The purchase of credit protection through credit derivatives may not completely
eliminate the credit risk associated with holding a loan because the reference asset
may not have the same terms and conditions as the balance sheet exposure. This
residual exposure is known as basis risk. For example, upon a default, the reference
asset (often a publicly traded bond) might lose 25% of its value, whereas the
underlying loan could lose 30% of its value. Should the value of the loan decline
more than that of the reference asset, the protection buyer will receive a smaller
payment on the credit default swap (derivative) than it loses on the underlying loan
(cash transaction). Bonds historically have tended to lose more value, in default
situations, than loans. Therefore, a bank hedging a loan exposure using a bond as a
reference asset could benefit from the basis risk. The cost of protection, however,
should reflect the possibility of benefiting from this basis risk. More generally, unless
all the terms of the credit derivative match those of the underlying exposure, some
basis risk will exist, creating an exposure for the protection buyer. Credit hedgers
should carefully evaluate the terms and conditions of protection agreements to
ensure that the contract provides the protection desired, and that the hedger has
identified sources of basis risk.
1 Mart 2011 Salı
Managing credit risk: underwriting and administration
Managing credit risk: underwriting and administration
For banks selling credit protection (buying risk) through a credit derivative, management
should complete a financial analysis of both reference obligor(s) and the
counterparty (in both default swaps and TRSs), establish separate credit limits for
each, and assign appropriate risk ratings. The analysis of the reference obligor
should include the same level of scrutiny that a traditional commercial borrower
would receive. Documentation in the credit file should support the purpose of the
transaction and creditworthiness of the reference obligor. Documentation should be
sufficient to support the reference obligor’s risk rating. It is especially important for
banks to use rigorous due diligence procedures in originating credit exposure via
credit derivatives. Banks should not allow the ease with which they can originate
credit exposure in the capital markets via derivatives to lead to lax underwriting
standards, or to assume exposures indirectly that they would not originate directly.
For banks purchasing credit protection through a credit derivative, management
should review the creditworthiness of the counterparty, establish a credit limit, and
assign a risk rating. The credit analysis of the counterparty should be consistent
with that conducted for other borrowers or trading counterparties. Management
should continue to monitor the credit quality of the underlying credits hedged.
Although the credit derivative may provide default protection, in many instances (e.g.
contracts involving cash settlement) the bank will retain the underlying credit(s)
after settlement or maturity of the credit derivative. In the event the credit quality
deteriorates, as legal owner of the asset, management must take actions necessary
to improve the credit.
Banks should measure credit exposures arising from credit derivative transactions
and aggregate with other credit exposures to reference entities and counterparties.
These transactions can create highly customized exposures and the level of risk/
protection can vary significantly between transactions. Management should document
and support their exposure measurement methodology and underlying
assumptions.
For banks selling credit protection (buying risk) through a credit derivative, management
should complete a financial analysis of both reference obligor(s) and the
counterparty (in both default swaps and TRSs), establish separate credit limits for
each, and assign appropriate risk ratings. The analysis of the reference obligor
should include the same level of scrutiny that a traditional commercial borrower
would receive. Documentation in the credit file should support the purpose of the
transaction and creditworthiness of the reference obligor. Documentation should be
sufficient to support the reference obligor’s risk rating. It is especially important for
banks to use rigorous due diligence procedures in originating credit exposure via
credit derivatives. Banks should not allow the ease with which they can originate
credit exposure in the capital markets via derivatives to lead to lax underwriting
standards, or to assume exposures indirectly that they would not originate directly.
For banks purchasing credit protection through a credit derivative, management
should review the creditworthiness of the counterparty, establish a credit limit, and
assign a risk rating. The credit analysis of the counterparty should be consistent
with that conducted for other borrowers or trading counterparties. Management
should continue to monitor the credit quality of the underlying credits hedged.
Although the credit derivative may provide default protection, in many instances (e.g.
contracts involving cash settlement) the bank will retain the underlying credit(s)
after settlement or maturity of the credit derivative. In the event the credit quality
deteriorates, as legal owner of the asset, management must take actions necessary
to improve the credit.
Banks should measure credit exposures arising from credit derivative transactions
and aggregate with other credit exposures to reference entities and counterparties.
These transactions can create highly customized exposures and the level of risk/
protection can vary significantly between transactions. Management should document
and support their exposure measurement methodology and underlying
assumptions.
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’.
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’.
Risks of credit derivatives
When used properly, credit derivatives can help diversify credit risk, improve earnings,
and lower the risk profile of an institution. Conversely, the improper use of
credit derivatives, as in poor lending practices, can result in an imprudent credit
risk profile.
Credit derivatives expose participants to the familiar risks in commercial banking;
i.e. credit, liquidity, price, legal (compliance), foreign exchange, strategic, and reputa
tion risks. This section highlights these risks and discusses risk management
practices that can help to manage and control the risk profile effectively.
and lower the risk profile of an institution. Conversely, the improper use of
credit derivatives, as in poor lending practices, can result in an imprudent credit
risk profile.
Credit derivatives expose participants to the familiar risks in commercial banking;
i.e. credit, liquidity, price, legal (compliance), foreign exchange, strategic, and reputa
tion risks. This section highlights these risks and discusses risk management
practices that can help to manage and control the risk profile effectively.
Credit spread options
Credit spread options allow investors to trade or hedge changes in credit quality.
With a credit spread option, a protection seller takes the risk that the spread on a
reference asset breaches a specified level. The protection purchaser buys the right
to sell a security if the reference obligor’s credit spread exceeds a given ‘strike’ level.
For example, assume a bank has placed a loan yielding LIBOR plus 15 basis points
in its trading account. The bank may purchase an option on the borrower’s spread
to hedge against trading losses should the borrower’s credit deteriorate. The bank
may purchase an option, with a strike spread of 30 basis points, allowing it to sell
the asset should the borrower’s current market spread rise to 30 basis points (or
more) over the floating rate over the next month. If the borrower’s spread rises to 50
basis points, the bank would sell the asset to its counterparty, at a price corresponding
to LIBOR plus 30 basis points. While the bank is exposed to the first 15 basis
point movement in the spread, it does have market value (and thus default) protection
on the credit after absorbing the first 15 basis points of spread widening. The seller
of the option might be motivated by the view that a spread of LIBOR plus 30 basis
points is an attractive price for originating the credit exposure.
Unlike other credit derivative products, the US market for credit spread options
currently is not significant; most activity in this product is in Europe. Until recently,
current market spreads had been so narrow in the USA that investors appeared
reluctant to sell protection against widening. Moreover, for dealers, hedging exposure
on credit spread options is difficult, because rebalancing costs can be very high.
Table 11.2 summarizes some of the key points discussed for the four credit derivative
products.
With a credit spread option, a protection seller takes the risk that the spread on a
reference asset breaches a specified level. The protection purchaser buys the right
to sell a security if the reference obligor’s credit spread exceeds a given ‘strike’ level.
For example, assume a bank has placed a loan yielding LIBOR plus 15 basis points
in its trading account. The bank may purchase an option on the borrower’s spread
to hedge against trading losses should the borrower’s credit deteriorate. The bank
may purchase an option, with a strike spread of 30 basis points, allowing it to sell
the asset should the borrower’s current market spread rise to 30 basis points (or
more) over the floating rate over the next month. If the borrower’s spread rises to 50
basis points, the bank would sell the asset to its counterparty, at a price corresponding
to LIBOR plus 30 basis points. While the bank is exposed to the first 15 basis
point movement in the spread, it does have market value (and thus default) protection
on the credit after absorbing the first 15 basis points of spread widening. The seller
of the option might be motivated by the view that a spread of LIBOR plus 30 basis
points is an attractive price for originating the credit exposure.
Unlike other credit derivative products, the US market for credit spread options
currently is not significant; most activity in this product is in Europe. Until recently,
current market spreads had been so narrow in the USA that investors appeared
reluctant to sell protection against widening. Moreover, for dealers, hedging exposure
on credit spread options is difficult, because rebalancing costs can be very high.
Table 11.2 summarizes some of the key points discussed for the four credit derivative
products.
Credit-linked Notes
A credit-linked note (CLN) is a cash market-structured note with a credit derivative,
typically a CDS, embedded in the structure. The investor in the CLN sells credit
protection. Should the reference asset underlying the CLN default, the investor (i.e.
protection seller) will suffer a credit loss. The CLN issuer is a protection buyer. Its
obligation to repay the par value of the security at maturity is contingent upon the
absence of a credit event on the underlying reference asset. Figure 11.4 shows the
cash flows of a CLN with an embedded CDS.
A bank can use the CLN as a funded solution to hedging a company’s credit risk
because issuing the note provides cash to the issuing bank. It resembles a loan
participation but, as with other credit derivatives, the loan remains on the bank’s
books.
The investor in the CLN has sold credit protection and will suffer a loss if XYZ
defaults, as the issuer bank would redeem the CLN at less than par to compensate
it for its credit loss. For example, a bank may issue a CLN embedded with a fixed
payout (binary) default swap that provides for a payment to investors of 75 cents on
the dollar in the event a designated reference asset (XYZ) defaults on a specified
obligation. The bank might issue such a CLN if it wished to hedge a credit exposure
to XYZ. As with other credit derivatives, however, a bank can take a short position if
it has no exposure to XYZ, but issues a CLN using XYZ as the reference asset. Like
the structured notes of the early 1990s, CLNs provide a cash market alternative to
investors unable to purchase off-balance sheet derivatives, most often due to legal
restrictions.
CLNs are frequently issued through special-purpose vehicles (SPV), which use the
sale proceeds from the notes to buy collateral assets, e.g. Treasury securities or
money market assets. In these transactions, the hedging institution purchases
default protection from the SPV. The SPV pledges the assets as collateral to secure
any payments due to the credit hedger on the credit default swap, through which
the sponsor of the SPV hedges its credit risk on a particular obligor. Interest on the
collateral assets, plus fees on the default swap paid to the SPV by the hedger,
generate cash flow for investors. When issued through an SPV, the investor assumes
credit risk of both the reference entity and the collateral. When issued directly, the
investor assumes two-name credit risk; it is exposed to both the reference entity and
the issuer.
Credit hedgers may choose to issue a CLN, as opposed to executing a default swap,
in order to reduce counterparty credit risk. As the CLN investor pays cash to the
issuer, the protection buying issuer eliminates credit exposure to the protection
seller that would occur in a CDS.
Dealers may use CLNs to hedge exposures they acquire by writing protection on
default swaps. For example, a dealer may write protection on a default swap, with
XYZ as the reference entity, and collect 25 basis points. The dealer may be able to
hedge that exposure by issuing a CLN, perhaps paying LIBORò10 basis points, that
references XYZ. The dealer therefore originates the exposure in one market and
hedges it in another, arbitraging the difference between the spreads in the two
markets.
typically a CDS, embedded in the structure. The investor in the CLN sells credit
protection. Should the reference asset underlying the CLN default, the investor (i.e.
protection seller) will suffer a credit loss. The CLN issuer is a protection buyer. Its
obligation to repay the par value of the security at maturity is contingent upon the
absence of a credit event on the underlying reference asset. Figure 11.4 shows the
cash flows of a CLN with an embedded CDS.
A bank can use the CLN as a funded solution to hedging a company’s credit risk
because issuing the note provides cash to the issuing bank. It resembles a loan
participation but, as with other credit derivatives, the loan remains on the bank’s
books.
The investor in the CLN has sold credit protection and will suffer a loss if XYZ
defaults, as the issuer bank would redeem the CLN at less than par to compensate
it for its credit loss. For example, a bank may issue a CLN embedded with a fixed
payout (binary) default swap that provides for a payment to investors of 75 cents on
the dollar in the event a designated reference asset (XYZ) defaults on a specified
obligation. The bank might issue such a CLN if it wished to hedge a credit exposure
to XYZ. As with other credit derivatives, however, a bank can take a short position if
it has no exposure to XYZ, but issues a CLN using XYZ as the reference asset. Like
the structured notes of the early 1990s, CLNs provide a cash market alternative to
investors unable to purchase off-balance sheet derivatives, most often due to legal
restrictions.
CLNs are frequently issued through special-purpose vehicles (SPV), which use the
sale proceeds from the notes to buy collateral assets, e.g. Treasury securities or
money market assets. In these transactions, the hedging institution purchases
default protection from the SPV. The SPV pledges the assets as collateral to secure
any payments due to the credit hedger on the credit default swap, through which
the sponsor of the SPV hedges its credit risk on a particular obligor. Interest on the
collateral assets, plus fees on the default swap paid to the SPV by the hedger,
generate cash flow for investors. When issued through an SPV, the investor assumes
credit risk of both the reference entity and the collateral. When issued directly, the
investor assumes two-name credit risk; it is exposed to both the reference entity and
the issuer.
Credit hedgers may choose to issue a CLN, as opposed to executing a default swap,
in order to reduce counterparty credit risk. As the CLN investor pays cash to the
issuer, the protection buying issuer eliminates credit exposure to the protection
seller that would occur in a CDS.
Dealers may use CLNs to hedge exposures they acquire by writing protection on
default swaps. For example, a dealer may write protection on a default swap, with
XYZ as the reference entity, and collect 25 basis points. The dealer may be able to
hedge that exposure by issuing a CLN, perhaps paying LIBORò10 basis points, that
references XYZ. The dealer therefore originates the exposure in one market and
hedges it in another, arbitraging the difference between the spreads in the two
markets.
Total return swaps
In a total return swap (TRS), the protection buyer (‘synthetic short’) pays out cash
flow received on an asset, plus any capital appreciation earned on that asset. It
receives a floating rate of interest (usually LIBOR plus a spread), plus any depreciation
on the asset. The protection seller (‘synthetic long’) has the opposite profile; it receives
cash flows on the reference asset, plus any appreciation. It pays any depreciation to
the protection buying counterparty, plus a floating interest rate. This profile establishes
a TRS as a synthetic sale of the underlying asset by the protection buyer and
a synthetic purchase by the protection seller. Figure 11.3 illustrates TRS cash flows.
TRSs enable banks to create synthetic long or short positions in assets. A long
position in a TRS is economically equivalent to the financed purchase of the asset.
However, the holder of a long position in a TRS (protection seller) does not actually
purchase the asset. Instead, the protection seller realizes all the economic benefits
of ownership of the bond, but uses the protection buyer’s balance sheet to fund that
‘purchase’.
TRSs enable banks to take short positions in corporate credit more easily than is
possible in the cash markets. It is difficult to sell short a corporate bond (i.e. sell a
bond and hope to repurchase, subsequently, the same security at a lower price),
because the seller must deliver a specific bond to the buyer. To create a synthetic
short in a corporate exposure with a TRS, an investor agrees to pay total return on
an issue and receive a floating rate, usually LIBOR (plus a spread) plus any depreciation
on the asset. Investors have found TRSs an effective means of creating short
positions in emerging market assets.
A TRS offers more complete protection to a credit hedger than does a CDS, because
a TRS provides protection for market value deterioration short of an outright default.
A credit default swap, in contrast, provides the equivalent of catastrophic insurance;
it pays out only upon the occurrence of a credit event, in which case the default
swap terminates. A TRS may or may not terminate upon default of the reference
asset. Most importantly, unlike the one-way credit exposure of a CDS, the credit
exposure in a TRS goes both ways. A protection buyer assumes credit exposure of
the protection seller when the reference asset depreciates; in this case, the protection
seller must make a payment to the protection buyer. A protection seller assumes
credit exposure of the protection buyer, who must pay any appreciation on the asset
to the protection seller. A protection buyer will suffer a loss only if the value of the
reference asset has declined and simultaneously the protection seller defaults. A
protection seller can suffer a credit loss if the protection buyer defaults and the value
of the reference asset has increased.
In practice, banks that buy protection use CDSs to hedge credit relationships,
particularly unfunded commitments, typically with the objective to reduce risk-based
capital requirements. Banks that sell protection seek to earn the premiums, while
taking credit risks they would take in the normal course of business. Banks typically
use TRSs to provide financing to investment managers and securities dealers. TRSs
thus often represent a means of extending secured credit rather than a credit hedging
activity. In such cases, the protection seller ‘rents’ the protection buyer’s balance
sheet. The seller receives the total return of the asset that the buyer holds on its
balance sheet as collateral for the loan. The spread over LIBOR paid by the seller
compensates the buyer for its funding and capital costs.
Credit derivative dealers also use TRSs to create structured, and leveraged, investment
products. As an example, the dealer acquires $100 in high-yield loans and
then passes the risk through to a special-purpose vehicle (SPV) by paying the SPV
the total return on a swap. The SPV then issues $20 in investor notes. The yield, and
thus the risk, of the $100 portfolio of loans is thus concentrated into $20 in securities,
permitting the securities to offer very high yields.7
flow received on an asset, plus any capital appreciation earned on that asset. It
receives a floating rate of interest (usually LIBOR plus a spread), plus any depreciation
on the asset. The protection seller (‘synthetic long’) has the opposite profile; it receives
cash flows on the reference asset, plus any appreciation. It pays any depreciation to
the protection buying counterparty, plus a floating interest rate. This profile establishes
a TRS as a synthetic sale of the underlying asset by the protection buyer and
a synthetic purchase by the protection seller. Figure 11.3 illustrates TRS cash flows.
TRSs enable banks to create synthetic long or short positions in assets. A long
position in a TRS is economically equivalent to the financed purchase of the asset.
However, the holder of a long position in a TRS (protection seller) does not actually
purchase the asset. Instead, the protection seller realizes all the economic benefits
of ownership of the bond, but uses the protection buyer’s balance sheet to fund that
‘purchase’.
TRSs enable banks to take short positions in corporate credit more easily than is
possible in the cash markets. It is difficult to sell short a corporate bond (i.e. sell a
bond and hope to repurchase, subsequently, the same security at a lower price),
because the seller must deliver a specific bond to the buyer. To create a synthetic
short in a corporate exposure with a TRS, an investor agrees to pay total return on
an issue and receive a floating rate, usually LIBOR (plus a spread) plus any depreciation
on the asset. Investors have found TRSs an effective means of creating short
positions in emerging market assets.
A TRS offers more complete protection to a credit hedger than does a CDS, because
a TRS provides protection for market value deterioration short of an outright default.
A credit default swap, in contrast, provides the equivalent of catastrophic insurance;
it pays out only upon the occurrence of a credit event, in which case the default
swap terminates. A TRS may or may not terminate upon default of the reference
asset. Most importantly, unlike the one-way credit exposure of a CDS, the credit
exposure in a TRS goes both ways. A protection buyer assumes credit exposure of
the protection seller when the reference asset depreciates; in this case, the protection
seller must make a payment to the protection buyer. A protection seller assumes
credit exposure of the protection buyer, who must pay any appreciation on the asset
to the protection seller. A protection buyer will suffer a loss only if the value of the
reference asset has declined and simultaneously the protection seller defaults. A
protection seller can suffer a credit loss if the protection buyer defaults and the value
of the reference asset has increased.
In practice, banks that buy protection use CDSs to hedge credit relationships,
particularly unfunded commitments, typically with the objective to reduce risk-based
capital requirements. Banks that sell protection seek to earn the premiums, while
taking credit risks they would take in the normal course of business. Banks typically
use TRSs to provide financing to investment managers and securities dealers. TRSs
thus often represent a means of extending secured credit rather than a credit hedging
activity. In such cases, the protection seller ‘rents’ the protection buyer’s balance
sheet. The seller receives the total return of the asset that the buyer holds on its
balance sheet as collateral for the loan. The spread over LIBOR paid by the seller
compensates the buyer for its funding and capital costs.
Credit derivative dealers also use TRSs to create structured, and leveraged, investment
products. As an example, the dealer acquires $100 in high-yield loans and
then passes the risk through to a special-purpose vehicle (SPV) by paying the SPV
the total return on a swap. The SPV then issues $20 in investor notes. The yield, and
thus the risk, of the $100 portfolio of loans is thus concentrated into $20 in securities,
permitting the securities to offer very high yields.7
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