Credit Risk

The most obvious risk credit derivatives participants face is credit risk. Credit risk is
the risk to earnings or capital of an obligor’s failure to meet the terms of any contract
with the bank or otherwise to perform as agreed. For both purchasers and sellers of
protection, credit derivatives should be fully incorporated within credit risk management
processes. Bank management should integrate credit derivative activity in their
credit underwriting and administration policies, and their exposure measurement,
limit setting, and risk rating/classification processes. They should also consider
credit derivative activity in their assessment of the adequacy of the allowance for
loan and lease losses (ALLL) and their evaluation of concentrations of credit.
There are a number of credit risks for both sellers and buyers of credit protection,
each of which raises separate risk management issues. For banks selling credit
protection (i.e. buying risk), the primary source of credit risk is the reference asset
or entity. Table 11.3 highlights the credit protection seller’s exposures in the three
principal types of credit derivative products seen in the USA.

As noted in Table 11.3, the protection seller’s credit exposure will vary depending
on the type of credit derivative used. In a CDS, the seller makes a payment only if a
predefined credit event occurs. When investors sell protection through total rate-of
return swaps (i.e. receive total return), they are exposed to deterioration of the
reference asset and to their counterparty for the amount of any increases in value of
the reference asset. In CLN transactions, the investor (seller of credit protection) is
exposed to default of the reference asset. Directly issued CLNs (i.e. those not issued
through a trust) expose the investor to both the reference asset and the issuer.
When banks buy credit protection, they also are exposed to counterparty credit
risk as in other derivative products. Table 11.4 highlights the credit protection
buyer’s exposures in the three principal types of credit derivative products.

As noted in Table 11.4, the protection buyer’s credit exposure also varies depending
on the type of credit derivative. In a CDS, the buyer will receive a payment from the
seller of protection when a default event occurs. This payment normally will equal
the value decline of the CDS reference asset. In some transactions, however, the
parties fix the amount in advance (binary). Absent legal issues, or a fixed payment
that is less than the loss on the underlying exposure, the protection buyer incurs a
credit loss only if both the underlying borrower (reference asset) and the protection
seller simultaneously default.
In a CDS transaction with a cash settlement feature, the hedging bank (protection
buyer) receives a payment upon default, but remains exposed to the original balancesheet
obligation. Such a bank can assure itself of complete protection against this
residual credit risk by physically delivering the asset to the credit protection seller
upon occurrence of a credit event. The physical delivery form of settlement has
become more popular as the market has evolved. Absent a credit event, the protection
buyer has no coverage against market value deterioration.
If the term of the credit protection is less than the maturity of the exposure, the
hedging bank will again become exposed to the obligation when the credit derivative
matures. In that case, the bank has a forward credit risk.
In a TRS, the protection buyer is exposed to its counterparty, who must make a
payment when the value of the reference asset declines. Absent legal issues, a buyer
will not incur a credit loss on the reference asset unless both the reference asset
declines in value and the protection seller defaults.
A bank that purchases credit protection by issuing a credit-linked note receives
cash and thus has no counterparty exposure; it has simply sold bonds. It may have
residual credit exposure to the underlying borrower if the recovery rate as determined
by a bidding process is different than the value at which it can sell the underlying
exposure. This differential is called ‘basis risk’.