Managing leverage considerations

Most credit derivatives, like financial derivatives, involve leverage. If a bank selling
credit protection does not fully understand the leverage aspects of some credit
derivative structures, it may fail to receive an appropriate level of compensation for
the risks assumed.
A fixed payout (or binary) default swap can embed leverage into a credit transaction.
In an extreme case, the contract may call for a 100% payment from the protection
seller to the protection buyer in the event of default. This amount is independent of
the actual amount of loss the protection buyer (lender) may suffer on its underlying
exposure. Fixed payout swaps can allow the protection buyer to ‘over-hedge’, and
achieve a ‘short’ position in the credit. By contracting to receive a greater creditevent
payment than its expected losses on its underlying transaction, the protection
buyer actually benefits from a default. Protection sellers receive higher fees for
assuming fixed payment obligations that exceed expected credit losses and should
always evaluate and manage those exposures prudently.
For a protection seller, a basket swap also represents an especially leveraged credit
transaction, since it suffers a loss if any one of the basket names defaults. The
greater the number of names, the greater the chance of default. The credit quality of
the transaction will ordinarily be less than that of the lowest rated name. For
example, a basket of 10 names, all rated ‘A’ by a national rating agency, may not
qualify for an investment grade rating, especially if the names are not highly correlated.
Banks can earn larger fees for providing such protection, but increasing the
number of exposures increases the risk that they will have to make a payment to a
counterparty.
Conceptually, protection sellers in basket swaps assume credit exposure to the
weakest credit in the basket. Simultaneously, they write an option to the protection
buyer, allowing that party to substitute another name in the basket should it become
weaker than the originally identified weakest credit. Protection buyers in such
transactions may seek to capitalize upon a protection seller’s inability to quantify
the true risk of a default basket. When assuming these kinds of credit exposures,
protection-selling banks should carefully consider their risk tolerance, and determine
whether the leverage of the transaction represents a prudent risk/reward
opportunity.