Lecture 6

Credit derivatives and

securitisation
 Learning objectives
• Explain the nature of credit derivatives
• Describe how credit derivatives can service
for credit risk portfolio management
• Detail the motivations and principles of
securitisation
 Credit derivatives
• Instruments serving to trade credit risk by
isolating the credit risk from the underlying
transactions
– Flexible instruments that can be used to
rebalance the credit of their portfolios
• Three main categories: credit default
swaps, total return swaps and credit
options
– A protection seller, a protection buyer, and the
underlying assets
 Credit default swaps

• The buyer of CDS

– Pays a recurring premium
– Receive a loss under default payment
• CDS is quoted with the premium in basis points
(100 bps=1%)
• For reference assets, credit events includes
– Payment obligation default
– Bankruptcy or insolvency event
– Restructuring or equivalent
– Rating downgrades beyond a specified threshold
– Change of credit spread exceeding a specified
level
• Loss under default is a standard practice of
rating agencies for assess the LGD
– Alternatively, a fixed LGD amount as a percentage
face value of the bond
 Correlation products
• Basket derivatives provide protection against the
defaults within a basket/portfolio
• A first to default derivatives provides a payment if
any single asset within the basket is the first
default
• Instruments for trading the correlation between
portfolios of credit products
• Diversification can reduce the risk of basket but it
does not reduce the risk of first-to-default
derivatives
• The probability of zero default within a basket
is the joint probability that all survive
• This joint survival probability is higher when
the correlation is positive
– One assets or more defaults is the complement
of the joint survival probability
– Correlation increases, meaning the basket is less
diversified, the joint survival probability increases
and the probability that at least one default is
lower
• Two independent assets of DP is 1% and 2%
– Joint survival probability is 99%*98%=97.02%
– The probability that any one of both defaults is 1-97.02%
= 2.98%
• Greater than any one of the two single DP
• The risk of first-to-default baskets is greater than for single assets
– If correlation increases, the joint survival probability
increases above 97.02%
– The probability that at least one defaults becomes lower
than 2.98%
– The risk of the product is lower when the correlation of
the portfolio increases
 Some notes of CDS
• Risk of default products is inversely related to
correlation
– Seller is selling default correlation or being short correlation
– Buyer is long correlation
• Basket products have benefits for both protection buyer
and seller
– For buyer: Very large exposures of high-grade obligors to
hedge. Insuring them together in a portfolio makes sense
– For seller:
• Some comfort in finding high-grade exposures in the basket
• Pooling together into a first-to-default derivative, the credit quality of the
derivative is lower than that of any one high-grade asset
• An eligible investment in low-risk assets with an enhanced return
compared to the returns of individual high-grade assets
 Usage of credit derivatives
• Transferring or customizing credit risks, taking
synthetic exposure or replicating risky assets
• Banks are protection seekers
– Capping exposures and diversifying the loan
portfolio in other industries
– Credit derivatives as the additional option
• Users can leverage the actual exposure to an
underlying assets by using a notional different
from the actual asset value
• A banks can diversify some the risk of its
portfolio by selling CDS
– CDS sold replicate assets and are synthetic
exposures
– Synthetic exposures are unfunded
– A sold CDS has a capital charge for credit risk
• CDs are used for trading different expectations
on the same risks
– Credit spreads embed expectations of DPs and
recoveries
 Credit portfolio management

• Is closely related to the business model of

banks
• Buy and hold business model: Bank
originates loans and keeps them in its
balance sheet until maturity (or default)
• Originate and distribute model: Bank
originates loans and sell their risk, freeing
up some capital for originating new
business
• Main techniques for managing the credit
portfolio include securitisation and credit
risk trading
– Securitisations for long time for managing
credit portfolios
– Securitisations involve the sale of asses to a
vehicle financed in the market
– Credit derivatives allow the sale of the credit
risk of portfolio without selling the assets
• An active credit portfolio management
refers to actions for reshaping and
enhancing the risk-return profile of the
credit portfolio of the bank
– Developing new business by offloading credit
risk onto the markets
– Freeing capital for expanding activities
– Taking advantage of price discrepancies of the
same credit risk, on the balance sheet of a
banks and in the market
 Trading credit risk and the return
on capital
• Capital base depends on exposures hedged or
gained from the CDSs
• The return depends on CDS premium paid for
hedging or received from selling credit protection
• Regulatory arbitrage
– Take advantage of price discrepancies for the same
credit risk, on the balance sheet and in the market
– The capital-based price of credit risk on the balance
sheet does not match with the market price of the
same credit risk
• For example
– A bank hedges a loan by buying a CDS from
another bank
– CDS does not have the loan as underlying
asset but a traded assets
– Capital charge is lower if the risk weight of the
loan is higher than the risk of the bank selling
the CDS
– The discrepancy can enhance the return on
capital
• Let’s take a look
– The risk weight of corporate borrower is 100%
– 20% for a banking counterparty of good credit
quality
– The capital charge of a corporate loan is 8%
– If the loan is hedged with the bank, the capital
charge is 20%* 8%=1.6%
– With a capital ratio of 8%, the funding of the
loan is 92% and the rest is capital
• The spread on loans over the funding cost is
100 bps with a portfolio yield is 6% and
bank’s debt costing is 5%
• Capital charge is 8% of loan (risk weight of
100% and LGD 100%)
• The debt size is 92>> the cost is 5%*92=4.6
• Before any derivative transaction, the earning
pre-tax: 6-4.6=1.4
• ROE: 1.4/8=17.50%
• When buying protection, given the lower risk weight
of the seller of CDS of 20%
• The capital charge now is 1.6
• If the premium paid for hedging the loan with a
CDS is 60 bps
– Direct effect on earning is a decline of 0.6 for a notional
of CDS of 100
– Earning also declines further as debt backing the loans
increases by the amount of capital saved
– The additional debt is 8-1.6=6.4
• The cost of incremental debt: 5%*6.4= 0.32.
• New earning: 6-5-0.32-0.6= 0.480
• New ROE after hedging: 0.48/1.6=30%
• >>>hedging has leverage the ROE from
17.50% to 30%
• What is the condition for a positive
leverage effect?
• The new return on capital is higher than
the initial return on capital when
• r: Return of portfolio.
• i: Cost of bank’s debt.
• k1: Capital before hedging, in percentage of
portfolio size.
• k2: Capital after hedging with CDS, in
percentage of portfolio size.
• p: CDS premium, in % of notional hedged.
• The ratio of final capital to initial capital is:
k2/k1=1:6%/8%=0.2.
• 1 –p/(r –i)=1-0.6%/(6%-5%)=0.4.
• The bank can also sell a CDS for minimizing its
hedging cost
– The capital charge for a sold credit derivative is identical
to the capital charge of a direct exposure to a corporation.
– Earn the recurring fee from the CDS sold
– Have an additional exposure, and capital charge, for credit
risk.
– By entering into such trades, the bank might enhance its
risk-adjusted return
• Such synthetic exposure is unfunded,
– No impact on bank’s debt,
– The additional capital charge.
• Assuming that the capital charge is k3 and the premium on CDS
sold is p.
• The return on capital from CDS sold is simply: p=k3.
• Assume a capital charge of 8% of notional and a premium of CDS
sold of p = 1%.
• The return on capital 1%/8% = 12.5%. This is less than the original
return on capital.
• By combining CDSs purchased and sold, the bank mitigates its
cost and could enhance its initial return.
• This calculation does not consider any diversification effect from
the new synthetic exposure.
• Credit derivatives can also serve for other arbitrage
between returns based on ratings and economic
returns.
• A bank can assemble a portfolio of credit derivatives,
– Sell the risk to investors
– Earn the corresponding market premium.
• The investors buy the risk based on the assessment
of the same risk by rating agencies.
• The bank can potentially earn a positive differential
between the market price of the risks sold in the
market and the rating-based spread paid to investors.
 Securitisation
• A mechanism that allows assets to be sold on
the capital markets, using the cash flows from
assets for compensating investors in asset-
backed notes.
• The securitized assets are removed from the
balance sheets of banks,
• A core process of the “originate and
distribute” business model,
– Banks originate credit and distribute the financing
of their loans across investors in the capital
markets
 The motivations of
Securitisation
• Traditional lending consists of lending and
keeping the loans in the banking portfolio
until maturity
– Assets held on balance sheet require a
financing that could potentially be used
elsewhere if they could be sold
– Loans withheld in the balance sheet freeze the
capital required by regulators
– excluding origination of new loans if the bank
has capital constraints
• The mechanism facilitated the financing of growing
economies
– The same capital base could be reused for new loans
– Securitizations became a major source of funding for banks
• Take advantage of discrepancies between the cost of
financing on balance sheet and the cost of financing
the same assets in the market.
• Such discrepancies arise from regulatory capital
charges standardized across banks
• Such discrepancies also arise from differing
perceptions of the same risk by banks and by credit
rating agencies.
• The securitization process was disrupted at the
time of the financial crisis
– Investors perceived the securitization vehicles as
disseminating toxic risks throughout the financial
system.
• Securitizations have virtually stopped since the
crisis.
• The securitization mechanism relies on sound
economics and should reappear perhaps in new
forms, and under more conservative approaches
for assessing the risk of asset-backed bonds
The principles of securitisations
• Financial assets generating cash flows, interest and principal
repayments, sold to investors
– The cash flows from assets are sufficient to provide them with an
adequate compensation.
• The assets are sold to special purpose vehicles
– Issue bonds backed by the assets and acquired by capital market
investors.
– Several notes are issued by the same vehicle.
– The proceeds of these issues serve for acquiring the securitized assets.
– The pool of loans makes up the asset side of the SPE.
– In a non-recourse sale of loans to the SPE, the investors have no claim on
the seller of loans
• The seller is the bank who originated the loans.
• Investors are compensated by the cash flows from assets.
• The credit risk is not borne by the seller of assets but by the
 The mechanism of securitisation
• Is feasible only if the investors in the notes issued by the
SPE receive a return in line with the risk of their
investments
• Rating agencies provide the required risk assessment of
these notes, which allows the rated notes to become
tradable securities
• The cost of financing the assets in the securitization
vehicle is the weighted average return of SPE notes
required by investors
• The return from securitized assets should, at least,
match this weighted cost of financing.
• Assets include mortgages, credit cards receivables,
leasing receivables, bonds of various credit standing
and industrial or commercial corporate loans
• The pool of assets securitized can be static,
replenished periodically or managed
• Traded assets form a portfolio that can be actively
managed during the life of the transaction, subject to
the terms of contract governing the SPE.
• In theory, any asset generating cash flows can be
sold to investors through an SPE
• Cash securitizations are transactions where assets are
effectively sold to an SPE.
• Synthetic securitizations use credit derivatives for selling
only the credit risk of a pool of assets without selling the
underlying assets.
– The SPE is the seller of the credit derivative - the buyer of the
risk
– The bank is the buyer of protection and seller of the risk
– The proceeds from investors are invested in risk-free assets.
– The bank pays an insurance premium to the SPE, which is
added to the risk-free return from the SPE investment in
Treasuries, and allows the SPE to reconstruct a credit risky
return
Organisation of securitisation
• The bank sells the assets to the securitization vehicle,
which is bankruptcy remote.
• The SPE issues a series of notes, differing by their risk,
of which credit standing is assessed by rating agencies
for making them eligible investments for investors.
• The “arranger”, typically an investment bank, structures
the transaction, and is usually an investment bank.
• The “servicer”, usually the bank who sold the loans, takes
care of day-to-day relations with the borrowers whose
loans have been securitized, during the life of the
transaction
 The structuring of securitisation
• In a pass-through vehicle, the cash flows of
the assets are passed on to the notes
issued by the vehicle.
– Several notes are issued by the same vehicle,
each class of notes can be backed by a
dedicated subpool of assets.
– In a pure pass-through mechanism, the risk of
each note is identical to the risk of the pool of
assets.
• Use a credit enhancement mechanism for mitigating
the risk of notes issued.
– Investors can be protected from the first losses of the
portfolio securitized by oversizing the size of the pool relative
to what is needed to service the claims of investors.
– Since only a fraction of the pool is sufficient to compensate
these investors, the overcollateralization of notes provides a
safety cushion against adverse deviations of the flows
generated by the pool
– An oversized pool of assets would generate a cash flow of
100, when only 80 are necessary to compensate investors.
– The risk of loss for investors materializes only when the
actual cash flow goes under 80.
• Modern securitizations relied on a structuring of the
notes issued by the SPE.
– The SPE does not issue a single class of bond that would
bear the entire risk of the portfolio of assets securitized.
– It issues several types of notes of different seniority
levels.
– A specific feature of a securitization is that the default of
one class of notes, such as the riskiest notes, does not
trigger the default of other more senior notes of the SPE.
– Bonds backed by assets are called “notes” or “structured
notes”.
• The variety of notes issued allows customizing the risk of
these various issues to the profiles of potential investors
• Structuring consists of defining how many classes of notes
should be issued, the size and the risk of each one
• The difference between the expected return of assets and
the cost of financing the vehicle = the “excess spread”.
• The cost of financing the SPE = the weighted average of the
required returns by investors, the weights being those of
each note.
• The excess spread does not belong to the investors.
– Released to the seller of assets over the life of the transactions or
at maturity.
• The subordination level of a note is defined by its
attachment point and its thickness, or size
• The higher this “safety cushion”, the lower the risk of
the note protected by more subordinated notes.
• The most subordinated tranche is the equity tranche,
which concentrates the first losses of the portfolio
and has no rating
• If the seller keeps the equity tranche, it is held on the
asset side for a value of zero
– The portfolio losses will entirely absorb this tranche.
• On the liability side, a cash account is dedicated to the
tranche and debited when losses hit the equity tranche.
• If the equity tranche is sold, the investor benefits from an
upfront premium and a higher spread than other
tranches, as a compensation for holding this highest risk.
• The return depends on how long the equity tranche
survives, and hence on the timing of defaults of the pool
of assets.
• If the size of subordinated notes is 30% of
the portfolio, the probability of losing 30%
of the portfolio is extremely small.
• A senior note can therefore be rated AAA.
When moving down the scale of seniority,
the risk of notes increases as they benefit
from a much lower loss franchise.
• The structure routes the cash flows generated by the pool of
assets to investors using priority rules based on the seniority
level, first to senior notes and last to the equity tranche
• The mechanism is the “waterfall” of cash flows, describing
how cash flows cascade from one tranche to the next. The
“waterfall of losses” follows symmetrical paths.
• The losses first hit the equity tranche, then the subordinated
notes and finally the senior notes.
 The economics of securitisation
• To free up capital for expanding business volume
• The expected return on assets of the SPE
should be at least equal to the return required by
investors in the SPE notes.
• The difference is the excess spread, which
potentially belongs to the seller of the loans.
• The spread depends on a number of factors:
– The yield of assets (loans) sold by the bank to the
SPE;
– The market spreads applicable to the notes issued
by the SPE
– The direct costs of setting up a securitization.
 Analysis of securitisation transaction
• The portfolio of loans of a bank has an annual expected return of
10.20%.
• The risk-free rate is 9%. The debt on the balance sheet of the bank is
rated A, corresponding to a spread of 1% over the risk free rate.
• The assets have a risk weight of 100% and the capital ratio is 8%.
• The required return on equity before tax is 20%.
• The bank considers securitizing an amount of loans, of size $1,000
million, from a total loan portfolio, the size of which is $10,000 million.
• In the securitization, the pool of loans is financed with notes sold to
investors in the SPE.
• There are two classes of tranches issued to investors. The
subordinated tranche represents 25% of the amount securitized. The
credit spread required over the 9% risk-free rate is 2% (200 bps).
• The senior tranche represents 75% of the pool of loans, is investment
grade, is rated AA and its credit spread is 0.50% above the risk-free
rate.
• The direct costs of the securitization
include a legal cost and the servicing cost.
– The servicing of loans is born by the bank that
has the relationship with the clients, and its
cost is netted from the return of loans.
– The legal cost, annualized, is 0.15% of the
face value of securitized loans.
• These costs are senior costs: they should
be paid before investors are compensated.
 Analysis of related costs

• The cost of financing loans on balance sheet is the weighted

average cost (WAC) of the bank
• This cost of financing is higher than the net yield of loans.
• The effective return on capital is lower than the minimum of
20% required.
• This can be checked directly by calculating the earnings of
the bank with the current portfolio.
• Given expected return on assets, the
book return on capital is 12.50%, lower
than the required 20%
• The cost of financing through securitization is the WAC of
the notes issued, using the credit spreads matching the
ratings of the two classes of notes.
• The direct operating cost of setting up the securitization
vehicle is not included at this stage.
• The cost of financing loans through securitization is
9.825%
• WAC-S is lower than on-balance sheet (10.80%) and the net
yield of loans.
• The cost of financing through securitization might or not be
lower than on-balance sheet, depends on market spreads
• The full cost of financing through securitization includes the
direct operating costs of setting up the SPE and the servicing
cost.
• The all-in cost of financing with securitization is the sum of the
required return by investors (assuming 0.15%) and of direct
costs: 9.975%.
– Still lower than the cost of financing on-balance sheet and the loan
yield
• The securitization generates a positive excess spread, is:
10.2% - 9.975% = 0.225%.
• With a securitized portfolio of 1,000, the value of this spread is
• This excess revenue does not belong to
investors and goes back to the bank as
additional earnings.
• The effective usage of the excess spread
depends on the covenants governing the
securitization.
• The excess spread can remain trapped in the
SPE as an additional safety cushion under
adverse conditions, before being released.
 ROE after securitisation

• Once the loan is sold to the SPE, the bank is left

with a smaller portfolio, 10, 000 -1,000 = 9,000.
• The bank loses the earnings of the securitized
portfolio but earns the excess spread
• The initial cost of financing is the cost of
bank’s debt, weighted 92%.
• The final cost of financing is the cost of the
SPE notes, weighted 100%.
• The differential earnings, before and after
securitization, is the difference between
these two costs: (92%*10% - 100%
*9.975%)* 1,000 = 7.75
– Equal to the variation of bank earnings before
and after securitisation
• The new return on capital is 12.81%, higher than
before securitization
• The new return on capital can be decomposed into
the initial return on capital plus an additional return –
on the same capital – resulting from the excess
spread.
• The capital after securitization is 720 and the excess
spread 2.25.
– The incremental return on capital is 2.25/720= 0.312%.
– This is exactly the difference between the original return on
capital, 12.50%, and the final return on capital of 12.812%.
 The pricing of assets
• The seller can capture upfront the excess
spread by selling assets at a price such that
the return on assets acquired by the SPE
matches the required return for investors
• The securitized loans can be sold at a higher
price than face value, given that they yield
more than what is required to absorb senior
costs and compensate investors
 Variations in the
securitisation scheme
• The bank might retain a fraction of the retained
tranche
• The bank’s earnings combine several effects: the
lost earnings from the portfolio; the additional cost
of bank’s debt, weighted 100%, for the retained
tranche; and the algebraic excess spread from the
SPE, recalculated with the new weights of the
senior and junior tranches.
• The resulting variation of earnings can be also
seen as a differential cost of financing,without and
with securitization
• Synthetic securitizations are a different scheme
– The entire portfolio is retained on-balance sheet.
– The bank buys from the SPE a credit derivative that ensures
the portfolio in exchange for the recurring premium paid by
the bank to the SPE.
– Investors earn the premium, which is added on top of risk-
free rate, from investing risk-free the cash from investors, to
reconstruct a yield.
– The capital allocation for the portfolio ensured by the credit
derivative is lower.
• For making the transaction safe for the bank, the risk-
free assets of the SPE can be pledged as collateral for
the benefit of the bank
 The risk of asset-backed notes
• The methodologies for assessing the credit standing
of notes include stress scenarios and credit portfolio
models
• All factors that have an influence on the loss rates of
the portfolios backing the notes directly affect the
credit standing of the notes:
– The delinquency rate (delays in payment),
– The charge-off rate (losses due to default),
– The payment rate (both monthly payments of interest and
principal),
– The recovery rate (both percentage amount and timing of
recoveries) and the average yield of the portfolio of loans.
• Stress-test such factors and find out under which
scenarios losses affect the notes
• Credit portfolio models can serve the same purpose of
assessing the risk of the notes issued by the SPE
• The probability that some individual tranche defaults is
the probability that a minimum number of all assets
default.
• Its risk is comparable to an N-to-default basket.
• Like such baskets, the risk of tranches of
securitizations is directly dependent on correlations
between defaults