The British Bankers Association (BBA) estimated that the global credit derivatives market (excluding asset swaps) was about $1.2 trillion by the end of 2001. Expectations are that the credit derivatives market will grow rapidly in the next few years. The BBA projects that without con- sidering asset swaps the global credit derivatives market will grow to
$4.8 trillion by 2004; the market is projected to exceed $5 trillion if asset swaps are included.20
As with every financial innovation, there will be setbacks in the mar- ket. As discussed in later chapters, several have already occurred in the credit derivatives market. These have provided critics of credit deriva- tives with ammunition. The criticisms are the same as those advanced for all derivative products and several cash market products such as high- yield bonds and asset-backed securities.
While the market will grow, the impediments to growth are the fol- lowing:
■ Documentation of the transactions ■ Liquidity and transparency ■ Counterparty risk
■ Complexity of pricing ■ Hedging difficulty ■ Information asymmetries
■ Lack of understanding by end users
We will discuss documentation of a credit derivative transaction in Chapter 3. What is important to understand is that the documentation defines what a credit event is. This definition is obviously crucial since it specifies when the credit protection buyer is to receive one or more pay- ments from the credit protection seller. Market participants are structur- ing transactions to be more specific about what constitutes a credit event.
20British Bankers Association, Credit Derivatives Report 2002.
Credit derivatives have limited liquidity. There are only a few deal- ers in the market. Exhibit 1.4 provides a list of the 25 commercial banks and trust companies in the United States as of March 2002 with the most exposure to derivatives. Note the following. First, relative to their exposure to derivatives in general, credit derivatives rarely exceed 2%, and in most instances are less than 1%. Second, and most important for our point here, is that there are only seven major commercial banks/
trust companies involved in the market. As a result, there are concerns with liquidity. Since the transactions are over-the-counter trades, trans- parency is an issue. Market transparency has improved as a few firms specializing in credit derivatives have provided internet trading plat- forms. Two examples are creditex and CreditTrade.21
Due to the limited number of dealers in the credit derivatives area, counterparty risk is more pronounced than for other types derivatives.
Thus, a credit protection buyer is exposed to the credit risk of the dealer.
Since market participants seek to reduce their counterparty risk, a credit protection buyer may have to limit its exposure to credit derivatives because of overexposure to the limited number of acceptable dealers.
When the array of interest rate derivatives were first introduced, their pricing was viewed to be the province of the financial engineer.
Today, the pricing of basic interest rate derivatives is well understood by market participants. Pricing is not so simple for most credit derivative products. We will discuss the general principles of the valuation of credit derivatives in later chapters. The complexity of pricing them has made some investors who could benefit from participating in the credit derivatives market cautious about doing so. Moreover, because of their complexity it is difficult for dealers to hedge their positions, thereby reducing the number of potential dealers.22
A major concern in the market is the information asymmetry between the buyers of protection and the sellers of protection. This results in two adverse consequences to protection sellers. The first is that when banks buy protection based on credits in their loan portfolio, they often have access to information about those credits that are not readily available to the public. In fact, it could be that such information is the very reason why a bank would want to purchase credit protection.
This consequence is referred to as adverse selection. The second conse- quence of information asymmetry occurs when the protection buyer has the ability to influence the likelihood that a credit event will occur. For example, suppose a credit event includes the restructuring of a loan. If
21Their web sites are www.creditex.com and www.credittrade.com.
22Moreover, the capital charges associated with hedging have made making markets in credit derivatives less profitable.
EXHIBIT 1.4 Notional Amount of Derivatives Contracts of the 25 Commercial Banks and Trust Companies with the Most Derivative Contracts: March 31, 2002 ($ millions)
Data source: Call Report, schedule RC-L.
Source:Office of the Comptroller of the Currency.
Rank Bank Name
Total Derivatives
Total Credit Derivatives
(OTC)
Percent Credit Derivatives 1 JPMorgan Chase Bank $23,480,417 $268,429 1.1 2 Bank of America NA 9,820,528 65,733 0.7 3 Citibank National Assn. 6,683,260 77,158 1.2 4 First Union National Bank 2,304,420 4,113 0.2 5 Bank One National Assn. 957,097 5,091 0.5 6 Wells Fargo Bank NA 728,524 2,131 0.3 7 Bank of New York 425,493 1,920 0.5 8 HSBC Bank USA 368,185 801 0.2 9 Fleet National Bank 311,760 7,209 2.3 10 State Street Bank & Trust Co. 182,866 0 0.0 11 National City Bank 122,668 176 0.1 12 Keybank National Assn 78,410 0 0.0 13 Lasalle Bank National Assn. 67,817 0 0.0 14 Standard Federal Bank NA 65,936 0 0.0 15 Mellon Bank National Assn. 66,390 471 0.7 16 National City Bank of Indiana 63,544 0 0.0 17 Suntrust Bank 63,724 245 0.4 18 Bankers Trust Co. 59,604 189 0.3 19 PNC Bank National Assn. 48,627 169 0.3 20 Wachovia Bank National Assn. 41,689 96 0.2 21 Merrill Lynch Bank USA 30,992 890 2.9 22 U S Bank National Assn. 28,551 0 0.0 23 First Tennessee Bank NA 27,736 217 0.8 24 Comerica Bank 21,070 11 0.1 25 Northern Trust Co. 18,236 53 0.3 Top 25 commercial banks & TCs with
derivatives
$46,067,544 $435,100 Other 354 commercial banks & TCs with
derivatives
$263,741 $2,431 Total amounts for all 379 BKS & TCs
with derivatives
$46,331,285 $437,532
the credit protection buyer is a bank that made the loan and the bank has the authorization to restructure the loan, then the bank can cause a credit event to occur and realize a payoff by restructuring loan. Another example would be where a credit event includes a specified deterioration of the cash flows of a borrower. If the borrowing entity’s cash flows are affected by the extension of credit from the bank that is buying protec- tion, then the bank can trigger a credit event and receive a payoff from the protection seller.
Finally, as with all new markets, an understanding of the product and its application by potential market participants is critical. Credit deriva- tives are perceived as complex products. Potential end users frequently read in the popular press about fiascoes with new financial products.
That is what sells newspapers and magazines. It is not very interesting for journalists to report on how derivatives may have prevented an end user from a financial disaster.
The purpose of this book is provide the basic features and applica- tions of credit derivatives so that the reader will understand how he or she may be able to benefit from participating in this new sector of the derivatives market.
CHAPTER 2
23
Types of Credit Risk
n Chapter 1 we discussed the three types of credit risk: credit default risk, credit spread risk, and downgrade risk. Credit default risk is the risk that the issuer will fail to satisfy the terms of the obligation with respect to the timely payment of interest and repayment of the amount borrowed. To gauge the default risk, investors rely on analysis per- formed by nationally recognized statistical rating organizations that perform credit analysis of issues and issuers and express their conclu- sions in the form of a credit rating. Credit spread risk is the loss or underperformance of an issue or issues due to an increase in the credit spread. Downgrade risk is the risk that an issue or issuer will be down- graded, resulting in an increase in the credit spread. In this chapter we take a closer look at each type of credit risk.