seen a few.
The problem is that there are a lot of people in jobs that they shouldnt be in, says the London fund manager. Sellers of the CDOs often get a payment upfront, which can be very tempting to them.
A good system of controls is necessary to track how much risk is being taken on. One problem is that credit derivatives are off-balance-sheet items, and are not readily detected, even by a banks top management.
For the most part, the banks that we regulate are operated by professionals, they are not just out there collecting fees without having done their homework first. There is a reason why they are willing take a credit risk of a certain company for a certain period of time and why they think that that price is fair, assures Brosnan.
All U.S. commercial banks are required to report their credit derivative activities every quarter on their call reports to the FDIC. They are also required to hold the same amount of capital behind a credit derivative as they would a loan. And according to Brosnan, the OCC has specialists to examine these complicated instruments and their impact on the credit exposure of a bank.
So far, the performance of credit derivative instruments has been pretty good. Analysts point to the smooth settlement of claims after the defaults of Swiss Air and Railtrack last year. In face of all the defaults, theyve performed better than I would had thought a new product would have this early in the game, says Brosnan.
Yet, its still early to determine what impact the credit derivatives market will have. There are still numerous cases in court over credit derivative issues in the bankruptcy of Enron and the recent default of Argentina. Definition of terms will need to be constantly updated to accommodate evolving situations and institutions involved with these products will need government agencies surveillance.
In no case should anyone be complacent with the success we have had so far, says Brosnan.
Theres no question, though, that the market has been growing by leaps and bounds. The global credit derivatives market grew to a notional $694 billion by the end of June 2001, from $108 billion three years earlier, according to a survey conducted by the Bank for International Settlements.
And in the U.S. alone, the notional value of credit derivatives at commercial banks was $360 billion at the end of September. They have grown more than five-fold since the OCC first reported them separately in the fourth quarter of 1997. At that time, the notional amount stood at $55 billion.
Credit derivatives dealers, investors and other market participants expect the sector to continue to grow at exponential rates, outperforming all other sectors of the derivatives market. The global notional market value is projected to grow to $1.5 trillion in 2002.
But even as this market swells, credit derivatives are still a tiny sector, less than 1% of the total derivatives market. These instruments are complicated and sometimes are as individual as the individuals who write them. They continue to mystify many financial professionals.
The lack of knowledge or education is a great barrier for the credit derivatives market, says Citigroups Mithal.
There is not a universal definition for credit derivatives. It is a term used to describe a group of derivative products that separate and transfer credit default or spread risk of an underlying asset or pool of assets between transacting parties. The underlying asset could be a bond, loan, note, letter of credit, and in more sophisticated instruments, an index, an equity, or a commodity.
They are traded over-the-counter and may be kept off an organizations balance sheet because they do not involve a transfer of assets.
The most common and liquid credit derivative instrument is the credit default swap or CDS. As the simplest variety, it makes up about 38% of the market, according to data from the British Bankers Association. The next two most common types are total rate of return swaps, or TRORS and collateralized debt obligations, known as CDOs. Together, the trio make up 70% of the credit derivative market. Other instruments include asset swaps, credit spread swaps and credit linked notes.
In a credit default swap, a risk protection buyer pays the protection seller a premium, usually in the form of a semi-annual annuity. In most cases, credit default swaps are genuinely used to offset risk, but they also can be used by speculators to take positions without actually owning the underlying security.
Credit default swaps can be used by a commercial bank to lend money to a client beyond the banks risk tolerance for that borrower. A bank seeking to lend more to a customer than the banks risk profile would allow, could lay off the excess by entering into a CDS with an outside party.
In total rate of return swaps, the buyer collects the interest payments of the underlying security and can profit or lose to the degree that the market value of the underlying security changes over the period of the contract. The underlying asset never changes hands. The buyer pays the seller an agreed-upon fee, usually the London Inter-Bank Offered rate plus the financing spread. In other words, the seller of the TRORS rents his security to the buyer.
Investors use TRORS to take advantage of leverage. No initial payment is required. The investors fee to the seller is netted out of the interest payment from the underlying bond. The original investor in the underlying security does nothing and receives interest minus the fee. However, if the issuer of the underlying bond defaults, the buyer of the swap has to pay the seller (the original investor) the entire amount of the principal value when the contract was initiated.
Collateralized debt obligations are much more complicated. They are a cross between credit derivatives and asset-backed securities. CDOs are usually created in conjunction with credit default swaps and total rate of return swaps and are sold in various tranches with different coupons to investors in the cash market. Moodys rates some of the outstanding CDOs. CDOs are most popular with asset managers for the purpose of raising capital.
Despite the complexity of credit derivatives, many believe that credit derivatives improve world capital markets by making it easier to spread risk. Markets in credit risk transfer have the potential to contribute to a more efficient allocation of credit risk in the economy, the Bank of England says in a recent report.
The credit derivatives market is still relatively young only a few years old except for a few that surfaced in the 1970s. It will take many more years to become standardized. Were not at a boom yet, says Brosnan.
