FRM 4: Credit Risk Transfer Mechanisms

A credit derivative is any vehicle that moves credit risk from one party to another. Credit default swaps qualify, and so do credit-linked notes and collateralized loan obligations, alongside a family of structured products built by securitization. Whatever the label, the contract sits off the balance sheet and joins two counterparties: the beneficiary, who sells the credit risk, and the guarantor, who buys it. Credit derivatives do for credit risk what interest rate and currency derivatives did for market risk.

Source: key terms and vehicles in the chapter.

How a credit default swap works

The protection buyer pays a periodic fee, quoted in basis points on notional, and receives nothing unless a credit event occurs, at which point the protection seller must pay. A single-name CDS carries one reference entity; where several sit inside one contract, the structure is a basket CDS. Settlement is usually in cash.

That last point carries the practical value. A credit default swap requires no funding and no participation from the reference creditor, so a bank sheds concentration in a name while keeping the asset and the customer relationship. A sale achieves neither. Both sides must still pin down what is moving, how the triggers are defined, and whether the documentation holds.

The older toolkit predates credit derivatives, and banks still lean on it, name by name and across the book.

Buying insurance from a third-party guarantor

Protection bought on a single obligor is a financial guarantee, written by a specialist known as a monoline insurer. Such guarantees were routine in the United States municipal bond market and in the ABS market, and worked only while the insurer held a AAA credit rating, since a lower rated insurer cannot lift a bond to AAA. Having guaranteed a large volume of ABS and privately issued MBS before the crisis, monoline insurers faced payouts as defaults arrived, were downgraded, and guaranteed issuance fell away.

Netting exposures to a counterparty

Netting compares asset and liability values for each counterparty, with documentation allowing the two to be set against each other. Without it, a bankruptcy turns whatever the counterparty owes into a claim while the bank stays fully liable for anything owed the other way.

Marking to market and margining

Counterparties can agree to revalue a position periodically and transfer any net change in value, which keeps the exposure small. This needs sophisticated systems and has historically been seen in exchange-traded derivatives.

Requiring collateral to be posted

Collateral absorbs losses when a default arrives. The complication is that whatever produces the default sometimes damages the collateral too. Picture an oil company posting barrels of crude: its default probability climbs as the oil price falls, and the security loses value in step. That is wrong way risk.

Termination and put options

At inception the counterparties can agree trigger events which, once realised, require the position to be unwound by a pre-determined methodology, often the mid-market valuation. Downgrades and balance sheet metrics are typical triggers, and the exit comes before a deteriorating counterparty defaults. Where the protection takes the form of a put option, the lender can force early termination at a price fixed in advance, and a related device reassigns the exposure to a third party once a predefined trigger fires.

Syndicating a large loan and selling it on

A very large loan need not rest with one lender. The lead bank originates it, distributes it for a percentage fee, and keeps a portion on its own book. Under a firm commitment the banks guarantee the obligor a set amount, so weak demand lands a larger share on the lead bank; under best efforts the target may not be reached. Syndicated loans are the backbone of the secondary market in bank loans, where a bank can also sell loans it already owns.

These techniques are cumbersome and costly, and none separates credit risk from the position carrying it, so the exposure cannot be redistributed to a broader class of investors or sliced finely enough to tune a credit portfolio. Credit derivatives were formulated for precisely that.

Transferring risk is one use of a credit derivative. Pricing it is another. In a robust, liquid and transparent market they quantify what a given type of credit risk is worth, which is price discovery, and because they trade continuously CDS prices track default risk in real time, where credit ratings are reassessed only periodically.

Corporate bond markets have long performed this function, with two handicaps: a bond blends interest rate risk with credit risk, and sometimes liquidity risk, so the credit component is inferred rather than observed, and only bond-issuing companies are covered, generally the largest. Credit derivatives reach privately traded high-yield loans and loan portfolios too.

Credit risk is wider than default risk

In a mature credit market, credit risk covers default risk, upgrades and downgrades, and credit spread risk. A credit spread measures the gap between the yield on an instrument exposed to credit risk, a bond, a derivative or a loan, and the yield on a comparable maturity Treasury bond.

When the spread widens, every instrument priced off it is revalued downward, and no borrower need have missed a payment for the loss to be real. For liquid assets, credit risk becomes the market risk of credit risk.

Securitization repackages loans and other assets into new securities sold in the securities markets, collateralised by the pool itself, so their performance follows the pool. It funds financial institutions and non-financial corporations, which matters because banks alone lack the capital to satisfy businesses, consumers and governments, and doubles as a risk management tool. Banks have used it to move corporate bank loans, mortgage loans, automobile loans and credit card receivables off their balance sheets, creating mortgage-backed securities, collateralized loan obligations and asset-backed securities.

From originate-and-hold to originate-to-distribute

Before securitization, an entity that originated a loan simply held it as an investment. That is the buy-and-hold strategy, also called originate-and-hold, and it leaves three risks with the originator: credit risk, price risk and liquidity risk. Securitization instead pools similar loans as collateral for new securities, the originate-to-distribute approach, and each of the three falls away. The originator owns neither the collateral nor the individual assets, so credit risk and price risk go, and illiquid loans now back securities instead of sitting on the books, so liquidity risk goes too.

The special purpose vehicle

Everything turns on one legal entity the originator establishes, the special purpose vehicle. The SPV buys the pool from the sponsor, as the originating entity is called, and funds it by selling the new securities, whose holders receive interest and principal under rules covering distribution and default. It issues senior bonds, junior bonds and equity, the classes or tranches. The senior class has the most protection and usually carries a AAA rating, with junior classes rated below AAA. The equity class, or residual class, is paid only after every debt class and so bears the greatest credit risk, and equity tranches typically make up less than 10 percent of total funding.

Securitization is not only for banks

Non-financial companies use the same machinery. General Motors created the captive finance company GM Financial, whose affiliates use SPVs such as AmeriCredit Automobile Receivables Trust (AMCAR), GM Financial Automobile Leasing Trust (GMALT) and GM Financial Consumer Automobile Receivables Trust (GMCAR). Harley-Davidson Financial Services issued a first securitization of USD 301.9 million in 2016 and a USD 552.16 million deal in 2019. SoFi issued through its SPV in April 2018 two student loan-backed securitizations, USD 960 million in SOFI-A Notes and USD 869 million in SOFI-B notes, plus USD 774 million in SCLP 2018-1 Notes backed by consumer loans, USD 2.6 billion in total.

The trend began in 1968 with the Government National Mortgage Association, GNMA or Ginnie Mae, the mechanism for securitizing government-insured and government-guaranteed mortgage loans. Consumer ABS emerged in the United States during the 1980s, United Kingdom residential mortgage-backed securities alongside them, and commercial mortgage-backed securities in the 1990s. Between 2000 and 2007 the private label market produced a surge of complex, risky, opaque CDOs.

Why banks moved away from buy-and-hold

From the 1980s, parts of banking shifted out of buy-and-hold into originate-to-distribute, selling on credit risk a bank would once have kept, cash flows attached. Basel capital adequacy requirements drove much of the enthusiasm, since moving capital-consuming loans off the books optimised capital, while accounting standards encouraged banks to chase upfront commissions.

Three groups appeared to gain: originators through capital efficiency and funding, investors through a wider choice of holdings, borrowers through cheaper credit.

Moral hazard and underwriting standards

Those benefits eroded as risks accumulated before the crisis. How much the originate-to-distribute model contributed is disputed; the moral hazard is not, because a lender who plans to sell has less reason to hold underwriting standards high or to keep checking the creditworthiness of the borrower, and too few safeguards stood against that. Regulators also worried that liquidity in the credit derivative market came from few providers, so distress at any of them could disrupt a young market. Credit default swaps moved credit risk out of the loan book and generated counterparty credit risk of a systemic nature in its place.

How the model was actually used

Before the crisis, banks departed from the originate-to-distribute model rather than following it, taking the investor role themselves instead of passing risk to capital market investors, so little mortgage credit risk actually moved. What should have been dispersed was concentrated in vehicles created mainly to sidestep capital rules: highly levered ABCP conduits and structured investment vehicles held off the balance sheet. Banks misjudged the reputation risk in those commitments and assumed funding would keep flowing. Firms that thought they were selling exposure built a pipeline of unsold credit risk instead, and a levered vehicle funding long assets with short paper carries a maturity mismatch that leaves it open to a run.

Four failings ran the length of the chain: incentives misaligned at every stage by the pursuit of short-term profit; opaque products, so investors could not judge the quality of the underlying assets or the correlations between them; weak securitization risk management, above all in stress testing liquidity, concentration and pipeline risk; and too much reliance on credit ratings, since the agencies understated the risk in subprime CDO structuring.

What changed after the crisis

Risk retention rules were the direct answer to moral hazard. A securitizer must keep at least 5 percent of the credit risk, with no recourse to transferring or mitigating it and no hedging of that slice, the aim being skin in the game. The model still weakens the incentive to monitor credit risk compared with buy-and-hold, so the rules narrow the gap rather than close it. Opaque structures built for distribution rather than protection did not return, while the single-name credit default swap market kept functioning through the crisis under the International Swaps and Derivatives Association. Securitization now runs below its pre-crisis scale, held back by regulatory uncertainty.